The great policy divergence

Over the next few weeks, the US Federal Reserve and the European Central Bank are likely to put in place notably different policies. The Fed is set to raise interest rates for the first time in almost ten years.

Meanwhile, the ECB is expected to introduce additional unconventional measures to drive rates in opposite direction, even if that means putting forward downward pressure on some government bonds that are already trading at negative nominal yields.

In implementing these policies, both central Banks are pursuing domestic objectives mandated by their governing legislature. The problem is that, they may be few, if any, orderly mechanisms to manage their international repercussion of this growing divergence.

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The Fed is responding to continued indications of robust job creation in United States and other signs that the country’s economy is recovering, albeit moderately so.

Also conscious of the risk to financial stability if interest rates remain at artificially low levels, the Fed is expected to increase them when its policy-setting Federal Open Market Committee meets on December, 15-16. The move marks a turning point in the Fed’s approach to the economy.

In deciding to raise interest rates, it will be doing more than simply lifting its foot from the financial-stimulus accelerator; it will also be taking a notable step toward the multi-year normalization of its overall policy stance.

In the meantime, the ECB is facing a very different set of economic conditions, including generally sluggish growth, the risk of inflation, and worries about the impact of the terrorist attacks in Paris on business and consumer confidence.

As a result, the bank’s decision-makers are giving serious consideration to putting the account rate further into negative territory and extending its large-scale assets-purchase program (otherwise known as quantitative easing). In other words, the ECB is likely to expand and extend experimental measures that will press even harder on financial-stimulus accelerator.

In a perfect world, policy-makers would have assessed the potential for international spillovers from these divergent policies (including possible spillbacks on both sides of the Atlantic) and put in place a range of instruments to ensure a better alignment of domestic and global objectives.

Unfortunately, political polarization and general policy dysfunction in both the US and European Union continue to inhibit such an effort. As a result, lacking a more comprehensive policy response, the harmonization of Central Banks’ divergent policies will be left in the market in particular, those fixed-income assets and currencies.

Already, the interest-rate differential between “risk-free” bonds on both sides of the Atlantic – say US Treasuries and German Bunds – has widened notably. And at the same time, the dollar has strengthened not only against the euro but also against most other currencies. Left unchecked, these trends are likely to persist.

If history is any guide there are three major issues that warrant careful monitoring in the coming months. First, the US is unlikely to stand by for long if its currency appreciates significantly and its international competitiveness deteriorates substantially.

Companies are already reporting earning pressures due to the rising dollar and some are even asking their governments to play a more forceful role in countering a stealth “currency war.”

Second, because the dollar is used as a reserve currency, a rapid rise in its value could put pressure on those who have used it imprudently. As particular risk are emerging-country that, having borrowed overwhelmingly in dollars but generating only limited dollar earnings, might have large currency mismatches in their assets and liabilities on their incomes and expenditures.

And, finally, sharp movements and interest rates and exchange rates can cause volatility in other markets, most notably for equities. Because regulatory controls and market constraints have made brokers less able to play a counter cyclical role by accumulating inventory in their balance sheets, the resulting price instability is likely to be large.

There is a risk that some portfolios will be forced into disordered unwinding. Furthermore, the central banks’ policy of curtailing so called “volatile volatility” is likely to be challenged.

Of course, none of these outcomes is preordained. Politicians on both sides of the Atlantic have the ability to lower the risk of instability by implementing structural reforms insuring more balanced aggregate demand, removing pockets of excessive indebtedness and smoothen out the mechanisms of multi-lateral and regional governance.

The three possible outcomes of all this include a relatively stable multi-speed world, notable disruptions that undermine the US’s economic recovery and a European revival that benefits from US growth.

The good news is that the Impact of divergence will depend on how policy makers manage its pressures. The bad news is that they have yet to find the political will to act decisively to minimize the risk.


Is a Chief Economic Adviser at Allianz and a member of its International Executive Committee, is Chairman of President Barack Obama’s Global Development Council. He previously served as CEO and co-Chief investment Officer of PIMCO. Project Syndicate.


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