The ECB and the US Federal Reserve, world’s top two central banks, accept they will face periodic market jolts as they move in opposite policy directions, senior officials say, with such risks inevitable given the hugely differing fortunes of the U.S. and European economies.
The European Central Bank and U.S. Federal Reserve – which appear poised respectively to ease and tighten monetary policy – talk to each other regularly but do not coordinate policy or try to guess what the other may do next, the central bankers say.
The banks’ strategy is to factor in financial market moves that may result from their divergent paths without trying to counter them through monetary policy, they say.
The ECB surprised markets last month by raising the prospect of easing as soon as December. By contrast, with the U.S. economy in a buoyant state, the Fed delivered an unexpectedly hawkish message, boosting the chance that it will raise rates next month after keeping them near zero for almost seven years.
Together, these signals sent the euro down by more than 5 percent against the dollar in a matter of weeks, and this is unlikely to be last sharp market move as a number of leading central banks act.
A Fed increase is likely to be followed by the Bank of England sometime next year as the British recovery gathers strength. But growth is anaemic in the euro zone and slowing sharply in China, where the People’s Bank of China is already easing policy. The Bank of Japan and the Reserve Bank of Australia have also both flagged the potential for more easing.
“Now we are going to enter a period of divergence,” an ECB Governing Council member said. “We’re going into this with our eyes open. It reflects the different stages in the cycle on different continents.”
ECB Governing Council member Ardo Hansson also argues that such divergences are a fact of life.
“The monetary policy of other jurisdictions is an external factor that we can’t influence. It’s like the weather, we factor it in but it’s a given,” Hansson said. “It of course matters, it’s like the exchange rate, it has an impact as a policy variable so you factor it into the outlook.”
Another Governing Council member, who asked not to be named, said the euro’s exchange rate had not been widely discussed at previous ECB policy meetings, and there had been no attempt to manage currency rates.
Citigroup estimates markets have priced in 115 basis points of Fed rate increases between January 2016 and January 2018. Anything more than this very gradual course could cause some upset.
“The risk is if the Fed lift-off is quicker than now expected … that could significantly increase market volatility and make it difficult for us to shrug off the Fed,” a third Governing Council member said.
YELLEN’S COMMITTEE STYLE
Sources close to the Fed said U.S. central bankers are reluctant to discuss policy with others because its upcoming decisions are far less certain under Fed chief Janet Yellen’s committee style of decision-making. Officials also fear the consequences of making or discussing policy behind closed doors with foreign counterparts, the sources said.
The Fed also factors exchange rate movements into its decisions. However, most U.S. foreign trade is invoiced in dollars, so the currency’s impact on the real economy is much less direct than in the euro zone, and complaints from U.S. exporters about the dollar’s strength have been muted.
Nevertheless, Fed Governor Lael Brainard said the economy was feeling the dollar effect, which has already tightened monetary conditions somewhat. “We have seen about 15 percent broad real appreciation in the exchange rate over the past year, which is a drag on prices and exports,” she said.
“We’ve already seen by that measure some material tightening in the United States,” Brainard said on a recent visit to Frankfurt, Germany’s financial capital and home to the ECB.
Still, the United States is approaching full employment, a factor that warrants a rate increase regardless of what the ECB does. Also, the Fed has long prepared markets for the move, so hesitation would be more damaging than acting.
“If you wait too long, you might end up having to raise rates at a faster pace than you want,” said a Bank of Japan policymaker who asked not to be named. “That may be more disruptive for markets than kicking off the rate hike circle early.”
Fed and ECB officials talk regularly on the sidelines of Bank of International Settlements and G30 meetings but mostly to explain and discuss what is already public information, sources said.
The conversations are often held by Fed Vice Chairman Stanley Fischer and ECB Board member Benoit Coeure, central banking sources said.
ECB President Mario Draghi is also known to have a personal relationship with Fischer, his professor at the Massachusetts Institute of Technology in the 1970s.
Reserve Bank of India Governor Raghuram Rajan says central banks should be talking to each other a lot more than they do now. Often their policies are counterproductive, especially when too many banks are easing at the same time and trying to reduce the value of their currencies, he says.
“You may try to depreciate your currency but (what) if somebody (else) is also depreciating their currency?” he said. “We can’t all depreciate against each other, therefore the net effect will be limited.”
The price of inaction can also be high. “If you stop doing it, your exchange rate appreciates significantly and you get burnt on the way up if it gets really strong,” he said. “We may need more global, not so much coordination, but collective action.”