A pause in the normalization / tightening cycle of monetary policy, but until when?
While the business cycle is incredibly long in the United States (US), the longest in modern history, a wind of recession is blowing in the Eurozone, which would lead to the third recession in a decade. These economic peculiarities could force central banks to question themselves in the short to medium term. Indeed, the financial markets saw that the US economy was slowing down, as the Federal Reserve (Fed) thought and said it was “solid” and that it was therefore necessary to continue its policy of monetary tightening: to raise rates two or three times in 2019, once or twice in 2020 and one last time in 2021. Donald Trump has repeatedly attacked both the Fed and Jerome Powell for raising rates. Either Donald Trump felt the wind turn and indeed the US economy slowed, or he said to himself, “as a market man,” that financial markets were right. In any case, Jerome Powell was afraid of the risk of recession if he continued his (maybe) too aggressive strategy: to raise the rates to be able to lower them, in the case of a new recession. This type of policy has long been considered as an endogenous cause of business cycle distortions.
The monetary paradigm may be changing, in spite of a US economy with full employment, inflation is struggling to come back, and wage inflation is in first place. Indeed, jobs that are not qualified enough and labor shortages are almost non-existent. The secular stagnation sets in and if no exogenous factor appears in the US landscape, this secular stagnation could last a few more years.
On the European Central Bank (ECB) side, the context is very different. In the first place, Mario Draghi, the chairman of the Eurozone central bank, must constantly review the direction of his monetary policy because he has to juggle the different needs of 19 economies in the monetary union, which is not an easy task. Growth is weakening, especially in the eurozone's largest economy, Germany, which has been on the brink of a technical recession since the fourth quarter of last year. Inflationary pressures are far from homogeneous and some populist governments are making the task even more difficult than it already is.
Although the ECB just ended a EUR 2.6 trillion bond purchase scheme to stimulate growth, it is now preparing the ground for giving banks more multi-year, cheap loans, i.e., (Very) Long Term Refinancing Operation ((V)LTRO) to ensure they keep credit flowing to the economy even during the slowdown. This would also help lenders in Italy and other southern European countries to avoid a funding cliff edge when the previous Targeted LTRO (TLTRO) starts maturing next year. There was talk in 2018 that the ECB would start to raise rates from the end of summer 2019. At present, it is more a question of supporting economies out of breath in a degraded international environment. In short, if we were to use a metaphor, we could say that Mario Draghi is the only one player at all the posts on a football field while the countries of the Eurozone remain on the bench of substitutes…
In conclusion, it seems that the Fed has begun a pause in its monetary policy tightening cycle as the ECB softens its normalization by offering more cheap liquidity to the banks within the monetary union until the recovery becomes more vigorous. But until when? For the Fed, this pause could last until the uncertainties related to a US slowdown become a reality. The Fed does not want to be accused of speeding up a cycle reversal as it may have happened in the past. As for the ECB, as long as the recovery will not be stronger and core inflation will not show signs of acceleration, the ECB will give itself more time to continue to normalize its monetary policy. Finally, if a major financial crisis were to manifest (and risks are not lacking), the monetary policy cycles of these two central banks would become much more synchronous!
Julien Moussavi, Head of Economic Research
Sources: Beyond Ratings