By Mohamed A. El-Erian / BloombergEwald Nowotny, the governor of Austria’s central bank and a member of the Governing Council of the European Central Bank, said last week that “it’s no secret we’re monitoring closely what the Fed did, and is doing.” Such sentiments are understandable, even desirable. After all, the Federal Reserve’s process of monetary policy normalization is unprecedented and, at least so far, successful.
Yet, because the challenges facing the ECB are considerably more complex, the U.S. central bank’s experiment is just a good starting point. Indeed, even the most basic aspect of policy design and implementation — sequencing specific measures — may not necessarily translate as smoothly in Europe as it does in the U.S.
After a bit of a nervous start with the “taper tantrum” in May-June 2013, the Fed has managed to stop its large-scale asset purchase program known as quantitative easing, raise interest rates six times and roll out a timetable for reducing its sizeable balance sheet. Importantly, all this has been done without derailing the economy or disrupting the functioning of markets.
The Fed’s successful process of policy normalization follows a period of reliance on unconventional mea-sures that lasted a lot longer than even policy makers had anticipated. Under this experiment, the central bank was forced to carry the bulk of the policy burden for promoting growth and ensuring financial stability.
As it exits, the Fed has highlighted the importance of
- close data monitoring.
- timely communication and forward policy guidance.
- careful sequencing of quantity (balance sheet) and price (interest rate) measures; and, in this context,
- maintaining appropriate policy optionality.
What makes the U.S. experience even more noteworthy is that the Fed is well ahead of the ECB and the Bank of Japan in the policy normalization process. By forging a path in unchartered territory, the Fed naturally becomes a reference point, if not a lighthouse.
Yet the challenge facing the ECB is a lot more complicated, and not just for domestic reasons. The regional and international contexts are also more delicate.
The majority of the 19 members of the eurozone, the countries where the ECB directly influences monetary conditions, are less advanced than the U.S. in adopting pro-growth policies. Despite indications of greater budgetary stimulus in Germany, the region’s most systemic nation, individual countries’ fiscal policies have yet to make significant room for easing off exceptional monetary stimulus.
Regionally, the ECB continues to face the tricky task of using a single policy approach for countries that still have significant economic and financial divergences, and that are yet to be linked more closely by a full banking union and deeper fiscal and political integration. This makes policy design and difficult, and that’s before you add trickier conditions for the international economy and markets.
Economic data have become more mixed in recent weeks, highlighting the need for structural reforms and more balanced demand management to reinforce the synchronized pickup in global growth. Europe’s contribution has been driven primarily by a natural healing process whose beneficial impact diminishes if it isn’t accompanied by pro-growth policies. Meanwhile, the period of unusual calm in markets has been replaced by volatility, including large two-way price movements, as investors have revisited their faith in previous stabilizers, as artificial as some were (such as the belief in an endless willingness of “non-commercial flows” from central banks and corporate balance sheets to repress volatility).
Then there is the big uncertainty of simultaneity — that is, how the global economy and markets would respond to not just one, but several systemically important central banks withdrawing exceptional monetary stimulus at the same time. No one can be entirely certain how much the protracted period of unconventional policies has led to inappropriate resource allocations, unrealistic promises of liquidity and other excessive risk-taking in certain areas of the nonbank sector.
For all these reasons, the ECB will have to be even more careful in
- monitoring an even bigger set of indicators of economic and financial health,
- communicating with the markets,
- maintaining internal cohesion,
- minimizing the threat of political interference, and
- mixing all this while retaining sufficient policy flexibility.
Even more intriguing is the possibility that the seemingly obvious sequencing of measures — halting QE, then getting most of the interest rate hikes done, which would allow for significant balance-sheet contraction over time — may not be as much of a slam dunk as many observers seem to believe.
For the eurozone, balance-sheet purchases have played an important role in maintaining order and financial stability amid notable economic and financial divergence among member countries. Moreover, the persistence of ultra-low policy rates, with levels in negative territory in nominal terms for quite a while, eats away a lot faster at the integrity of the financial system, including the robustness of essential long-term financial protection for households (such as for life insurance and retirement).
This is not to say that the ECB should raise interest rates either before or as it stops its QE program. I have competing feelings about the most appropriate sequencing. All this points to the considerably more complex policy task facing the ECB in the months to come, both on a standalone basis and relative to the Fed, and warns against too quick a mapping from the U.S. to the eurozone.
El-Erian is a Bloomberg View columnist. He is the chief economic adviser at Allianz SE, the parent company of Pimco, where he served as CEO and co-CIO. He was chairman of the president’s Global Development Council, CEO and president of Harvard Management Company, managing director at Salomon Smith Barney and deputy director of the IMF. His books include “The Only Game in Town” and “When Markets Collide.”Speech