The perils of diverging monetary policy
- Monetary policies in the eurozone and US are on the verge of parting ways, as the US recovery has advanced much further than the recovery in the eurozone.
- This divergence complicates the normalisation of Fed policies. It may make the job for the ECB somewhat easier, but the effectiveness of QE is likely to remain limited, while QE could have unwelcome side effects.
- For the world economy as a whole, there is a risk that monetary divergence will fuel external imbalances among the largest economies.
Monetary policy in the U.S. and the eurozone is very likely to start to diverge this month. The US economy seems strong enough for the first rent hike since 2006, which is highly likely to take place in December 2015. Meanwhile, ECB chairman Mario Draghi last week announced a 10bp cut to the deposit rate and an extension of the ECB’s asset purchases (QE) until at least March 2017 at the current rate of EUR 60bn a month. While this package somewhat disappointed markets as it did not contain an increase of the monthly purchase amount, it still results in a further roll-out of unconventional monetary policies in the eurozone.
Positive developments on the US labour market point towards an imminent US Fed hike, even as inflation is currently low. The US unemployment rate has remained on a constant downward trend since peaking at 10% in October 2009. It stood at 5% in November, its lowest level since April 2008. As economic growth is expected to remain solid at about 2.5% next year, further improvements of the labour market may lead to more upward pressure on wages and inflation in the coming months, even as this effect might be dampened by rising labour market participation and low commodity prices.
In the eurozone monetary policy is guided by the fact that both inflation and inflation expectations are below the ECB’s objectives. Though the recovery of the eurozone has continued on the back of an easing of concerns about eurozone governance, lower commodity prices and a slowdown of the pace of fiscal consolidation, it has not progressed far enough to seriously reduce slack on the labour market. The improvement from 12% in March 2013 to 10.7% in October 2015 leaves the unemployment rate well above its pre-crisis level of about 8%. As recently published purchasing managers indices (PMI) point to growth of about 0.4% qoq in 15Q4, comparable to the economic expansion in the previous quarters, unemployment is likely to remain relatively high in the near term. Consequently, wage pressures will remain weak, which, in combination with ongoing weakness of commodity prices, may weigh on already low inflation and inflation expectations.
Difficult balancing acts
The monetary divergence between the US and the eurozone makes the normalisation of US Fed policies an even more difficult balancing act. Normalisation was likely to be difficult anyway as it comes after a long period of unprecedentedly loose policies. Further monetary loosening in the eurozone could make the impact of a US Fed hike on the exchange rate both more pronounced and harder to estimate. However, the fact that the monetary expansion of the ECB was somewhat smaller than expected, resulting in appreciation of the euro against the US dollar, might make it somewhat easier for the US Fed to keep inflation expectations anchored, while the economy maintains its growth pace. Meanwhile, the imminent rate hike in the US is likely to expose vulnerabilities in many emerging markets, particularly those countries with a high reliance on external financing. Low commodity prices, worries about a growth slowdown in China and the increasing imminence of a US interest hike already contributed to a negative sentiment towards emerging markets in the second half year of 2015. Partially as a result, over the whole of 2015 emerging market net capital outflows are likely to turn negative for the first time since these data started to be recorded in 1998, according to the IIF. Fortunately, most emerging markets look relatively resilient, as FX reserves are at sound levels and FX denominated non-financial corporate debt is below 20% (figure 3) and thus modest in most countries.
Monetary divergence may make the job for the ECB somewhat easier, but the effectiveness of QE is likely to remain limited. The monetary divergence between US and eurozone is likely to enhance the impact of QE in the eurozone through the exchange rate channel, as a weaker euro should boost the competitiveness of producers in the eurozone. However, we expect the impact to be limited, as the competiveness gains could be offset by the impact of weakness in emerging markets. What is more, depreciation itself might be limited. In fact, as mentioned above, the euro actually appreciated against the dollar after the ECB decision turned out to be less dovish than markets had expected. Meanwhile, the fact that fixed investment in the eurozone remains weak is one of the indicators that the ample liquidity is not reaching the real economy. Besides, unconventional monetary policies can lead to the misallocation of investments and encourage banks to rollover bad loans and postpone restructuring, while reducing the incentives for politicians to pursue structural reforms (see Outlook 2016: Global Economy).
Global imbalances 2.0?
Monetary divergence may create risks for the world economy, as it carries the danger of restoring past external imbalances. To a large extent thanks to the Great Recession, the rise of US oil production and China’s investment boom, global imbalances are now smaller than they were before the Great Recession. This could change. A stronger USD on the back of a tightening of US monetary policy is likely to lead to a widening of the current account deficit of the US, which is already the most important current account deficit country (figure 4). Meanwhile, downward pressure on the exchange rate due to more unconventional monetary policy in the eurozone could lead to a further increase of the current account of the eurozone, after this surplus has already grown rapidly in recent years. At the same time, the rebalancing of its economy and low commodity prices may also fuel China’s current account surpluses.