Against the tide: The Fed versus the ECB

by David Roche

The US Federal Reserve has finally bitten the bullet and hiked its policy rate by 25 basis points to 0.5%, with the aim of raising it further by another 1% this year. The six years of cheap money, near-zero rates and quantitative easing are over in the US, while Europe and Japan continue to ease. Stock markets are relieved that the uncertainty is over and they have a better handle on Fed plans, so stock prices rose on the rate move.

By contrast, the European Central Bank underwhelmed financial markets in December.

It delivered an extension of its Asset Purchase Programme (APP), commonly called ‘quantitative easing’; cut by 10bp its deposit rate for banks to -0.30%; and widened the assets to be purchased to include eurozone local and regional government debt.

The ECB also promised to roll over the stock of debt it has already purchased, thus keeping up the size of its balance sheet. And as Draghi is fond of saying, the ECB would do more if necessary.

ECB balance sheet forecasts

Source: ECB, Independent Strategy

But the ECB governing council’s decision was not unanimous and it is clear that the German members offered vocal resistance. Financial markets were seriously disappointed as they had higher expectations for all of the ‘exceptional measures’ and had looked for a larger 20bp cut in the deposit rate, or some form of split-rate that would penalise banks with larger deposits in an attempt to deter cash hoarding. Some further disappointment was no doubt generated by the modestly upbeat economic forecasts, with eurozone growth revised higher across the forecast horizon. Draghi was also positive on what QE has achieved to date, in raising the annual inflation rate by half a percentage point. It should also lift real GDP growth by 1% through to 2017, he reckoned.

Since the meeting, one of the ECB board members from Luxembourg, Yves Mersch, claimed that a great majority of ECB governors do not want to boost quantitative easing further. Mersch said the decision to keep buying bonds would anyway amount to an injection of €320 billion ($351 billion) if it continued for two years from 2017. Bundesbank president Jens Weidmann attacked further measures by the ECB as well. Weidmann, who also sits on the ECB’s rate-setting governing council, has been among the Draghi’s biggest critics, arguing that ECB policy is already loose enough, leaving the euro area prone to asset bubbles and financial instability. He thinks the ECB programme dangerously blurs the line between fiscal and monetary policy, reducing the incentive for governments to keep spending tight.

The Fed’s move also has risks. If it means an even stronger dollar, as I believe, it could hit US economic growth. Fed chair Janet Yellen may think US growth is fast enough to get through any rough patch, but I don’t.

A stronger dollar will finally force China to enter the devaluation game.

There is the possibility of a disorderly devaluation of the Chinese yuan as the dollar strengthens. The upshot of this is that we could see a reversal of global economic prospects and Fed policy at some point in the next year.

But before this happens, the US economy is likely to clock up a good growth rate in the first quarter. That will keep the dollar strong. After a batch of unseasonally cold winters, which have dragged on Q1 growth, warmth this year (an El Nino dividend) sets the scene for a more robust US GDP reading in this first quarter of 2016. At first glance that would seem to vindicate the Fed, but in reality the 2% or so real GDP growth rate that the US economy has been stuck to since 2010 will not have changed.

The euro’s steady decline towards parity with the dollar was halted by the ECB disappointment. But I expect this will be temporary. The Fed’s move is likely to cause a resumption of a weaker euro versus the dollar. I also expect the ECB to have to do more as the EM leverage crisis will worsen this year. While the latest ECB policy steps may have underwhelmed the market, Draghi’s programme will remain a powerful headwind against the euro. So euro parity with the dollar is still the call for 2016.