JOHN MASON: Contrasting Federal Reserve and ECB policy
BY: John M. Mason
The Federal Reserve and the European Central Bank continue to follow divergent paths.
The Federal Reserve System is on a path to raise its policy rate of interest and to shrink its balance sheet.
The European Central Bank will, at least for a few more months, continue to increase its balance sheet and keep its policy rates of interest constant.
Last week, evidence was forthcoming that economic growth in the eurozone economies had moderated and the ECB reported that it was not yet ready to stop buying securities and start raising rates in this environment.
Some economists think that eurozone growth will accelerate again this summer or fall and this will allow the ECB to start pursuing a ‘normalization’ process pushing interest rates higher.
On the other hand, the Federal Reserve is facing an economy where pressure on wages and prices seems to be building as the effects of the December tax reform bill and the February federal budget agreements loom over the economy, creating more debt while, at least for the short-run, stimulating faster growth.
This would continue to support the Fed’s efforts to raise interest rates and reduce the size of its securities portfolio.
The Federal Reserve has been very diligent to try and stay on target in terms of reducing the size of its securities portfolio.
From September 27, 2017, just before the start of its ‘reduction’ program, to the end of the latest banking week, April 25, 2018, the Federal Reserve has reduced the size of its securities portfolio by almost $80 billion.
The size of the bank’s balance sheet has declined by about the same amount.
Over this time period, the Fed has reduced the amount of reserve balances banks hold at Federal Reserve banks, a proxy for excess reserves in the banking system, by almost $170 billion.
The reason the difference is that, operationally, Federal Reserve officials wanted to stop using some of the ‘tools’ it had relied upon as it moved away from its third round of quantitative easing.
Specifically, it wanted to reduce the amount of reverse repurchase agreements on its balance sheet, something that needed to be done if it was going to engage in a outright reduction of the size of its securities portfolio.
Repurchase agreements are short-run transactions that involve the sale of a security under the agreement to repurchase at the end of a agreed upon time period, usually three to five days.
The Federal Reserve used repurchase agreements to manage its balance sheet rather than the outright sale of securities in order to be able to move swiftly, if necessary, to protect the banking system from reserve disruptions. This was a part of the effort to make the departure from the period of quantitative easing as ‘safe’ as possible for the banking system.
Up to this point in time, the Federal Reserve has done an exceptional job in reducing the size of ending the use of the temporary ‘tools’ it used at the end of quantitative easing, like reverse repurchase agreements, by reducing the size of its securities portfolio, and by reducing the size of its balance sheet.
Of course, a lot of work still remains.
The efforts of Federal Reserve officials to carry out this ‘normalization’ efforts just provides a brief indication of what the officials of the European Central Bank will have to go through after its ends its program of quantitative easing in this summer of next fall.
If the Federal Reserve continues upon its ‘signaled’ plan of raising its policy rate of interest at least two more times this year and then three times in 2019 and if it tends to stay pretty much on its schedule to reduce the size of its balance sheet, then one could assume that the value of the US dollar might continue to rise…at least for the short-run.
However, many economists and market participants believe that events will occur that might force the Fed to end both its efforts to raise its policy rate of interest and reduce the size of its securities portfolio and balance sheet.
One is the possibility that the Fed will have to stop getting rid of its portfolio of government securities or will have to start buying government securities once again.
A substantial amount of government debt is expected to hit the financial markets in the next several years. The tax reform bill and the budget passed in early 2018 is expected to swell the amount of government debt outstanding.
All this debt might put too much pressure on market interest rates and the Federal Reserve might have to intervene to keep interest rates from rising too rapidly in order to finance all the deficits projected .
Another possible event might be the start of a new recession. The current economic recovery in the United States is now eight and three-quarters years old…a long time by historical standards.
Although a recession is not in sight at the present time, one could ‘pop up’ in the next year or so.
If a recession did occur, the Federal Reserve, obviously, would not want to continue to raise its policy rate of interest or continue to reduce the size of its balance sheet. All efforts would be focused on ending the recession.
The monetary policy positions of the Federal Reserve System and the European Central Bank have been ‘out of sync’ for much of the past several years.
It is possible that as the ECB comes out of its quantitative easing either this summer or fall, it could be reversing the policy positions of both itself and the Federal Reserve. How ironic.
It is, however, a reality that each central bank must accept and work with. It is also a reality that investors and analysts will also have to accept and work with.
At another time, I would like to reflect on how this change in policy positions might impact the relative values of the US dollar and the Euro.