Released within 24 hours of each other this week, the minutes of the Federal Reserve and the European Central Bank policy meetings in January make for a fascinating “compare-and-contrast” exercise. They highlight common economic optimism, identify similar analytical challenges, but point to different risks. They also show that policy makers may be sidestepping a global risk factor that could attract more attention in the quarters ahead.
Both systemically important central banks have, rightly, embraced brighter economic prospects, reinforcing the notion of a virtuous synchronized pickup in global growth and of lessened concern about “lowflation.” This, in turn, increases the chances of emerging from too many years of “new normal” growth that is too low and insufficiently inclusive.
The Fed: Members of the Federal Open Market Committee have revised upward their growth expectations, citing “accommodative financial conditions, the recently enacted tax legislation, and an improved global economic outlook.” These drive “gains in household and business spending” that, in turn, indicate “substantial underlying economic momentum.”
This macro analysis reinforced the message U.S. central bankers are hearing from their business contacts. Specifically, manufacturers cite “the recent tax cuts and notable improvements in the global economic outlook" as the reasons for an increase in orders and plans to step up their business investment and expand capacity.
The brighter growth prospects amplify questions that Fed officials have had about remaining labor market slack and the responsiveness of wages.
Despite the historically low headline unemployment rate ( 4.1 percent for January) and the recent decline to pre-crisis levels of U-6 -- the broader measure of unemployment that also captures involuntary part-time employment -- there are questions about the extent of the remaining slack in the labor market. Some members of the FOMC seem less optimistic about a prospective increase in the labor participation rate and foresee faster wage growth. Others expect wage increases to stay muted, especially if productivity growth (another analytical puzzle for the Fed, economists and policy makers) also remains low. All of these factors contribute to the central bank’s broader assessment of threats ahead.
While the risks to the economic baseline are seen as balanced for now, Fed officials suggested two developments that could be associated with “imbalances in the financial markets.” The first, “elevated asset valuations,” has been highlighted before. The second, “increased use of debt," is notable because it would apply to “nonfinancial corporations,” as opposed to the banking system, which is under the direct oversight of the central bank.
It remains to be seen how the Fed’s thinking on these two concerns has evolved since the January policy meeting, especially after the sudden spike in volatility in the market at the beginning of this month. Policy makers will have to determine whether the move to a higher trading band for both the VIX and bond yields dampens worries about market complacency without fueling concerns about some of the more exotic products that have been readily embraced by segments of the non-bank sector yet are subject to bouts of severe illiquidity.
The ECB: Like the FOMC, the Governing Council of the ECB welcomed improved economic prospects in its policy discussions last month. It assessed the economic expansion as “robust and broad-based.” As in the U.S., growth is being driven by both private consumption and business investment. And like its U.S. counterpart, the ECB believes the resulting growth outcome could be running above its estimate of potential.
The similarities between the two assessments do not end there. The ECB also expressed more confidence that inflation would converge over time to its 2 percent target. And Europe also faces a puzzle on wage determination (which, along with the productivity mystery, affects the assessment of the neutral rate of interest for the economy).
The ECB’s risk assessment diverges from the Fed's in two important ways:
The first is that the European bank appears less worried about high asset prices, suggesting that it has not evolved as much beyond the principle that “macroprudential policy tools were to be seen as the first line of defense in addressing potential financial stability risks.”
The second, and much bigger contrast with the Fed, is the amount of discussion, and the related space in the minutes, devoted to recent foreign-exchange movements that, according to the ECB, represent “a source of uncertainty that had to be monitored with respect to its implications for the medium-term outlook.”
In unusually blunt language, the ECB singled out the euro's appreciation against the dollar and reprimands the U.S. by reaffirming “the agreed G7 and G20 exchange rate language, which entailed the commitment to market-determined exchange rates and refraining from targeting them for competitive purposes.” In worrying about “spillover from global financial conditions,” the bank went further in pointing to “the overall status of international relations.”
With further euro appreciation threatening to complicate long-awaited progress toward meeting the inflation target, as well as constituting a headwind to growth, the ECB highlighted what I have labeled the “hot potato” syndrome -- that is, virtually no country or region is experiencing strong enough internal growth dynamics that would extend well into the medium-term. As such, these countries and regions feel neither willing nor able to absorb with ease a sustained appreciation in their currency.
All of these factors lead to another global policy risk that, judging from this week’s two sets of minutes, appears to attract little attention so far: the growing probability that several central banks will reduce monetary stimulus at the same time in the quarters ahead.
This is not just about the Fed rightly feeling more confident about its baseline of three interest rate hikes in 2018 and the ECB having to think much harder about easing away from unconventional stimulus more rapidly than anticipated a few months ago. Internal policy discussions at other central banks, including the Bank of Japan and the People’s Bank of China, are likely to focus more on the case for paring back a tremendous amount of monetary stimulus. To the extent the collective shift in policy is more simultaneous than sequential, it remains to be seen how well the global financial system as a whole would respond after years of having been conditioned to expect central banks to repeatedly repress financial volatility using quite a range of unconventional tools.
This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
Mohamed A. 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."
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