ECB, the Fed and interest rate targets

In a discussion on the Bloomberg's podcast "The Tape" podcast series, London Business School’s Dr Vania Stavrakeva talked about the decision by the European Central Bank (ECB) to raise interest rates by 25 basis points, while the Fed has chosen to ‘pause’, recently choosing not to raise interest rates.

Dr Stavrakeva says that what one might be seeing here is an interesting divergence between the US and Europe on interest rate targets.

“We tend to see the US as the leader, leading on the hiking cycle, and the first to move on interest rates followed by the Bank of England and the ECB. Presently, what we have seen is the Fed choosing to pause for one bound. This produced quite a lot of speculation about this as the US economic performance was better than expected and there was growth in US GDP. My opinion is that we may be seeing a period where the Fed is preparing us for a higher inflation target,” says Dr Stavrakeva.

“It is worth noting that all central banks are saying that it will take at least two years to go back to the inflation target of two per cent. In the US, there is perhaps an acknowledgement that they may not return to two per cent, with the Fed preparing for a higher inflation target.”

With regard to ECB, Dr Stavrakeva say that it will be significantly harder to adjust inflation targets given the history of the ECB. “We all know that, for example, Germany hates inflation, so we may begin to see an interesting divergence in policy making between the FED and the ECB which is quite unusual across the large central banks,” says Dr Stavrakeva.

“What is different is that the ECB has many different business cycles to contend with and we’re seeing, for example, inflation falling faster in some parts of Europe where labour markets are less tight. So therefore, in Germany we see that core inflation is still higher than in some Southern European economies. During the zero-bound period in the past, some critics have complained that the ECB had put too high a weight on the German economy as opposed to the rest of the Eurozone. Today it may be that southern Europe and the rest of the Eurozone do not require as much tightening on interest rates, but we are still perhaps seeing the ECB prioritising Germany.”

In the US, Dr Stavrakeva observes, the Fed hasn’t adjusted the inflation target for a long time and it could be that it is now considering the possibility that a higher inflation target may be beneficial. One reason could be that if the US is stuck in the zero-bound - or the so-called liquidity trap, the lower limit that rates can be cut to, but no further - and the economy underperforming, then the central bank can no longer provide stimulus via interest rates.

“It may be best therefore to have an adjustment in the inflation rate target then pretend that there is an ambition to return to two per cent and actually being above that target for a further two to three years.”

Dr Stavrakeva points to concomitant issues associated with inflation, referring to the UK as the “worst example”, with wage inflation becoming unanchored.

“I believe therefore that markets are beginning to believe that we’re not going back to two per cent as a target and, as such, this may be a good time to adjust the target to something more reasonable such as somewhere between three and four per cent.”

The Fed’s recent decision to pause on interest rates could also be explained by what has been happening in the US banking sector and what further difficulties and possible contraction might be happening there. The importance of smaller, regional banks, which lend to the vital employment driver in the US economy, the SME community, is another key factor in the Fed’s decision-making in this respect.

“It could be that the Fed will eventually choose to aim for a higher inflation target or indeed come up with a more flexible regime.”

One further matter that Dr Stavrakeva discussed concerned whether the ECB’s decision to raise interest rates might push the Eurozone into a deeper recession.

“We know that historically the Deutsche Bundesbank is tough on inflation and this originates from the period between the wars when that country suffered hyperinflation. While if you look at the overall performance of the Eurozone and those economies that do not need as much tightening, deeper political issues may be at play here.”

In terms of southern European countries struggling with sovereign debt, Italy remains a key focus (“the elephant in the room”), with the “uncomfortable position where there is purchasing of Italian debt while shaving German debt”.