Tuesday, May 10, 2011

Is the ECB Still in the Fed's Orbit of Influence?

One of the arguments I have made over the years on this blog is that the Fed is a monetary superpower.  It manages the world's main reserve currency and many emerging markets are formally or informally pegged to dollar. Thus, its monetary policy gets exported to much of the emerging world. This means that the other two monetary powers, the ECB and Japan, have to be mindful of U.S. monetary policy lest their currencies becomes too expensive relative to the dollar and all the other currencies pegged to the dollar.  Thus, we have seen these two countries move their policy rates in line with what the Fed does usually with a lag.  

The recent interest rate hike by the ECB in the absence of a similar move by the Fed goes against this pattern.  Does it mean the ECB is finally breaking free of the Fed's orbit of influence?  It could be, but I doubt it.  The ECB raised its policy rate in April and was talking up further rate hikes throughout the year.  Last week, however, the ECB backtracked to some degree by avoiding a further rate hike.  It also has toned down its rate-hiking rhetoric.  Some of this is directly due to the problems in the Eurozone.  Just as important, though, is the concern that if the ECB were to follow through on all of it rate hikes the Euro would get intolerably expensive against the dollar and the dollar-pegging countries. I interpret these developments as the ECB facing up to reality of their proposed tightening cycle.  It is not the first time they tried to tighten while the Fed was easing. In mid-2008 the ECB tried increasing interest rates while the Fed was lowering its target rate.  This didn't last long as seen in the figure below:

I suspect that as long as the Fed keeps the expected path of the federal funds rate at low levels, the ECB will not be able to raise its interest rates.  For the time being, the Fed remains a monetary superpower.  

P.S. I have a working paper with Chris Crowe where we more fully develop the view that the Fed is a monetary superpower.  You can find it here.  Comments are welcomed.


  1. DB: I will have to look at your paper but one thought is you could look at how far each central bank deviated from the optimal interest rate from a Taylor rule. If the ECB was closer to Taylor rule optimum while the Fed was further from it, that might be evidence of some monetary independence of the ECB.
    Rajan in Fault Lines argues that Fed policy is further from optimality than ECB because Fed has to take on so much more of the countercyclical burden due to the US lack of welfare state.

  2. Why would anybody raise interest rates now?

    We need much more demand, not less.