When European Central Bank governors met over the weekend, they must have looked primarily at developments across the Atlantic. After all, American colleagues at the Federal Reserve (Fed) have been setting the pace for international monetary policy for decades.
This is not only because of the paramount importance of the dollar, the reserve currency, to the global economy. distance Untersuchung des Center for Economic Policy Research (CEPR) For a long time, economic development in the USA and in the Eurozone was roughly parallel until about 2011. After that, the economic tracks separated for a few years, the American economic locomotive left Europe behind and the word “separation” appeared.
Are we facing a similar crossroads today? There are some indications of this: Thanks to its rapid onslaught on vaccination, the United States has awakened its economy from an earlier pandemic coma. Government economic aid in America is about twelve percent of GDP, twice the size of the eurozone. Accordingly, economic growth and inflation across the Atlantic is likely to be significantly higher this year and unemployment significantly lower.
So Christine Lagarde, president of the European Central Bank, warned weeks ago of a “time lag”. Between the economic recovery in the two economic regions. If the Eurozone and the US economy are no longer on a steady pace, the European Central Bank will not be able to orient itself towards the Federal Reserve’s monetary policy. The first deviations can already be seen: while European monetary authorities want to maintain the easing path, US central bankers have now signaled a rate hike for the first time in 2023.
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The new strategy gives the Federal Reserve more freedom
In addition, and here we are again looking for the right compass, the US Federal Reserve has already gained a new monetary policy strategy last year and thus more wiggle room. Rather than stubbornly pursuing a fixed inflation target of 2%, he is willing to allow the rate of inflation to exceed this target at times in order to repair the damage caused by previous deflation, for example to wage developments, and to create inflation in the economy. Expectations are back in line.
This sounds reasonable, but it is also risky. In order for the Fed not to miss the right time to switch from the gas pedal to the brake pedal, he must be absolutely sure why. Otherwise, there is a risk of an emergency halt with aggressive rate hikes, which would weigh on the rest of the global economy.
ECB President Lagarde open to more flexible inflation target
Should European central bankers follow the experiences of their American colleagues, or should they separate themselves from the previous hour in terms of monetary policy? This is exactly what the European Central Bank’s “strategic review” was about last weekend outside the gates of Frankfurt.
Lagarde is at least open to a symmetric and more flexible inflation target: “We must carefully analyze the forces driving today’s inflation dynamics and consider whether and how we should adapt our strategy in response to this,” the French lady said in the fall of 2020.
If both central banks use the same compass, this does not mean that they go hand in hand in synchrony again. As is known, the compass only indicates the direction. However, it does not tell you where you are. Economic location is as important to monetary policy as path setting. For the European Central Bank, determining the current position is more important than the position of monetary policy.
Beware the hole Beware the hole
However, determining the current location of the economy is not so simple. Central bankers usually settle for a simple idea and ask: How far is the economy still from full capacity? If you know the so-called “production gap”, you’ll get a very good idea of how strong an economy can still grow without overheating the economic engine and increasing inflation.
Even if Lagarde doesn’t know exactly how much room there is for improvement in the eurozone, the European Central Bank chief knows her leeway is likely to be greater than that of Fed Chair Jay Powell. The economic downturn in Europe has been stronger than in the United States, and unfortunately, European growth forces are still less dynamic.
More: Analysts expect a first rate hike by the European Central Bank in 2024