Interest rates diverging in US, Europe
Similar pattern to 1990s – but Europe this time mired in debt
by David Marsh in London
Mon 11 Nov 2013
Interest rates in the world's two largest economies are set to move in different directions now that the European Central Bank (ECB) has confirmed deflation fears in Europe and US quantitative easing looks likely to wind down in coming months.
The result seems likely to be a weaker euro, which would be the outcome of a relatively strong US recovery next year and a still very sluggish European climb out of a two-year recession. On this reading, and assuming that the retreat from the Federal Reserve’s asset purchases does start as early as next month and not in January following stronger than expected US jobs data for October, the fall in the euro from earlier highs of $1.38 has a long way further to run.
The split between debtors and creditors in economic and monetary union (EMU) has now come to the fore with representatives of the ‘hard money’ central banks, led by the Bundesbank, on the 23-man ECB council voting against last week’s 0.25 percentage point cut in benchmark interest rates to a record low of 0.25%. The key element behind the decision, pre-empting council members pleading for a further wait before a cut, was the fresh fall in euro area inflation to only 0.7% in October from 1.1% in September, well below the 2% ECB benchmark and reinforcing fears that some countries in EMU face deflation.
Mario Draghi, the ECB president, and key figures on the ECB board such as vice president Vitor Constancio and Peter Praet, the chief economist, have been preparing the ground for a further cut in interest rates for several months, even though there is some scepticism about how quickly or effectively this will feed through in producing a much-needed pick-up in lending throughout the euro area.
A growing body of industrial and financial opinion in Germany believes that the further fall in European interest rates, in spite of the recovery from recession, could stoke up asset bubbles and inflation as at least some European economies start to regain dynamism.
The Bundesbank has been highlighting for several months the risk of real estate bubbles developing in metropolitan areas in Germany as a result of funds flowing into property in a retreat from traditional safe haven, and now very low-yielding instruments like bonds. The Austrian National Bank has also been warning behind the scenes about asset price bubbles. Ewald Nowotny, the Austrian central bank governor, joined with Jens Weidmann, the Bundesbank president, in opposing last week’s move.
In a bid to gain psychological traction over the more dovish core of the ECB council, the Bundesbank president cannily voted with the majority for a previous 0.25 point rate cut at the ECB council meeting in May. However this time Weidmann appears to have been fully part of the ‘hard money’ mainstream and moved in line with Jörg Asmussen, the German representative on the six-man ECB board, in arguing against last week’s rate cut.
The ECB reduction will further reinforce Mario Draghi’s status as a monetary dove – an accolade he will not be eager to embellish, since most central bank governors win or lose their reputations on their willingness to court unpopularity by increasing rather than lowering interest rates.
Meanwhile in the US, expectations that the Federal Reserve will begin winding down America's economic stimulus as early as next month grew last Friday after the latest figures showed the US created 204,000 new jobs in October, well above expectations, in spite of the three-week government shutdown.
If the euro and dollar move in different directions in coming months, this could be a rerun of the position in the 1990s in the run-up to monetary union. Then, a stronger dollar during the years of US revival under president Bill Clinton led to a moderate weakening of European currencies that helped economic growth after the 1993 European recession as well as the overall transition from the D-Mark to the euro in 1999.
This time round, the position is still less benign.
Public and overall national debt levels are still rising – or are falling only moderately - in the peripheral European countries in spite of high unemployment, low growth and increased competitiveness, caused by painful efforts to shift resources away from the domestic economy and into exports. Because countries’ increases in nominal GDP are still very low, and are being held back by low or negative inflation, their overall debt is still inexorably building up in many cases. This is in spite of a return to current account surplus by countries like Spain which many thought would be sufficient to bring down debt levels in sustainable fashion.
Tell a friend