Great Monetary Polarisation set to widen
History shows central bank divergence could spark unrest
by David Marsh and Ben Robinson
Tue 1 Dec 2015
The Great Monetary Polarisation between the US and Europe is underway. After a period of close alignment since the collapse of Lehman Brothers in September 2008, US and European monetary policies are about to diverge in dramatic fashion. The message from 70 years of monetary history is that, in the next few months, there is a roughly 50% chance of large-scale foreign exchange upheaval.
With the US more or less back to full employment, the Federal Reserve at its policy meeting on 15-16 December is likely to raise interest rates for the first time in nine years. On the other hand, in response to persistently low inflation and output growth, the European Central Bank on 3 December is expected to announce a range of easing measures that could include a further cut in its negative deposit rate for banks holding funds in its facilities, as well as an extension of its €60bn a month quantitative easing programme of bond purchases.
Since the second world war, US and European interest rates (first as the German Bundesbank’s key Lombard rate, then from 1999 the ECB policy rate) have experienced seven periods of divergent policies. On roughly half of those occasions, this resulted in financial and sometimes political disruption.
These episodes included, notably, the late 1960s run-up to the break-up of the Bretton Woods system of fixed exchange rates, the early 1980s upheavals in Germany caused by the dollar’s strength and the D-mark’s weakness, the early 1990s near-death experience of the European Monetary System (the forerunner of economic and monetary union), and the economically disastrous climb in the euro exchange to $1.60 in 2008, one of the reasons for the unduly severe slump in euro area output after the global financial crisis.
Episode 1 was between 1966 and 1969, when the Bundesbank reduced interest rates from around 6% to 3.5%, while the US federal fund rate increased from 4.4% to 6.3%. This reflected weaknesses in European domestic economies and a desire in the US to stem an outflow of capital caused by the US trade and current account defects. These imbalances had caused a rise in the D-mark against the dollar and had forced the sterling to devalue in 1967 – the first major shock wave in the build-up to the collapse of Bretton Woods in 1971-73.
Episode 2 came between 1980 and 1982 when the Fed under Paul Volcker, its chairman, raised rates to above 19% (in 1981) to bring down inflation exacerbated by the 1979 oil shock, forcing the Bundesbank after initial hesitation to follow suit. This generated a slowdown in Germany that was one of the reasons for the ousting of Chancellor Helmut Schmidt in 1982.
Episode 3 was in 1991-92 when the Bundesbank raised interest rates sharply as the Fed was easing – part of a rearguard action by the German central bank to counter the inflationary effects of the fall of the Berlin Wall in November 1989 and German reunification in October 1990. The result was considerable disruption in the EMS, in particular the withdrawal of the UK and Italy from the scheme in September 1992 and violent upsets in the French franc-D-mark exchange rate in 1992-93.
Episode 4 came in 1993-98 when the Fed raised rates from 3% to 5.5% while the Bundesbank rate fell from 8% to 4.5%. The consequences were benign this time as European countries needed a weaker exchange rate to boost exports and overcome the effect of the early 1990s recession caused by EMS unrest.
Episode 5 saw the euro fall between 2000 and 2001 as an eight year run of dollar strength accelerated, the result of strong US growth of around 4% a year and a sluggish European economy. The nascent ECB was forced to increase interest rates while the Fed was easing, leading to the euro falling below $1.
Episodes 6 and 7 surfaced in 2008 and again in 2011 when the ECB raised rates while the Fed was maintaining easy money. These divergences boosted the euro at a time when Europe was already suffering competitive problems, further depressing euro area growth. The ECB speedily reversed the interest rate hikes (made before the accession of Mario Draghi, ECB president since November 2011), but the damage had been done.
The seven periods of divergence display some similar patterns. US rates tend to move in a more extreme manner than in Europe, with overcorrection on both the upside and downside. European rate movements eventually mirror US rates, with a variable lag of between several months and a year.
There are important lessons for the effect of the impending Fed rate rise. The divergence may be deeper and longer-lasting than in previous cases. The ECB is discussing extending its quantitative easing at a time when the Frankfurt bank as well as several non-euro European central banks are already offering negative interest rates on deposits.
This has clear implications for the euro exchange rate, which the ECB seemingly wishes to lower as much as possible to help raise inflation and buttress economic growth. Japan is maintaining very loose monetary policies, but seems unlikely (in contrast to the ECB) to accelerate further its quantitative easing. The Bank of England is likely, like the Fed, to tighten rates in the coming year. So the Great Monetary Polarisation is affecting a wider spread of countries, over a longer period of time, than in the past. The results may be correspondingly broad too.
Some leading central bankers say the effect of the Fed’s and the ECB’s divergent monetary action is already priced in to financial markets. Yet there is a large chance that is not the case. Market participants should be ready for considerable currency turbulence in the next two months.
David Marsh is managing director of OMFIF and Ben Robinson is the economist at OMFIF.
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