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Analysis
Fed and ECB risk being caught off guard

Fed and ECB risk being caught off guard

Tightening ignores troubles in emerging markets and Italy

by Desmond Lachman in Washington

Mon 18 Jun 2018

In 2008, both the Federal Reserve and European Central Bank were caught off guard by the Lehman Brothers bankruptcy that led to the worst global economic recession in the postwar period. Judging by their respective decisions on 14 June to tighten their monetary policy stances, it seems both risk once again being caught out by impending crisis.

A striking feature of the Federal Open Market Committee's policy statement justifying the shift to tighter US policy was its lack of comment on the worsening of global economic conditions. Instead, in unqualified terms it justified its view that an additional US interest rate rise is needed this year on the grounds that the US economy is strong and that inflation is likely to approach the Fed's target.

The Fed's seeming indifference to developments abroad is even more surprising considering how significantly the external situation has deteriorated since the FOMC's last meeting. US steel and aluminium tariffs, together with the threat of automobile tariffs, have dealt a blow to European investor confidence and raised the spectre of a trade war.

At the same time, the installation of a populist government in Rome has put Italy, the euro area's third largest economy and the country with the world's third largest sovereign bond market, on a collision course with core European countries. This could presage a return of the euro area sovereign debt crisis and raise existential questions about the single currency. To underline this, over the past month Italian government bond yields have climbed higher and Italian capital flight has increased.

The Fed is also seemingly indifferent to a decline in the emerging market outlook. The currencies of Argentina, Turkey, Brazil, Mexico and South Africa are all under intense pressure that could threaten these markets' economic recoveries. With contentious elections scheduled in each of these economies for this year and next, the plight of emerging markets looks set to deteriorate further in the near future.

Like the Fed, the ECB seems to be following a questionable line of thinking. Its decision to end its bond buying programme by the end of the year is ill-advised in the light of tense trade relations with the US and troubles in Rome. It would have been more suitable to wait and see how the protectionist cycle and Italian situation play out before removing a key source of support from the overall European economy, which includes purchasing around €3.5bn of Italian bonds each month. The decision to end the programme will complicate the delivery of ECB support if Italy comes under severe market pressure.

The Fed and ECB are mandated to run policies aimed at meeting their respective domestic economic policy objectives. However, the 2008 financial crisis should have taught central bankers that no modern economy exists independent of others, and that events abroad can have a material impact on any country's economic outlook. By not focusing on the rapidly deteriorating international economic outlook, the Fed and the ECB risk failing to deliver on their respective mandates.

Desmond Lachman is a Resident Fellow at the American Enterprise Institute. He was formerly a Deputy Director in the International Monetary Fund's Policy Development and Review Department and the Chief Emerging Market Economic Strategist at Salomon Smith Barney.

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