“The Great Divergence”: Elements for an Early Assessment
At the beginning of 2015, as many investors grew increasingly skeptical about the prospects of the euro area’s economy and its central bank’s capacity to fight what appeared to be the beginning of a deflationary spiral of falling prices and weakening economic activity, the European Central Bank (ECB) launched its own version of quantitative easing (QE), thus cementing the diverging monetary paths in the euro area and the U.S. Indeed, as the ECB was getting ready to dramatically increase the size of its balance sheet via asset purchases, including government bonds, its U.S. counterpart, the Federal Reserve, had exited its own QE program. At the time of writing, the Fed expects that if economic conditions improve further, it will soon even be able to take a further step. Most members of the rate-setting Federal Open Markets Committee (FOMC) now think that the Fed could start tightening its monetary policy stance before the end of the year. If it happens, this would be the first key short-term interest rate rise since 2006, in sharp contrast with the ECB’s own monetary stance.
Shortly before the official launch of its own version of QE, on 22 January 2015, Mario Draghi, the President of the European Central Bank, travelled to Berlin seeking the endorsement of German Chancellor Angela Merkel for the central bank’s soon-to-be-expanded asset purchases. Many senior officials at the Frankfurt-based institution feared that anything short of unmistakable public support from Berlin had the potential to undermine the effectiveness of the program. The powerful Bundesbank was still not convinced that the euro zone was in danger of falling into a deflationary trap and was skeptical about the potential effectiveness of the program. It did not see any urgency for the euro system to act as the Bundesbank cited the high level of debt and lack of competitiveness in individual countries as the cause of the problem. But the majority of members of the rate-setting governing council was not willing to take a wait-and-see approach. Political backing from Berlin seemed to be a precondition for a smooth start to a program that surely would stir controversy, at least in Germany.
But Mario Draghi did not get everything he went to Berlin to ask for. Just like its national central bank, the German government remained skeptical about the benefits of QE. The chancellor would not stand in the way, but her public comments in the wake of the launch of the program fell well short of a ringing endorsement. On many occasions, her finance minister Wolfgang Schäuble stressed that the unintended consequences of QE risked outweighing its benefits. He feared that QE would simply add debt and cause governments in stressed countries of the euro zone to relax in their pursuit and implementation of structural reforms. But at the same time, he stressed that the German government respected the independence of the central bank. In short, Berlin remained unconvinced. It decided to tolerate rather than endorse the ECB’s actions. According to several observers, the strong relationship between Draghi and Merkel had suffered since Draghi’s speech at the summer gathering of central bankers in Jackson Hole in August 2014, when he opened his public campaign for QE and bluntly reminded deficit countries in the euro area that they, as well as surplus countries, needed to do their homework. The speech and the oblique reference to Germany’s unfulfilled duties wrong-footed Berlin.
Fast forward to 12 June 2015. In an address to business leaders in Berlin, in the midst of ongoing efforts to keep Greece in the monetary union, the chancellor made remarks that amounted to a U-turn of her previous position on monetary policies, saying that low interest rates were helping stressed countries to carry out structural reforms, because they contributed to keeping a lid on the euro’s appreciation in foreign exchange markets. She stated, “At the very least I’d like to ask for your understanding that central banks, like the European Central Bank, have to think about what to do if the inflation rate is so low and to ensure that we don’t end up in a deflationary cycle.”
What happened? Why had Merkel suddenly abandoned her previous stance on QE? The chancellor’s shift can probably be reduced to one word: Greece. QE and the deteriorating negotiations between the government in Athens and its creditors run parallel. Contrary to what many observers and government officials in Berlin expected only months ago, governments of all euro area countries have rallied around Germany and its chancellor because of the confrontational behavior of the new government in Athens. Even stressed nations, long wary of austerity and bound to profit the most from ultra-loose monetary policies and a relaxation of fiscal rules, supported Berlin in its efforts to convince the new Syriza government to make a deal and accept some degree of austerity and serious commitments to structural reforms.
A very simple explanation for the sea change in Merkel’s stance toward QE could therefore be that she is simply returning the favor. However, the chancellor could also be looking ahead. Much of her late public support of QE could indeed be linked to the evolving situation in Athens. If the stand-off between creditors and the current Greek government deteriorates further and the ECB deems it necessary to adapt its policies in order to better deal with the fallout, surely Draghi can use any further endorsement from the German government to do “whatever it takes,” either to protect the euro area in its current form from growing uncertainty and increasing volatility or, in an extremely adverse scenario, to protect a monetary union without Greece.
Of course the central bank’s program that is designed to deal with an existential threat to the monetary union is primarily OMT (Outright Monetary Transactions). But OMT should be viewed as a weapon of last resort. Can and should QE, as it is currently designed, deal with sudden swings in financial markets that risk undermining the very effectiveness of the asset purchase program?
In order to offer possible answers, it can be helpful to briefly review some driving factors behind the narrative of the “Great Divergence.”
What’s Driving the “Great Divergence”?
Let’s start with the obvious: the great divergence of monetary policies is not merely the byproduct of diverging paths of economic performances between Europe—the euro area in particular—and the U.S. economy. Rather, it is part of a coherent choice by monetary policymakers. If both economies fare better because of it, the strategy is working and both sides profit. If one side suffers while the other speeds ahead, that would imply that the Great Divergence is not working. U.S. authorities believe that one of the main reasons for the disappointing recovery in the U.S. is the drag coming from Europe. Washington recognizes that a weak old continent is not in the U.S.’ interest. In that respect, euro area QE cannot be seen in isolation and what the Federal Reserve does, or does not do, matters just as much.
In other words, the current divergence in monetary policies should support greater convergence in economic performance. That is the real measure of success. Specifically, and from the perspective of the ECB, this means that the inflation rate should be moving closer to the central bank’s target of below but close to 2 percent. In the U.S., where the Fed has a dual mandate, success is determined by meeting both the inflation and unemployment targets. While the Fed has failed to push inflation up to a rate closer to 2 percent for the sixth year in a row, it has achieved greater success in contributing to pushing down the unemployment rate. After the latest Federal Open Markets Committee (FOMC) meeting on 17 June 2015, Fed Chairwoman Janet Yellen made clear that in the committee’s view, the unemployment rate needs to fall further in order to move closer to what she and her colleagues think is a rate consistent with the definition of full employment. A tighter labor market should eventually support rising wages, which of course would help to push prices up, closer to the Fed’s own inflation target.
To sum up, just as it takes two to tango, it takes two central banks—the ECB and the Fed—to underpin the narrative of the “Great Divergence.” Managing this new phase of monetary paths is just as important as it was to react to the most acute phase or phases of the recent financial crisis. It requires two central banks that very much take each other’s actions into account and try, when possible, not to undermine each other’s efforts.
Measuring Success – For Now
In order to measure success—or the lack thereof—in the euro area, it can be helpful to look to at least four indicators: inflation, bond yields, bank lending, and last but not least, developments in the foreign exchange market.
If the signaling effect of the launch of the expanded asset purchases program aimed to re-anchor inflation expectations, the ECB can be quite satisfied with the early results. Eurostat estimates that in May prices moved up from 0.0 percent in April to 0.3 percent as some of the effects of lower oil prices faded. Services, food, alcohol, and tobacco were the main drivers behind the slightly better reading. Energy prices continued to contract while industrial goods saw a modest increase. While the price increases are nowhere near the central bank’s target, the danger of a deflationary spiral seems to be contained, at least for now.
The expansion of the ECB’s balance sheet was also supposed to flatten the term structure and to reduce real rates along the yield curve. One goal here was to achieve a portfolio rebalancing effect; in other words, to push investors into riskier assets, from sovereign to corporate bonds, from debt to equity. Initially, QE worked as intended, with German ten year Bund yields falling precipitously, at some point very close to zero. Lately, though, this trend has gone into reverse, and rather abruptly with yields climbing above 1 percent before coming back to a range of about 0.70 – 0.90 percent. Market observers have offered multiple explanations for this sudden moves, ranging from rising growth and inflation expectations in the euro area leading to a sell-off of low yielding assets to a sudden adjustment in the pace and composition of asset purchases by the national central banks (NCBs) that are purchasing assets on behalf of the ECB. In a note to clients, Goldman Sachs points out that the Bundesbank has “reduced the weighted average maturity of its Bund purchases from 8.1 years in March to 5.7 in May, in contrast to the Eurosystem as a whole where this number has stayed around 8 years. There is thus something more than supply dynamics or ECB communications going on, something that has the potential to undercut the credibility of ECB QE.” The main reason for the recent sell-off is hard to predict but is most likely a combination of factors. But it is certainly true that an even more transparent communication policy regarding the asset purchases, e.g., announcing a precise schedule of when, how much, of what is bought and by whom, could help to tackle the flurry of speculative interpretations.
The fact that the ECB decided to let NCBs do the buying can add to the confusion when trying to get a complete picture. Furthermore, the potential constraints on purchases caused by the negative yield floor that the ECB has attached to its program can have counterproductive effects. Indeed, as volatility increased and yields on Bunds climbed (potentially a negative development for QE), the pool of eligible bonds the ECB can buy under the program rose, reducing the danger that the central bank would run out of assets to buy—definitively a positive effect on QE.
The Importance of the Forex Market
Let’s briefly review the developments on the forex market as well. For months, many ECB watchers assumed that the most effective impact of ECB QE would be on the euro. Weakening the common currency was not and is not the official target of unconventional monetary policies, but a weaker currency is usually a byproduct of loose monetary policies. It helps to restore competitiveness and to lift exports. Indeed, as soon as the narrative of diverging monetary policies started to materialize, the euro started to depreciate against a basket of currencies. But the real accelerator for the common currency’s downward trajectory only came when QE was finally launched, prompting a growing number of market observers to believe that the euro and the U.S. dollar could reach parity within the year 2015. In June 2015, the euro seems to have stabilized in a range roughly between $1.08 to $1.15, down from $1.35 a year ago, but with the gravitational pull toward parity to the dollar losing momentum. Analysts have offered many explanations for this situation. Perhaps what matters in the context of the “Great Divergence” is the fact that the sudden initial, and perhaps unexpectedly fast, appreciation of the dollar, contributed to the slowdown of the U.S. recovery in early 2015. Investors realized that growth in the U.S. was still not strong enough to completely absorb sharp price moves in oil markets or, indeed, a rapidly falling euro.
At the same time, the surprising positive developments in the euro area, with GDP growth slightly better than expected and inflation ticking up, led some to reassess their outlook on Europe and the common currency. At this point and barring sudden shocks, it is unclear whether the euro vis-à-vis the U.S. dollar has found a range, or whether instead it will break out of it in the near future. It certainly seems to be the case that euro area policymakers would welcome further euro depreciation while policymakers in the U.S. would now prefer the dollar to stop the sharp appreciation of the past few months and stabilize, at least until they can paint a clearer picture of the state of the U.S. economy. The forex channel is significant as initially is was viewed as the most effective way to transmit the ECB’s monetary impulses to the real economy of the euro area.
This was primarily due to the fact that markets doubted that the bank-based financial system (bank loans are 70 percent of debt in Europe versus debt funding via capital markets at greater than 70 percent in the U.S.) in the monetary union would be capable of smoothly translating QE into more lending to the real economy. Indeed, despite the abundance of liquidity in financial markets with targeted longer-term refinancing operations (TLTROs) and despite the comprehensive health check that banks underwent in 2014, the non-performing loan (NPL) ratio among many banks in peripheral euro zone countries remains very high, potentially constraining credit intermediation even in the presence of QE. However, this is where the ECB’s asset purchases seem to have had a positive effect on lending, de facto ending years of credit growth contraction. However, in its Financial Stability Review of May 2015, the ECB remains cautious, noting that that, “in sharp contrast to the rise of financial risk taking, economic risk taking in the euro area is clearly lagging. This is vividly illustrated by the contrast between appreciating financial asset prices and a low level of real investment, which still remains below that of 2008, after a much more marked fall than those seen after previous recessions.” Against this backdrop, to boost the investment and thereby create jobs, attention is focused on measures that widen the funding base available to European firms. With a “new” blueprint, the Capital Markets Union (CMU), the European Commission introduced a major project to create a deeper and more integrated capital market in Europe.
Still on a Path of Divergence?
It is, of course, too soon to assess the story of the “Great Divergence” with the benefit of hindsight. As we have seen by looking at some of the building blocks of this new phase of the evolution of the central banks’ post-crisis response to the main challenges of restoring growth while preserving financial stability, seven years after the collapse of the investment bank Lehman Brothers the recovery remains very much a work in progress and central banks very much are still at the center of the ongoing efforts to find a path back to normality. So far they have been the grown-ups in the room, even when some politicians toyed with disaster. Let’s hope it stays that way.