All central banks are not created equal

Charles T. Trible, BridgeTower Media Newswires

In the United States, the federal government is in charge of its own fiscal policy (i.e., taxes and spending). State and local governments work along the same lines but on a smaller scale. Monetary policy, on the other hand, is set by an independent quasi-government group called The Federal Reserve. The Federal Reserve (the Fed) is given the reins to adjust short-term government interest rates to help smooth the business cycle by encouraging or discouraging marginal borrowing. In turn, this affects the unemployment rate and the rate of inflation.

When the economy is hot and money is easy to obtain, the Fed has the ability to raise rates. Conversely, when businesses are afraid to borrow in fear of a gloomy future, the Fed can lower rates (in recent history to zero) to entice entrepreneurs to invest in any project with the expectation of a positive return.

Working in concert with the Fed’s monetary policy is the U.S. government’s fiscal policy, which has the ability to lower taxes or spend money, borrowed or otherwise, to give a lagging economy a boost. Politicians seem more reluctant to slow down a hot economy than independently appointed Federal Reserve officials, for obvious reasons, but this lopsided incentive structure is universal. What is not universal is central bank jurisdiction. Although central banks like the Fed, the Bank of England, and the Bank of Japan manage one country’s monetary policy, The European Central Bank (the ECB) is in charge of a wide swath of heterogeneous economies in need of more than a one-size-fits-all policy.

Soon after the financial crisis in 2008, the fragility of the Euro changed from theory to reality. The GIPSI countries (Greece, Ireland, Portugal, Spain and Italy) of the Eurozone proved overly indebted and nearly insolvent while a cohort of stronger countries led by Germany found themselves on reasonably solid footing, considering the global malaise. After a series of bailouts and sovereign debt write-downs, the ECB was standing in front of a decision that had the potential to diverge the path of its unique constituent economies further. If the ECB were to simply ease monetary policy, the financially conservative members would feel as though they were carrying all the weight and be pressured to disband. If the ECB were to tighten monetary policy, the weaker countries, like Greece (which had a 27.9% unemployment rate in September of 2013), would move toward leaving the currency union themselves.

Instead of pushing the two groups apart, the ECB decided to get creative in what some called a breach of the treaty that initially brought them together. Under the premise that they were allowed to act in any fashion to quell a threat to the stability of the Euro currency, the ECB bought bonds specifically in the GIPSI counties to lower their cost of borrowing. When the price of a bond is bid up against a fixed interest payment, the yield is forced down — this lowered their interest burden, helping them live another day. Germany and company were not pleased, but a series of austerity measures were attached as a sort of hedge in hopes of nudging the derelict countries back in line.

Six years after ECB, President Mario Draghi expressed his desire to do “whatever it takes” to save the Euro; the 10 year bond yield in Greece has fallen from 25% to 4%. While the stronger countries may have been upset by this special treatment, such feelings were likely overcome by their own self-preservation, as over 10% of Germany’s exports were purchased by their GIPSI neighbors in 2016. In short, the Euro is an imperfect union, with restrictive monetary policy and wildly different fiscal policy. The ECB’s actions over the last decade were messy yet crafty and, on balance, effective.

Here in the United States, we are provided the luxury of having only one country to manage from a monetary perspective. The Fed has raised short-term rates seven times since December 2015 in hopes to regain the ability to lower rates in the future, if necessary. While the Fed stopped buying bonds in October 2014, they recently stopped reinvesting the proceeds of their bond purchases, effectively tightening policy. The ECB is way behind the curve; they are still buying bonds and expect to until year-end. Both raising rates and decreasing its balance sheet are seen as tightening the belt of credit creation.

What is unique this time around is that U.S. fiscal policy is stimulative at a time of no major war and concurrent with monetary tightening. Setting a single rate for a single country keeps things less complicated domestically than across the pond, and could keep the United States ahead of the monetary policy curve during this historically long, yet leisurely recovery.


Charles T. Trible, CFA is an equity analyst for Karpus Investment Management, a local independent, registered investment advisor managing assets for individuals, corporations, non-profits and trustees.  Offices are located at 183 Sully’s Trail, Pittsford, NY 14534, (585) 586-4680.