June 14, 2017    5 minute read

The Flight of the Birds: a Study of Monetary Policies

Schools of Thought Collide    June 14, 2017    5 minute read

The Flight of the Birds: a Study of Monetary Policies

After the financial crisis that plagued the world economy a decade ago, the path towards recovery has continued to prove difficult. This is partially down to the increased reluctance on behalf of banks to lend money, causing reductions in investment and economic growth. In order to best facilitate economic recovery, the three major central banks have taken diverging approaches in their respective monetary policies. Their varying strategies interestingly act as indicators showing their stance towards the strength of the economies they are responsible for.

What renders the analysis of monetary policy so important is that it is sometimes a study of an institution directly trying to stunt its nation’s growth, which at first glance seems grossly counter-intuitive. However, interest rates are a necessary instrument to ensure consistent and low inflation, which some argue is more important than ever-increasing productivity.

Uncle Sam’s Aggressive Hawk

Under the direction of Janet Yellen, the Federal Reserve has become increasingly hawkish in its monetary policy. The most recent rise in interest rates came in March, which brought them to 1%.

The discussion of a third increase to rates in 6 months arguably highlights the position of relative strength that the US economy is currently undergoing. Hawkish monetary policy is a way of curbing inflation by decreasing general productivity due to increases in yields across corporate and government bonds. The Fed currently finds itself in a conflicted position, as it must balance the need to revitalise the slowly depreciating US dollar (an objective aided by a rise in rates) with acquiring its target of price stability in the form of a 2% inflation rate. As CPI is currently hovering at 1.5%, it would seem as though the hawk is preparing for a premature flight.

The US economy has perhaps seen more positive signs of recovery in comparison with its European counterparts. However, the Fed is arguably overestimating this. If one bears in mind the recent underperformances of the US jobs and wage market, the case for incentivising investment via a lower interest rate (which in turn should raise inflation) seems strong. While the recent raises of rates have left little imprints on the markets, the Fed should also be cautious of the long-term effects of increased aggression in their monetary policy, which provides a subsequent reason in favour of delaying a further increase to rates.

Draghi’s Coy Dove

While the Fed’s hawkish monetary policy could be seen as a transitional process of moving away from quantitative easing, the European Central Bank seems determined to continue on this path after unveiling plans to purchase €2 trillion of assets by the end of 2017, by maintaining a bank deposit rate of -0.4%. By investing particularly in bonds, the ECB is contributing towards the growth of the Eurozone.

Although there is reason to believe that the ECB will also move towards a more hawkish stance, this is unlikely to occur until 2018. The time lag between their respective moves to a more aggressive monetary position arguably highlights the differences in strength between the USA and the Eurozone as a whole. A possible explanation for this variation could be down to the fact that the Eurozone is made up of 19 different countries, each needing to retain the same interest rate. While a move away from quantitative easing would benefit the German economy due to its current strength in output, the majority of the Eurozone requires added stimuli to promote economic growth, which can be seen through the ECB’s purchase of fixed income.

Britannia’s Evolution

The Bank of England, under the influence of Mark Carney, is starting to peer over the edge of the precipice, preparing itself for the possibility of a future dive. Historically, the Bank of England has mirrored the Federal Reserve with regards to monetary policy. However, due to current uncertainty (otherwise referred to as Brexit), rates are being kept at a stable 0.25%. The Bank also plans on purchasing £10 billion in corporate bonds and £435 billion in gilts in order to stimulate the UK economy.

However, the Bank of England arguably has the greatest dilemma of all. With inflation having risen to 2.7%, (0.7% above the target), it would appear as though Britannia’s dove is in need of a metamorphic transformation to curb inflation. This would allow a newly-born hawk to spread its wings. However, this rise in inflation has been seen as the by-product of depreciations in both sterling and in the price of crude oil. Given the monetary policy committee’s recent decision to keep interest rates at 0.25%, the Bank of England is likely predicting increased stability in the British currency and the energy market in order retain inflation close to the target, so as to incentivise productivity given the uncertainty surrounding Britain’s decision to leave the European Union.

Conclusion

The position of a central bank’s monetary policy is often a strong indicator of the economic strength of its nation. Despite travelling at different speeds, it is clear that these three economic birds have long term goals to sever their relationship with quantitative easing. While it will be interesting to see how the change evolves, it is clear that patience will be necessary as the journey towards economic recovery is a long one. A hasty change of policy by a central bank could destroy any progress made over the course of this past decade, as an attempt to control inflation could have strong repercussions to productivity.

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