Friday, May 3, 2013

The ECB and the Fed

This morning the European Central Bank acted on the recent run of weaker data and lower inflation by cutting the main refinancing rate by 25bps to 0.5%.  ECB President Mario Draghi said the bank remained “ready to act if needed”, which he suggested could mean negative interest rates whereby banks would be charged for depositing money at the ECB.
Economic conditions remain dire in the euro zone.  Unemployment reached 12.1% in March and the inflation rate has recently fallen to 1.2%.  I’m not convinced however that today’s action from the ECB will do much to help, other than send a message that they are worried. 
At risk of sounding like a worn record the best course of action right now is to take advantage of relative financial calm to relax deficit reduction targets.  I agree with the ECB’s comments today that Governments should not “unravel” progress on deficit reduction, but I think they should take a more pragmatic approach to further deficit reduction.  I’d also like to see the ECB target still difficult financing conditions, especially in the SME sector, by implementing a UK style funding for lending program.  If the Bank is going to do something, they might as well do something that’s going to make a difference.
Such measures would allow scope for further structural reforms in individual countries aimed at improving competitiveness.  At the same time authorities should continue reverse engineering the gaps in the original construction of the Euro by establishing a banking union, at least as the first step.  As it stands monetary policy is being required to do too much of the work and compensate for lack of structural reform and harsh front-loaded austerity.  That’s still not the first-best plan. 
In a similar vein the US Federal Reserve is working hard to try to offset the growth-dampening effect of fiscal drag that will be around 2 percentage points this year.  A comprehensive and credible medium-term plan would have spread that out a bit. Yep, it’s that same worn record.
I’m not overly concerned about the recent run of softer data in America.  The end of 2012 and first half of 2013 was always going to be a difficult period in which to read too much into the data.  The end of 2012 was weak as firms and households delayed activity on the back of fiscal cliff concerns. We saw the catch-up activity in early 2013 and now further into the year we are seeing the toll that fiscal drag is taking on the economy.  We always expected the June quarter to be the weakest patch of the year. 
The bright bit of news is recent labour market data such as initial jobless claims which is holding onto recent gains.  We will see if that translates into jobs growth with April payrolls data scheduled for release tonight.
The Fed is obviously watching closely as in this week’s statement they signalled that they are ready to reduce or increase their asset purchase program.  I think growth picks up in America later this year as the housing market continues to improve and as the impact of fiscal drag wanes.  That means the next likely move by the Fed is a reduction in asset purchases, but that’s a late 2013 story at the earliest.