In the Grand Prix of global monetary policy, U.S. Federal Reserve Chairman Jerome Powell has just popped the transmission into neutral. Meanwhile, across the Atlantic, Mario Draghi, president of the European Central Bank, is pressing on the gas.
The markets seem to think Chairman Powell should adopt bank President Draghi’s strategy of monetary easing, pricing in at least one rate cut in the United States this year.1 But investors are wrong—I think Chairman Powell should stick to his own lane for now, pursuing patience rather than easing.
The U.S. Federal Reserve (Fed) has turned 180 degrees in the past few months, downshifting its dot plot to zero interest-rate rises in 2019 from the two forecast just last December. Chairman Powell and his colleagues cite a number of crosscurrents to justify this massive shift, including weaker inflation. Persistently weak inflation has pushed the European Central Bank (ECB) to go even further, gearing up to provide more stimulus to eurozone economies.
On this point, I think Fed officials may have more reason to worry: The United States looks worse than the eurozone when it comes to inflation. Comparing official U.S. and eurozone measures of inflation is like comparing apples to oranges; the main difference is that the United States weighs housing much heavier in the basket of goods and services used to calculate inflation. One methodology isn’t better than the other, but if you want to compare apples to apples, you have to use the same methodology to calculate price levels for both regions.
Luckily, Eurostat and the Federal Reserve Bank of St. Louis do this for us. Using the eurozone’s weights to calculate inflation, prices have been rising more slowly in the United States than in the eurozone since last November. Weaker inflation pushes real rates higher, a de facto monetary tightening
Yet the Fed is pursuing patience while the ECB is easing. In the ECB’s 2018 annual report, released on April 1, 2019, President Draghi wrote that “substantial monetary policy stimulus remains essential to ensure the continued build-up of domestic price pressures over the medium term.” To provide that stimulus, the ECB recently announced a third targeted longer-term refinancing operation to boost lending by eurozone banks. And at a recent news conference, President Draghi suggested policymakers were considering ways to ease the impact of negative rates on bank earnings. One option is to implement tiered deposit rates to shield some banks from having to pay to park excess reserves at the ECB; this should make it easier to keep negative rates in place longer.
But inflation isn’t the only factor in the Fed’s monetary policy reaction function; its dual mandate includes maximum employment. While the jobs data faltered in February, it rebounded in March, and the U.S. economy added an average of 180,000 new jobs in the first quarter of 2019—impressive, given unemployment is below 4%.1
Financial stability is also key for the Fed, and U.S. banks look stronger than many of their eurozone counterparts. The United States was much faster to stress test and recapitalize its banks following the global financial crisis of 2008. Just as important, the Fed chose not to experiment with negative deposit rates, which compress commercial banks’ net interest margins (the difference between what banks pay to borrow and what they make to lend) and dent profitability. While eurozone banks have paid about €7.5 billion a year (US$8.4 billion) to the ECB deposit facility since negative rates were introduced in 2014, U.S. banks have collected the Fed’s interest on excess reserves.
Furthermore, the United States has higher GDP and potential growth than the eurozone. The IMF’s latest World Economic Outlook estimates U.S. growth of 2.3% in 2019 and eurozone growth of 1.3%. Germany, the supposed growth engine of Europe, barely skated past recession, and Italy fell into one in the fourth quarter of 2018. Potential U.S. growth, meanwhile, is about 2.0%, roughly half a percentage point higher than the eurozone. Stronger growth should underpin more robust inflation, and so the threat of deflation is more remote for the Fed than the ECB, whatever their relative inflation readings during the past few months.
While Messrs. Draghi and Powell are on the same track, I think their strategies should be different. With deflation a tail risk, the ECB may have to step on the gas to keep from falling behind, even though it seems that generating inflation today is a bit like doing loops on the racetrack—you keep driving, but never really get anywhere. But for Chairman Powell, stronger growth and a healthier financial system mean that, whatever the current inflation number, I don’t see a need for speed.
Editor's note: An earlier version of this note orignally appeared in the Financial Times on 4/16/19.
1 Bloomberg, as of 4/16/19.