The European Central Bank Turns into the Fed?

by Andreas Hoffmann*

The European Central Bank (ECB) and the Fed differ in many aspects. First, the ECB is considered to be more hawkish on fighting inflationary tendencies. Its primary goal is price stability and it has continued to watch money growth. Output gaps below full-employment are only considered secondary as instrument to forecast inflation.

Secondly the ECB was constructed to be more independent than the Fed. Thus there has been less interaction with fiscal authorities. Less mobility from governments to the ECB (and vice versa) documents this independence. While in the US it is common to see central bank officials and the secretary of treasury plan the future of the economy, in Europe this is not the case. Central bank independence is considered an important aspect of credibility and stability of the currency (the German central bank model). However, the current crisis has made the ECB more “Anglo-Saxon.”

Recently the ECB has announced to buy government bonds of crisis countries. This should help pushing down risk premia of bonds to a “normal” level (wherever this could be) to allow these countries to cope with consolidation and austerity plans. For the first time the ECB has followed Anglo-Saxon central bank policies to stabilize markets, because other solutions to the problems – such as defaults and insolvencies – have no political support. 

The Fed bought 5 % of the treasuries and more than 10 % of the mortgages in the latest crisis. A similar policy is likely to prevent a spill-over of the debt crisis from Greece to Portugal and may depress speculation against the euro. If this does not help, the ECB could monetize the debt completely. Therefore signaling that the ECB will do everything to keep countries solvent may contribute to stability (in the short-run).

In the long run, inflation expectations could rise. However, the ECB promises to watch money growth and sterilize bond purchases to not fuel inflation. There are at least three ways to sterilize: First, it could absorb surplus liquidity from last year’s 12 month tender in June, which could account for 442 billion euro or 600 billion dollars (link) Second, the ECB could go over to fine tuning measures and absorb liquidity here and there. And third, the ECB could sell debt securities to banks to take liquidity out of the system.

But currently the ECB does not even have control over money supply as it fully serves money demand of the banking sector through full allotment fixed rate tender operations, in which banks can ask for any amount of liquidity at a fixed interest rate. Further additional tenders (due to the crisis) rather increase money supply. Banks even store deposits at the central bank.

If the ECB takes money out of the system, these low-yielding deposits may shrink (which are being build up currently to have liquidity when the ECB starts absorbing), but not necessarily the money in the economy. Thus sterilization may not be successful right away. It is also not very likely in the midst of crisis due to two reasons: First, the latest fall in the euro does nothing but help the euro area’s periphery countries to regain some competitiveness and supports their recovery. Second, prices are levels are stable and a second recession could actually have deflationary consequences in some areas. Thus it is going to be interesting to watch the near future wording of ECB statements. I believe they are  likely to change from addressing the issues of money growth to price level stabilization as it is done in the US.

If sterilization works, the ECB may remain credible and could possibly point to this as a one-time bail-out. But even this is problematic as with the introduction of the “transfer union” countries with thriving deficits will expect to be bailed-out. Thus the independence of the ECB from fiscal policy making is in danger. If this last bastion falls, the transformation of the ECB to an Anglo-Saxon style central bank will be completed. France and other countries have been pushing for this for a long time.

*Andreas  Hoffmann is a doctoral candidate at the University of Leipzig and currently visiting the Department of Economics at New York University

9 thoughts on “The European Central Bank Turns into the Fed?

  1. Great analysis Andreas. Hear anything about a rumor floating around now is that Germany made a deal so that Weber takes over the ECB Pres. in 2011?

  2. The ECB is not the only organization in the midst of a very significant change; the whole EU might become more like the US because of the crisis – and nor so much because of the Lisbon Treaty – if one looks at various centralizing policies coming out from Brussels.

  3. I think the independence of the ECB has been lost, and it will drag the Fed further down that path. The Fed is committed to providing unlimited dollar swaps to the ECB. That effectively puts US monetary policy under the control of the ECB, which, in turn, is now subservient to EU fiscal authorities.

  4. @ Jerry

    Thank you for pointing this out. So the Fed is always considered to be dominating other central banks. But you are right, now these issues are much more intertwined and debt financing is going to be a main issue in the US as well as Europe in this decade.

    Maybe it would be politically feasible to keep up easy money policies – serving any demand of banks and governments – but raising rates in order to prevent too much malinvestment and to make new deficits costly. On this way banks and states would get as much money as they need to stay solvent but be discouraged from riskier investment etc. The interbanking market would also be supported. I am not sure if this is possible/makes sense as a “middle” solution?

  5. Andrea,

    Are the banks solvent and can liquidity stave off insolvency? Over the weekend, the Wall Street Journal reported that the top 5 US banks are seriously exposed to Europe. Their capital could be wiped out by defaults.

    And here is the problem with anything like current policy.

    A new housing bubble is being ignited by the low interest rates and government guarantees. New homes are being built in Las Vegas as foreclosures continue.

    Does anyone believe the real risk-free rate is below 2%? Or that inflation is zero or near it?
    In any case, real rates have been negative for a prolonged period of time. We know what that bodes.

  6. Jerry,

    this is probably the reason why the Fed engaged in providing dollars again.

    It is a difficult issue. I do think that consumer price inflation is positive and rates are negative, so there is enough liquidity – definitely.

    I also generally disagree with additional liquidity injections. I was thinking of what may be politically possible – as everything but inflating seems to be out of fashion. Higher rates could shrink demand and easy access to liquidity could be stabilizing. That was the idea.

    However, whatever way will be chosen, it is worrisome that the Ecb now lost its independence.

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