Sébastien Cabrol, economist at BSI Economics, answers several questions about the desynchronization of monetary policies among major central banks.
While the US Federal Reserve (Fed) continues to accelerate the pace of its monetary tightening by announcing, in June 2022, a third consecutive increase in its key interest rate and has already begun to reduce the size of its balance sheet, the European Central Bank (ECB) is still at the announcement stage, and the Bank of Japan (BoJ) has just confirmed that it will maintain its accommodative stance. How can these divergences in the monetary policy pursued by the three major central banks be explained?
These divergences can be explained mainly by the different risks and constraints facing central banks in the post-COVID-19 crisis environment. In response to the latest crisis, monetary authorities reacted swiftly, deploying significant resources in a synchronized manner. In particular, by directly supporting (through asset purchase programs on the secondary market) the financing capacities of governments and their « whatever it takes » policy, central bankers helped provide immediate and massive support to economic agents and financial markets.
However, the acceleration in inflation observed globally since 2021 is likely to force monetary authorities to choose between two objectives that require contradictory courses of action. Indeed, the fight against inflation requires monetary tightening, while support for the economic and financial system requires, in principle, an accommodative policy.
However, the risks and constraints are not the same for the Fed, the ECB, and the BoJ.
Thus, in response to the acceleration in price increases observed globally:
- the Fed is showing its determination and backing up its words with action,
- the ECB is reacting late and with less room for maneuver due to a less favorable economic and, above all, financial situation,
- the BoJ is maintaining its accommodative policy in the absence, for the time being, of a sharp rise in inflation in Japan.
How can we explain the relatively sudden tightening of US monetary policy in 2022, following a yearin which the Fed was slow to react in 2021?
In the US, economic momentum and tensions in the labor market (3.6% unemployment rate) are reflected in particular in wage growth of more than 10% year-on-year (April 2022), while inflation stood at 8.6% in May. Faced with this acceleration in price rises, consumer confidence is plummeting (the University of Michigan’s consumer confidence indicator reached a historic low in June 2022), while rising costs (producer prices up 10% year-on-year) are likely to erode corporate margins. With consumers and businesses seeking to rebuild their real income and margins, respectively, the threat of sustained and structurally high inflation via the « price-wage » loop has prompted the Fed to react and abandon its wait-and-see stance of 2021 (as well as its belief in a « transitory » acceleration of inflation).
As a result, the US central bank has begun to raise its key interest rates (the federal funds rate target – the main key interest rate – has been set at between 1.5% and 1.75% since June 15, representing a 150 basis point increase since March 2022) and has begun to reduce its balance sheet since June1. The pace of monetary tightening could accelerate further between now and the end of the year. In doing so, the Fed is demonstrating its determination, even if it means causing disruption in the financial markets and an economic slowdown that would cool an overheated job market.
The ECB appears to be lagging behind in its monetary tightening cycle and perhaps less determined than the Fed. Why?
Faced with a very similar level of inflation (8.1% in May 2022), the eurozone appears to be less advanced in the economic cycle. This is reflected in particular in a labor market which, although benefiting from the lowest unemployment rate since the creation of the euro (6.8%), does not appear to be overheating as is the case across the Atlantic. Wage pressure is therefore not as strong. On the other hand, companies’ production costs are rising sharply (more than 35% year-on-year in April) due to higher raw material prices, shortages of intermediate goods, and the weakness of the euro (down nearly 15% year-on-year). This situation reduces the likelihood of monetary tightening in Europe due to a more fragile economy whose resilience, particularly in the face of tighter monetary conditions, appears to be weaker.
Furthermore, the ECB is seeking to avoid provoking a financial crisis that would be a direct consequence of the fragmentation of the eurozone. The prospect of monetary tightening and the withdrawal of support for governments (notably through the planned end of the asset purchase program (APP) on July1, which consists mainly of sovereign debt securities) has led to a rise in sovereign interest rates since the beginning of the year, hitting the most fragile and indebted countries (particularly Greece, Italy, and Spain) the hardest. To prevent these countries from encountering financing difficulties that could threaten the financial stability of the eurozone (as was the case in the early 2010s with the Greek crisis), the ECB will certainly have to limit its monetary tightening and is already considering extending its support to the most fragile countries via intervention tools that have yet to be defined.
Constrained by a less favorable economic and financial situation in the eurozone, the ECB therefore has less room for maneuver than its US counterpart and is unable to act as decisively.
How can we explain the BoJ’s ability to continue its accommodative policy, bucking the trend of most other central banks in developed countries?
The Japanese monetary authorities confirmed that they would maintain their accommodative policy following their last monetary policy committee meeting in June. The main policy rate therefore remains negative at -0.1% and the asset purchase program, aimed at keeping 10-year sovereign interest rates around 0%, is being maintained. While inflation and wage growth remain moderate in the Land of the Rising Sun (2.5% and 1.7% respectively in April 2022), the BoJ wants to maintain favorable financing conditions to support economic growth, which is expected to remain moderate (1.7% expected in 2022 according to the World Bank’s June 2022 report).
Despite a balance sheet-to-GDP ratio of over 130%, the Japanese central bank has not yet been caught up in the economic constraints of high inflation affecting consumer goods and services. It can therefore afford to continue its efforts to support the government and the Japanese economic and financial system as a whole.
