Location: New York
Author: Shahin Shojai
Date: Monday, November 5, 2007
The recent cut in U.S. interest rates has certainly received mixed reviews. Some accuse the U.S. Federal Reserve of preempting the 25 basis point fall by its previously unexpected 50 basis point cut decision; and pre-emption is not something central bankers are supposed to do.
Those against the implications, rather than necessarily the act itself, of the cut argue that by building expectations the Fed forced itself into having to cut rates and closed the door on the other options, such as waiting an extra month for more information, that were open to it. They further suggest that the implications on the U.S. currency and long-term inflation could be severe.
Those who are very happy with the cut believe that it demonstrates the fact that the Fed, unlike the European Central Bank, is not excessively transfixed on inflationary expectations and that economic stability and activity are also taken very seriously. The Fed is now worried about the longer term implications of the falling house prices and the recent credit crunch, though the concerns about the latter have subsided somewhat in recent weeks, and is reacting accordingly.
No matter which side of the debate one is sitting one thing is clear and that is that the Fed is able to make decisions that can permeate across the entire union, and as a result does. By cutting interest rates the Fed can expect the entire country to benefit.
This is not the kind of environment that the ECB is operating in. A cut in interest rates by the ECB might help some countries but it could also dramatically increase inflationary risks in others.
While the founders of the ECB were hoping that intra-union financial mobility was strong enough and smooth enough to help pass on risks from one member to another it simply has not transpired. There are markets in Europe that have very weak property markets while others are exploding.
Existence of organizations such as Fannie Mae would help increase the connections between these markets, something that is certainly missing in the European Mortgage Market. Lack of labor mobility, exacerbated by certain national tendencies by some members of the European Union, does not help the situation either.
Whether by chance or planning, the U.S. has established the institutions that help transfer liquidity across the union. Such cross-union institutions simply do not exist in Europe . The likelihood that they will even be created is also quite small, as member states work very hard to protect their own part-ownerships in their national institutions.
The settlement and clearing of trades in Europe is a perfect example of that. Even when the ECB steps in to help create a mechanism for smoother cross-border, intra-union, trade settlements it is accused of trying to grab powers beyond its remits. Very few suggest alternatives but they do not want a supranational institution from establishing the terms of engagement.
Only time will tell which policy was right. Whether the Fed was correct in cutting rates so aggressively to help the economy or the ECB’s pronouncements that there might still be room for rate hikes in Europe .
But, one thing is for sure, even if the ECB wanted to take economic activity into account it would find it very difficult to do so. The fact is that the economies of the European member states are so different that the implications of decisions would be quite different in each. These countries are at different stages of economic development, let alone cycles.
Consequently, I believe that the recent rate decisions by the two central banks say a lot more about the intra-union connections and liquidity, capital, and labor transfer mechanisms than what policies are best in response to a rapid fall in credit availability.
If I had to choose, however, I would take the Fed every time, since it reacts in ways that it believes are in the best interest of the U.S. economy and not to demonstrate to the markets that it is in fact serious about fighting inflation. The ECB is still trying to prove itself to the markets, something the Fed does not have to, and as a result takes decisions that are great for economic textbooks but not necessarily for the European economies.
Only when the ECB feels that it has a similar credibility to the Fed, and hopefully by that time more intra-union transfer mechanisms have been established and the economies of Europe are more aligned, will it also be able to afford upsetting textbook economists to satisfy the financial markets and citizens of its members.
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