What won’t be in the strategy review
- The divergence between a decisive Fed and a more hesitant ECB is an interesting debate but it hides the fact that on both sides of the Atlantic monetary policy through its traditional transmission channels is facing diminishing returns. Allowing financial space for fiscally accommodative government is probably the most efficient channel at the moment – not something likely to be made explicit in a “strategy review”.
The ECB was in focus this week. Although no “hard announcement” was expected, Christine Lagarde’s press conference triggered a wave of comments on a divergence between the Fed’s decisiveness and the ECB’s more hesitant approach, which may be fuelling another bout of euro appreciation. It is true that while Jay Powell at Jackson Hole has communicated a significant change in approach – the shift to average inflation targeting – the ECB is not in a hurry to unveil its own strategy review.
Still, while we find the Fed’s decision intellectually alluring, we are not convinced it can “move the dial” that much. Central banks on the two sides of the pond are faced with the same diminishing returns on their stimulus. We find it interesting that the ECB is increasingly explicit about the contribution from fiscal policy to achieving their inflation target. In turn, allowing financial space to fiscally accommodative governments may well be at the moment the most efficient transmission channel for monetary policy. This suggests that more fiscal stimulus does not exonerate the central banks from acting more themselves. In truth, this is why we expect the European central bank to announce a time and quantum extension of its Pandemic Emergency Purchase Programme at the end of the year. Government issuance will grow next year and sticking to the current soft deadline for PEPP (June 2021) would collide with the likely emergence of the EU’s Recovery and Resilience debt issuance. The ECB can hardly warmly praise the initiative as Christine Lagarde did this week, without making sure that financial conditions will be favourable when it becomes a material issuer.
This might well be an extreme form of “fiscal dominance”, and one which central banks may be reluctant to make too explicit in any strategy review, especially the ECB given the nominal fiscal orthodoxy of the European Treaty. This is of course a slippery slope. Knowing where to stop will be key and finding the right balance between making public debt sustainable and condoning reckless fiscal behaviour is hard to find and will require a very high level of coordination between the central bank and the governments. The alternative though – allowing the economy to fall in a deflationary trap – is not more palatable.