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The ECB and the Fed: Divergent Paths to Doom?

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Americans tend to focus on the Federal Reserve, but often forget the US central bank isn’t the only game in town.

While Yellen and company hint they will try to continue pushing interest rates up, European Central Bank president Mario Draghi told European Parliament’s Economic and Monetary Affairs committee he intends to push ahead with his interventionist monetary policy. That means continued negative interest rates and quantitative easing for the EU.

So, are the world’s two largest central banks taking divergent paths to doom?

During Monday’s meeting, Draghi stressed the European bloc still needs “an extraordinary amount of monetary support” in spite of its growing economic recovery. The ECB president said he’s”firmly convinced” the bank should continue “support measures,” including €60 billion of monthly bond purchases.

Overall, we remain firmly convinced that an extraordinary amount of monetary policy support, including through our forward guidance, is still necessary for the present level of underutilized resources to be re-absorbed and for inflation to return to and durably stabilize around levels close to 2pc within a meaningful medium-term horizon.”

Sarah Hewin at Standard Chartered in London told Pound Sterling Live she thinks the ECB will continue quantitative easing and artificially low interest rate polices until at least early next year.

We think an explicit announcement about exiting QE is unlikely to come until the September meeting. We expect tapering of asset purchases to begin in January 2018 and end by Q3-2018, though this would require action to deal with asset scarcity. We think that the deposit rate will not be hiked until after the QE program ends, probably in Q1-2019.”

To put things into perspective, the ECB pushed interest rates to negative levels in June to 2014. Rates have remained in the basement ever since. So, even after more than three years of negative rates and quantitative easing, the ECB still doesn’t feel confident enough to “normalize.” A cynic might suggest Draghi doesn’t want to normalize rates because he knows it will tank the modest economic gains the EU has managed to ring out of the last three years.

Meanwhile, US central bankers continue to try to convince everybody they will push ahead with efforts to normalize. Federal Reserve Bank of San Francisco President John Williams said he still expects two more rate hikes this year. The Fed has also floated the notion that it will begin to unwind its balance sheet. Williams said he doesn’t think normalization policies will cause significant problems.

I’m not as worried about a severe reaction globally like the taper tantrum to this normalization of our balance sheet. We’re already raising interest rates. So pulling back on the balance sheet gradually, slowly over years, that’s just moving consistent with what we’re doing with our other tools.”

But it’s interesting Williams used the term “taper-tantrum.” That’s exactly what C. Jay Engel at the Mises Institute thinks will happen if the Fed actually pushes forward with normalization. After years of monetary expansion and interest rate manipulation to the benefit of Wall Street (and others), it has its proverbial back against the wall. If the Fed continues to push rates up and begins to unwind its balance sheet, it risks popping the stock market bubble it has inflated. But on the other hand, it can’t keep its current policy in place forever.

The Fed still has at the forefront of its mind the ‘tantrum’ that may ensue if historically unprecedented ‘accommodation’ is slightly taken away. The Fed is stuck, and refuses to admit it. The question remains to be seen: how far on the road to balance sheet ‘normalization’ can they go?”

Interestingly, the euro tanked after Draghi’s comments. This illuminates the choice facing the central bankers. They can keep the extraordinary monetary policy in place in order to keep the asset bubbles inflated at the expense of the currency, or they can “normalize” and risk popping the bubbles.

Peter has argued that the Fed will not aggressively move forward with normalization if it means crashing Wall Street. As he put it during a CNBC interview last summer, the Fed will ultimately sacrifice the dollar on the altar of the stock market. The central bank’s main goal is to make sure the stock market doesn’t crash again. Peter said they might succeed, but only at the expense of the dollar.

So we’re going into a currency crisis, and this crisis is going to be much bigger than a financial crisis. The impact it’s going to have on the average American, on his standard of living, on his way of life is going to be much more profound. And sure, people won’t lose as much money in their stock portfolio, but if they try to sell their stocks and spend the money, the purchasing power that they lose is going to be much greater then what was lost in ’08.”

How it will all play out remains to be seen, but it’s interesting the the ECB and the Fed seem to be walking down divergent paths to doom.

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