Archive for July 30th, 2008

Divergence in Fed and ECB monetary policy

July 30, 2008

Inflation is rising everywhere but only few central banks are trying to curb inflation and inflationary expectations by rising interest rates.

For instance, Fed has cut rates and paused now whereas ECB has started raising rates. How do you explain these divergences?

I came across this fantastic speech by Mr Ignazio Visco, Deputy Director General of the Bank of Italy who provides some answers.

  • If we compare, for example, the change in the forecasts of the two central banks in the last year, we see that the Fed has changed its forecasts of growth for 2008 by much more than the ECB (-2% vs. -0,5%), while the reverse is true for inflation (+0,4% vs. +0,9%).
  • The difference in the policy stance may also have accentuated the perception of differences in the liquidity provision policies followed  by the two central banks. While some differences were certainly present (in terms of counterparties, instruments and facilities used for open market operations), overall the two  banks did not inject more reserves than needed to maintain reference rates near policy rates and net injections were quickly reversed. However, while the ECB had to clearly (and successfully) distinguish liquidity provision from the monetary policy stance, in the Fed case active liquidity provision and more expansionary monetary policy went hand in hand.

So Fed is more bearish in growth outlook than ECB and more optimistic over low inflation than ECB. Hence rate cuts for Fed and rate hikes for ECB.

I found the second point more interesting. Fed not only injected liquidity but also lowered its interest rates leading to monetary expansion. ECB on the other hand, didn’t lower its base rate and just provided more liquidity. This is a very neat way of explaining the divergence.

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Time to read some literature on stabilization policies

July 30, 2008

As world economies and financial markets go under turbulence, time has come to read literature on stabilization policies.

In 2002 Kansas Fed in its annual symposium had a theme – Rethinking Stabilization Policy and all the papers are a must read. It will give some clues on where we are and how policies have fared or will help us restabilise. Above all, it will tell how certain policies are for certain purposes and whether it has served those purposes or not.

Here is some trivia with Kansas City Fed symposium. Every year Kansas Fed has a symposium around a main theme. Most economists reserve their best papers for the conference. For instance, the Raghuram Rajan paper that is often said to have predicted sub-prime markets (he highlighted huge incentives could  lead to more risk taking and financial turbulence) was presented in 2005 at this symposium.

In the same year symposium, Blinder and Reis presented a paper praising Greenspan and his policies which are criticised bigtime now. Then there is a famous paper presented by Romer couple in 2002 on stabilization which i see being referred now and then.

Interestingly, Bernanke also shifted his monetary policy stance in 2007 symposium. In 2007 Bernanke said:

It is not the responsibility of the Federal Reserve–nor would it be appropriate–to protect lenders and investors from the consequences of their financial decisions.  But developments in financial markets can have broad economic effects felt by many outside the markets, and the Federal Reserve must take those effects into account when determining policy.

We now know it is not true. The statement itself was problematic as developments in financial markets would imply that lenders and investors would be under stress. Now, we know you can always back on mon policy to bail you out.

Assorted Links

July 30, 2008

1. WSJ Blog points housing prices in US continue to fall freely

2. WSJ Blog points inflation continues to rise worldwide.

3. PSD blog points Doha round talks have ended without any progress.

4. DB BLog points to a paper on labor reforms

5. Econbrowser points people chaning demand patterns as oil prices rise

6. ASB points how auction is leading to lower public fund management costs in India.


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