Divergence in Fed and ECB monetary policy

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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