Divergence in Fed and ECB monetary policy -II

I had written a post explaining the difference in monetary policy between US and ECB. ECB is more hawkish on inflation compared to Fed; Fed is more bearish on growth, though with the recent ECB monetary policy statement, ECB is pretty bearish as well. As a result, Fed has used both liquidity and interest rates to calm markets but ECB has only used liquidity measures.

I came across this speechby Janet Yellen, President San Francisco Fed. She is quite bearish on the US economy and upbeat about inflation coming down. She says:

monetary policy in Europe has been less accommodative during this period than in the U.S. For example, while the Fed cut its target interest rate substantially to 2 percent during the course of the credit crisis that began last summer, the European Central Bank kept its policy interest rate steady throughout, and then tightened by 25 basis points to 4¼ percent in July.

Part of the reason for the difference is that the European Central Bank’s mandate requires it to focus on controlling headline inflation, which reached 4 percent for the twelve months ending in July—a rate well above its official objective of below, but close to 2 percent.

In addition, even though much of the recent increase in inflation is attributable to commodity prices, and therefore likely to be a temporary phenomenon, the central bank has been worried about second-round effects on inflation expectations, wages, and other costs, and justifiably so.

The euro zone has a greater degree of wage indexation and collective bargaining than the U.S. So it is more likely that higher headline inflation will fairly quickly get built into wages there, setting off a wage-price spiral that could be persistent and difficult to stop.

That is a nice way of explaning the differences in the 2 economies and monetary policy actions. She points there is little chance of it happening in US:

However, that does not mean that we can afford to ignore the risk that such a damaging spiral could develop here.

 Fortunately, I do not see signs of this development at this point. First, the reports of our directors and business contacts are consistent with the view that no such dynamic has taken hold. Outside of a few booming sectors such as energy, we hear no reports of escalating wage pressures even though higher food and energy prices have eroded the real incomes of American workers. Our contacts note that high unemployment is holding down labor turnover, suppressing the need to raise wages more rapidly. The two broad measures of national labor compensation that we monitor have shown remarkably small increases recently

Moreover, various measures of longer-term inflation expectations suggest that they remain relatively well contained. With the recent decline in commodity prices, inflation expectations for the next five years have edged down slightly in both the Michigan Survey of households and the Philadelphia Fed’s Survey of Professional Forecasters. Furthermore, since June, compensation for inflation and inflation risk over the next five years—as measured in markets for Treasury Inflation Protected Securities—has dropped noticeably and is now under 2 percent.

The key is managing expectations. I don’t understand this focus on inflation expectations  over 5 years!! That is too long a time. As I have explained in this paper long term is a sum of short-term. If people realise Fed isn’t anchoring inflation, they will revise their expectations.  Moreover, she expects the inflation to be higher.

Headline inflation is likely to remain much higher than I would like for a quarter or two as previous increases in commodity prices boost the prices paid by consumers for food and energy. With regard to core inflation, I wouldn’t be surprised if it runs modestly higher for a while, too, as businesses pass on some of their higher energy, transportation, and other costs to customers. However, for several reasons, I expect both headline and core inflation to move down to a much more moderate rate of just over 2 percent next year.

So, if inflation continues to be high, inflation expectations would follow as well. You need to have a more immediate approach than a 5 year approach to inflation.  And she also says inflation would ease by next year. Next year when? December?

However, Yellen has been quite right in her view on employment numbers as they have deteriorated further. So there is hope for sure. But again, never underestimate inflation. It has more surprises than you can ever imagine. That is the biggest lesson learnt.