Monetary Policy and the Fed

Case in Point: The Fed and the ECB: A Tale of Divergent Monetary Policies

In the spring of 2011, the European Central Bank (ECB) began to raise interest rates, while the Federal Reserve Bank held fast to its low rate policy. With the economies of both Europe and the United States weak, why the split in direction?

For one thing, at the time, the U.S. economy looked weaker than did Europe's economy as a whole. Moreover, the recession in the United States had been deeper. For example, the unemployment rate in the United States more than doubled during the Great Recession and its aftermath, while in the eurozone, it had risen only 40%.

But the divergence also reflected the different legal environments in which the two central banks operate. The ECB has a clear mandate to fight inflation, while the Fed has more leeway in pursuing both price stability and full employment. The ECB has a specific inflation target, and the inflation measure it uses covers all prices. The Fed, with its more flexible inflation target, has tended to focus on "core" inflation, which excludes gasoline and food prices, both of which are apt to be volatile. Using each central bank's preferred inflation measure, European inflation was, at the time of the ECB rate hike, running at 2.6%, while in the United States, it was at 1.6%.

Europe also differs from the United States in its degree of unionization. Because of Europe's higher level of unionization and collective bargaining, there is a sense that any price increases in Europe will translate into sustained inflation more rapidly there than they will in the United States.

Recall, however, that the eurozone is made up of 17 diverse countries. As made evident by the headline news from most of 2011 and into 2012, a number of countries in the eurozone were experiencing sovereign debt crises (meaning that there was fear that their governments could not meet their debt obligations) as well as more severe economic conditions. Higher interest rates make their circumstances that much more difficult. While it is true that various states in the United States can experience very different economic circumstances when the Fed sets what is essentially a "national" monetary policy, having a single monetary policy for different countries presents additional problems. One reason for this this difference is that labor mobility is higher in the United States than it is across the countries of Europe. Also, the United States can use its "national" fiscal policy to help weaker states.

In the fall of 2011, the ECB reversed course. At its first meeting under its new president, Mario Draghi, in November 2011, it lowered rates, citing slower growth and growing concerns about the sovereign debt crisis. A further rate cut followed in December. Interestingly, the inflation rate at the time of the cuts was running at about 3%, which was above the ECB's stated goal of 2%. The ECB argued that it was forecasting lower inflation for the future. So even the ECB has some flexibility and room for discretion.