Economic conditions are sowing seeds for monetary policy change

IN MARCH, the United States Federal Reserve kept its main interest rate on hold, while the European Central Bank cut its main interest rate to zero. The moves confirmed what investors already knew: the American and European economies still have plenty of weaknesses. But despite appearances, the Fed and the ECB are on track to end their expansionary monetary policies, writes World Review Expert Professor Enrico Colombatto. In keeping interest rates on hold, the Fed showed it is aware that the American economy is relatively solid, but growth remains less than satisfactory. It understands that there is no reason to expect growth to accelerate in the near future. The ECB, for its part, has cut its main interest rate to zero. It makes no bones about the European Union’s economic weakness, which in some countries is reaching critical levels. As usual, the focus is on public finances, banking and youth unemployment. Unless growth in the EU picks up significantly (and it will not), these pressing problems will become more acute, while monetary policy will remain a poor substitute for structural reform. Mario Draghi, president of the ECB, deserves credit for stating clearly that easy money cannot work miracles. On the other hand, one might wonder how long he can maintain such a generous policy – one that will intensify throughout this year and next. The macroeconomic data shows the U.S. economy has stabilized. Unless a major downturn hits, the Fed will soon stop using low interest rates to sustain growth and feed money supply, which is currently rising at about 5.5 percent per year. The more the economy stabilizes and the need for emergency intervention recedes, the nearer the end of expansionary monetary policy. Investors realize that a new crisis is not imminent, and that interest rates will slowly rise throughout this year and next. Stock markets should not be influenced by major economic news and volatility should subside. Political tensions will now drive the broad picture, while the health and performance of each company will determine the value of its shares. In particular, since the slow rise of interest rates has already been factored in since early 2015, it will not make a major difference, not even for companies that are heavily indebted. A firmer, more consistent stance from the Fed will help the dollar eventually bolster its role as reference currency. The dollar had recently lost some of its luster, but it can recover quickly if the Brexit saga worsens and if Chinese economic policymaking becomes more confused. We can expect a gradual strengthening of the dollar/euro exchange rate, which might actually drop below $1.05 before the end of the year. Dollar-indebted developing countries will feel the pain, and high-yield bonds will become synonymous with a high risk of default. Mario Draghi is in a much more difficult situation than his American counterpart Janet Yellen. He tends to lend a friendly ear to Brussels, doing whatever it takes to bail out governments and avoid enforcing bail-in procedures on financial institutions that agreed to support public debt and corporations’ bad investments. On the other hand, he keeps repeating that his actions have no effect on growth. One wonders whether Mr. Draghi could take advantage of a Brexit by forcing his political masters to reconsider how the EU operates. The ECB was certainly not designed to finance government indebtedness and subsidize large corporations by buying their bonds. The turning point will likely take place sooner than expected. In fact, it will probably come before the end of the year, after the dust after Brexit has settled, once the Greek problem resurfaces and when EU authorities take on a number of countries who continue to flout the rules. For a more in-depth look at this subject with scenarios looking to future outcomes, go to our sister site: Geopolitical Information Service. Sign in for 3 Free Reports or Subscribe.

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