Uh oh, it’s break-up time: Why the ECB and Fed will diverge on policy in 2014

Time to break it up, guys.

Ever since the global financial crisis erupted in full fury in 2008, the US and Europe (along with some other developed countries) have strived to ensure a co-ordinated monetary policy response.

At the height of the crisis, interest rates were slashed and emergency credit lines were extended to needy financial organisations. The US, arguably, was more liberal in easing monetary policy, even resorting to unconventional measures such as asset purchases (dubbed ‘quantitative easing’, or QE).

While these co-ordinated efforts managed to prevent the global economy from flatlining, they couldn’t quite prevent the large-scale destruction of economic activity that occurred over the next three years.

Nevertheless, those joining-of-hands efforts by major central banks around the world were crucial to nursing a devastated global economy back to convalescence by the end of 2013.

Now, if things go according to plan, in 2014, the US and Europe (more specifically, the eurozone) will go their separate ways on monetary policy.

That’s because things have changed for the nations on both sides of the Atlantic.

What’s happening in the US:

Consider the US. Its economy is currently enjoying a rather impressive economic recovery: GDP growth surged by 4.1% (partly due to seasonal factors) in the June to September quarter, its strongest showing since late 2011; the jobless rate is down to 7% from a high of nearly 10%; and manufacturing  activity and consumer spending are gaining traction.

With the economy increasingly looking like it can stand on its own feet, the Federal Reserve is attempting to dial back its unconventional monetary stimulus measures.

While interest rates are expected to remain low this year, the bond buying programme is set to be shuttered by the end of 2014, assuming the economy continues to be on the mend.

Even though monetary policy remains loose, the focus is now on sucking out excess stimulus because, well, the economy doesn’t need it anymore.

In addition, the withdrawal of QE (dubbed ‘tapering’) is set to take place amid another significant event: the end of the era of Ben Bernanke as US Federal Reserve chairman. Bernanke, the man who led the Fed during the worst financial crisis the US has seen since the Great Depression of the 1930s, steps down on January 31, after which Janet Yellen takes over.

What’s happening in the eurozone

The eurozone, meanwhile, has a completely different story to tell. GDP growth in the June to September quarter was a feeble 0.4% on an annualised basis; the unemployment rate remains at a high 12.1%; and bank lending continues to shrink, along with consumer spending.

Worse, with inflation near a four-year-low, the region faces the rising threat of deflation, which could kill any potential economic recovery in the future.

In the absence of any fiscal stimulus (politicians in Europe are still riding the austerity bandwagon), the task of juicing the economy will fall on the European Central Bank.

It has room to do that. Even though interest rates are at rock bottom levels, the ECB has done considerably less by way of monetary policy, so far, compared with the Federal Reserve.

Given that the eurozone barely managed to limp to recovery, the focus is still very much on reviving economic activity.

Indeed, in the last two months of 2013, some senior ECB officials started dropping hints about doing more, including introducing a negative rate on commercial bank deposits with the central bank, targeted long-term lending for commercial banks and even a Fed-style asset-purchase programme.

End of an era?

To sum up, while the Fed is trying to slowly remove some of its market props, the ECB is contemplating bringing in some new ones.

With the economies on both sides of the Atlantic drifting in different directions, the time is nearing monetary policy to disengage from the lock-step co-ordinated behaviour seen in the recent past.

The impact of increasingly different monetary policies by the world’s top two economic regions will, no doubt, be felt by emerging markets.

Yes, like bad romances, co-ordinated or easy monetary policies don’t last forever.

[Image Credit]

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