The Monetary Policy Divergence among U.S., Japan and Europe Resulting in Greater Global Risks - 2022-08-19
The world is undergoing high inflation not seen over several decades, with interest rate hikes in major central banks on a scale of the 20-year record. In the past 3 months, global central banks have raised key interest rates nearly 70 times. Due to factors such as different inflation and domestic political and economic situations, however, the policy adjustments by the three major central banks in the U. S., Japan and Europe are significantly differentiated in both frequency and intensity, which will further increase the complexity and unpredictability of the global economy and finance.
Now, inflation is the No. 1 enemy of the U.S. economy, and the stubbornness of U.S. inflation is far beyond our expectations. An article by Lawrence Summers, former U.S. Treasury Secretary and a professor at Harvard University, in last February warns that the large-scale fiscal and monetary stimulus policies in the U.S. may give rise to "inflationary pressures never seen by this generation" and that the U.S. needs to quickly adjust its fiscal and monetary policies to deal with inflation risks. However, the Biden administration and the Federal Reserve have repeatedly downplayed risks with a "temporary inflation theory", which later has proven to be a serious miscalculation.
The U.S. inflation rate has been over 5% for 13 consecutive months and over 8% for 4 consecutive months. In June, it soared to 9.1%, a new record over 40 years. In order to curb inflation, the Federal Reserve made a historic decision to hike interest rates by 75 basis points, the largest increase over 28 years. The Federal Reserve also stressed that it would continue hiking interest rates beyond the neutral level without delay, if necessary, until inflation could fall significantly. However, its policy adjustment has lagged far behind inflation.
Under the pressure of inflation, the whole world is experiencing a wave of interest rate hikes. Following the Federal Reserve, major central banks such as the Bank of England, the Bank of Canada, the Swiss National Bank, and the Bank of Korea have raised interest rates and adopted aggressive tight policies. However, not all developed economies have adjusted their monetary policies like the Federal Reserve. For instance, the authorities in the U.S., Japan and Europe present quite different stances in terms of monetary policy.
At present, Europe is faced with unprecedentedly severe inflation. In June, the inflation rate in 19 countries in the euro area surged to 8.6%, the highest record in the euro area since the common currency was introduced for bookkeeping in 1999. The European Central Bank (ECB) announced to raise the 3 key interest rates by 50 basis points respectively, which would put an end to the eight-year era of negative interest rates. At the same time, the ECB approved a "Transmission Protection Instrument" and a new plan to buy debt in Europe's most vulnerable economies, as it seeks to protect the euro area currency alliance against the twin threats of soaring inflation and slowing economic growth.
However, the current political and economic predicament in Europe makes it difficult for the European Central Bank to "aggressively" raise interest rates. On the one hand, energy dependence is Europe's Achilles heel. Due to rising energy prices, Germany has seen its first trade deficit since 1991, thus it is imperative to raise interest rates to fight against inflation. On the other hand, however, the European Central Bank doesn't mean to raise interest rates too quickly, so as not to stifle the economy.
Driven by the Russian-Ukrainian conflict, the European energy crisis, and the monetary policy divergence between the European Central Bank and the Federal Reserve, the interest rate gap between the U. S. and Europe has continued to widen, so that the exchange rate of euro, the unified European currency, against US dollar has fallen by more than 8% this year and euro even historically depreciated to the parity of the U.S. dollar. Once Russia cuts off the supply of natural gas, it is almost "certain" that Europe will fall into a severe recession with decreasing euro exchange rate, which will become a vane for the European Central Bank to take the next monetary policy turn.
In the context of successive tightening moves by major central banks around the world, the Bank of Japan (BOJ) is unique in that it still adheres to its easing policy. BOJ has continued holding short-term interest rates at minus 0.1%, and kept long-term interest rates around zero through the purchase of long-term government bonds. As part of the stimulus, the BOJ says it will buy 10-year Japanese government bonds at a 0.25% yield every business day, and it expects short- and long-term policy rates to remain at "current or lower" levels. As of the end of June, the long-term Japanese government bonds held by BOJ reached a record 528.23 trillion Japanese Yen, accounting for about 50% of the total market value of its long-term Japanese government bonds.
Given the policy motivation behind the BOJ's contrarian operation, when compared with major developed economies such as the U. S. and Europe, Japan's "stagnation" is more severe than its "inflation" which is more of imported inflation caused by soaring energy prices. Haruhiko Kuroda, Governor of the Bank of Japan, believes that it is necessary to maintain the current strong monetary easing policy for the 2% price stability target. With such policy, it can create a virtuous cycle of corporate earnings, employment and wage growth, and a modest rise in underlying inflation.
But, this may be another miscalculation. With the global combined inflation pressures and Japan's domestic easing policy, the consumer price index (CPI) in the country has risen to 2.5% in May, higher than that during the 2008 financial crisis and close to the peak in 2014, while the producer price index (PPI) has soared to 9%, a 20-year high. Going forward, the BOJ may have to "hit the brake" as the inflation worsens, where the unprecedented expansion of the central bank's balance sheet, the sharp depreciation of Japanese Yen, and the failure to achieve the yield curve control (YCC) policy goal will lead the Japanese government bond market to sharp turbulence and expose new and unpredictable risks to the Japanese and global economy.
The author is Zhang Monan, a researcher and Deputy Director of the Institute of American and European Studies, China Center for International Economic Exchanges, gives her opinion about the monetary policies in the U. S., Japan and Europe.
Source: China-US Focus
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