Is the Fed or ECB Making the Right Decision on Interest Rates?

The European Central Bank said last month that it would reduce the amount it spends buying bonds from 80 billion euros to 60 billion.

I thought this would be positive for the euro.

After all, German bond yields were on the rise after the ECB announced this tweak to its asset-purchase program.

And it was positive for the euro exchange rate … for a few minutes.

But details revealed the ECB also decided to extend the expiration date of the program from March 2017 to the end of 2017.

What was the reason for the whipsaw in the euro/U.S. dollar exchange rate on that early-December morning?

It was due to the simple fact that the ECB was extending its promises of monetary support … while the Federal Reserve is withdrawing its own monetary accommodation.

That is, the Fed is moving away from low interest rates while the ECB is in no rush to do the same.

And that expected yield differential means the dollar trades higher, as more capital is presumed to be flowing into dollar-based assets than euro-based assets.

But which central bank is right?

I mean, which one is making the right call on interest rates?

Well, one might suggest they both are … because the U.S. is simply ahead of the eurozone on the economic growth and inflation curves.

Maybe.

But you might remember me talking about Fed interest rates a bit when I recently penned, “Yuan Too Free? And Can the Fed Afford It?” That’s when I asked if the Fed could afford to raise interest rates much further if it posed a large and conceivable risk to stability in China’s economy.

More broadly speaking, I wonder whether the Fed is truly hopeful about a “normalization” of interest rates this year …

Janet Yellen recently made comments that seem to affirm gradual interest-rate hikes are probably warranted in the coming months. As to why, Yellen said,

“In the coming months, I expect some further strengthening in labor market conditions as the economy continues to expand at a moderate pace.”

She also said,

“Allowing the economy to run markedly and persistently ‘hot’ would be risky and unwise.”

At the same time, she explicitly stated that she does not feel the Fed is “behind the curve” with its policy decisions.

Is Yellen leaving the door open to more backpedaling on interest-rate expectations, just the way she did as 2016 unfolded?

She is also talking about how wage growth is only modest and GDP is restrained, admittedly less so, by forces stressing supply and demand.

The forces are “likely to restrain overall growth over the medium term, likely holding down the level of interest rates consistent with stable labor market conditions.”

What are those forces?

Eh, vague and typical stuff.

But her list of examples didn’t explicitly mention what I believe is THE force that will affect all those other things she and policymakers talk about.

That is … DEBT.

Back to the European Central Bank …

This month, when the ECB met again to discuss and announce policy changes, they chose to sit tight as-is.

But among the accompanying comments made by ECB Chief Mario Draghi were calls for European governments to implement fiscal reform plans. This most certainly includes spending that would provide economic support (ideally) in lieu of the support the ECB is providing.

Sound familiar?

The Fed has intimated the same.

And Donald Trump may very well have gotten elected by promising a big-time fiscal (as well as private-sector) infrastructure spending program.

Hey, why not? Japan has been taking this approach for years and, well, errr …

Debt continues to rise in Japan, with government debt now “only” a whopping 230% of GDP. Ha.

And the last time the Bank of Japan’s benchmark interest rates rose meaningfully was in the early 1990s. They’ve been pretty much stuck at 0% for the last 17 years. That’s all.

And Japan’s GDP has been lackluster all the while. It seems to like the zero number as well.

Is this why Janet Yellen is parsing her rate-hike talk with restrained GDP talk? Is it because the multiplier effect on GDP growth is negative for fiscal spending when debt is as high as it is?

I wouldn’t be surprised.

Just like I wouldn’t be surprised if Fed rate hikes don’t happen at the forecasted and highly-anticipated rate of three this year.

Do right,
JR

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“JR” specializes in trading commodities, currencies and options. He has spent nearly 10 years analyzing financial markets and writing about global economics. JR honed his trading techniques and global-macro worldview alongside his father, Jack Crooks, at Black Swan Capital. JR also …