After having hiked interest rates four times last year, each with a quarter of a percentage point increase, the US Central Bank (Fed) announced a more cautious approach to its interest rate cycle during the first half of 2019. The Fed acknowledged that global economic growth prospects were being tampered by the escalating US-China trade war and that inflation numbers were not strong enough to justify further rate hikes.

Towards the end of April, Jay Powell, current Fed chairman, announced that no immediate moves in interest rates were on the cards due to conflicting economic data. This was reconfirmed during the Fed’s June policy-setting meeting, where it was decided to keep interest rates unchanged. Although this was in line with market expectations, the statements released by the Fed suggested that evidence supporting interest rate cuts later this year was building.

Meanwhile, in Europe, economic growth remained muted and inflation well below target levels despite an extended period of unconventional monetary policy by the European Central Bank (ECB). European equities and government bonds rallied during June on the back of comments made by ECB president Mario Draghi. He indicated that the ECB was prepared to further cut rates or purchase additional government bonds if low inflation and weak economic growth in the single currency area (eurozone) persisted.

Although both central banks are expected to ease monetary policy following their recent policy meetings, the relative divergence between the performance of the US and eurozone economies over the past decade or so cannot go unnoticed. Following the 2007-2008 financial crisis, both the Fed and the ECB had embarked on quantitative easing programmes (QE) to stimulate economic growth by increasing money supply through purchases of government bonds. 

The resulting outcome of such programmes was that short-term interest rates were kept low in an attempt to encourage more consumer and business borrowings with the objective of supporting economic growth and inflation.

Nevertheless, many consider the European QE programme as a failure and that the US has done a much better job of recovering from the crisis, even though this was caused, in part, by financial institutions in its home turf. If we consider key economic performance metrics, the eurozone’s performance was uninspiring on all fronts. Real GDP growth within the eurozone has been stagnant, with the region registering an average growth rate of 0.8 per cent between 2009 and 2018, well below pre-crisis growth rates.

This looks even more unfavourable when compared with the US economy, which grew at an average rate of 1.75 per cent during the same period after adjusting for inflation effects. Similar conclusions can be drawn if economic growth is measured on a per capita basis. Unemployment in the euro area stood at 8.2 per cent as at the end of last year, more than double the unemployment rate of 3.9 per cent in the US. Excess capacity is far more prevalent in Europe, with unemployment in the US currently close to its natural level.

When it comes to interest rates, the current negative yield environment in Europe shows that the ECB is far from equipped to combat an economic slowdown. On the other side of the globe, the Fed has more latitude to control a possible decline in economic growth and is, comparatively, in a better position than the ECB due to higher interest rates. However, inflation and inflation expectations remained stubbornly low in the US as well as the eurozone, hence, the current dovishness of both central banks.

But what, or who is to blame for the region’s dismal performance over the years? Although the euro was one of the fundamental objectives of the European Union for nearly 40 years, it was created and adopted by the founding Member States in 1999. The principal objective of the currency was to encourage the free movement of capital and people within Member States while cutting down on exchange costs in order to promote business and trade.

Managing a number of economies with significant disparities in their economic and financial backdrops is easier said than done

The birth of the euro also meant that one central bank for the whole eurozone should assume the authority and responsibility to manage interest rates as well as the value of the currency. This led to the creation of the ECB. However, managing a number of economies with significant disparities in their economic and financial backdrops is easier said than done. If an economy falls into a recession, its national central bank could implement an expansionary monetary policy or devalue its currency to promote domestic spending and exports respectively.

However, this is not possible when forming part of the EU as monetary policy control is ceded to the ECB and no longer rests with the national central banks. Not only this, a country also relinquishes its control on the currency by being a monetary union Member State. Eurosceptics have long argued that the biggest problem with the European Union is the single currency itself. They contend that regional economies within the eurozone are highly fragmented for such Member States to follow a single monetary policy and collectively thrive in a reasonable manner.

European dissidents have put forward a great deal of criticism towards the institutional policies and political decisions over the years. Perhaps the most compelling is the Troika programme. The Troika refers to a consortium of institutions namely; the ECB, the European Commission and the International Monetary Fund whose purpose is to grant support loans to indebted Member States in crises and monitor adherence to imposed loan conditions.

Typically, such loans come with strings attached such as reduction in government fiscal deficits and debt levels, among others. In the absence of economic growth, such conditions can only be met by imposing harsh austerity measures through lower government spending, higher taxes and lower wages to the public sector. Many think of these policies as having compounded the crisis due to the adverse impacts on the living standards of the lower and middle working classes.

One of the foundational objectives of the ECB is to maintain price stability, which according to the Governing Council, is achieved if the eurozone registers an inflation rate of below, but close to, two per cent every year. This is in stark contrast to the Fed’s mandate, which considers economic developments more holistically. Apart from maintaining a controlled inflation rate, the Fed seeks to promote economic growth, reduce the unemployment rate and maintain financial stability, with the latter objective being added following the US financial crisis.

The ECB’s focus on controlling the inflation rate was particularly inappropriate in the run-up to the US financial crisis and in subsequent years where eurozone inflation exceeded two per cent. In response to the financial crisis, the Fed started easing monetary policy back in 2007 but inflation in the euro area was rampant at the time, consistently exceeding two per cent and peaking at four per cent. Due to the ECB’s sole focus on its inflation mandate, it wasn’t until late 2008 when the ECB started to reduce policy rates.

This resulted in tilting interest rate differentials in favour of the euro, making the currency stronger relative to the dollar but negatively impacting domestic exports and economic activity. This partly explains the solid rebound of the US economy out of the financial crisis.

Mr Draghi announced that the ECB might revert to unconventional monetary policy but this has already been tried and tested with unsuccessful results. To make matters worse, populism and the rise of right-wing political parties in recent years continue to demonstrate that Europe is in greater divide. Brexit is the most prominent example.

Undoubtedly, the region’s subdued economic performance should serve as a call for deep structural reforms at the federal level, as well as the exploration of new policy setting frameworks by European leaders.

Andrew Muscat is an assistant portfolio manager at APS Bank plc.

The information contained in this commentary represents the opinion of the contributor and is solely provided for information purposes. It is not to be interpreted as investment advice, or to be used or considered as an offer, or a solicitation to sell/buy or subscribe for any financial instruments nor to constitute any advice or recommendation with respect to such financial instruments.

APS Bank plc is a member of the Malta Stock Exchange, and is licensed to undertake the Business of Banking and to conduct Investment Services business by the Malta Financial Services Authority and is enrolled in Tied Insurance Intermediaries List under the Insurance Intermediaries Act 2006.