Implications of Fed and ECB Divergence

December 14th, 2015 by

Source: MarketWatch

Source: MarketWatch

After years of convergent monetary policy on both sides of the Atlantic Ocean, the Federal Reserve is likely to kick off an era of divergent policies if it indeed begins the process of normalizing interest rates on Wednesday.

What would this presumably long-term trend mean for the global economy, as well as the close relationship between the U.S. and Europe?

The Dollar vs. the Euro

One of the most direct effects of the expected ECB-Fed divergence will be felt in the foreign exchange (forex) markets. The value of an economy’s currency is one of the most fundamental measures of its strength, and most analysts believe the respective currencies of the United States and the European Union will reflect this. As the eurozone continues to increase its efforts at monetary stimulus, the natural reaction is for the euro to lose value.

At least, this is the intended outcome. Logically speaking, stimulus measures by the central bank to boost the money supply are supposed to weaken its currency. (There are more of them available, making each one worth less.) Strangely enough, when ECB President Mario Draghi announced more stimulus would be coming at the central bank’s most recent policy meeting, it was actually taken by the markets as not aggressive enough. As a result, the euro surged against the dollar.

Source: Wall Street Journal

Source: Wall Street Journal

In the long run, however, the QE-style stimulus by the ECB should result in a softer euro. At the same time, even the modest tightening of policy everyone expects from the Federal Reserve should lift the dollar. Currency exchange rates are a zero-sum game: when one currency gets weaker, it always means that its peers are getting stronger against it. Said differently, no currency’s value exists in a vacuum. Therefore, if the dollar is rising at the same time the euro is falling, these value movements are compounded.

USD-EUR chart. Source: Google Finance

USD-EUR chart. Source: Google Finance

With these dynamics in mind, most believe the euro (which has maintained a higher purchasing power than the dollar for the better part of 15 years) will come into price parity (i.e. a one-for-one exchange rate) by the end of next year. The euro currently trades at about $1.10.

Export Battle

exportThe constant battle for share of the export market is inseparable from the impact that divergent monetary policy will have on the euro and dollar. Simply enough, the weaker a country’s currency is, the more attractive (cheaper) its exports are for countries abroad. This encourages the various economies of the world to try and depress the value of their currencies in order to maximize export revenues. (This trend is explained in James Rickard’s Currency Wars.)

With this in mind, Europe undoubtedly gains an advantage by the divergence between the Fed and the ECB. While the euro will likely fall in value and help increase exports from Europe, the dollar will be going in the opposite direction. Already this year we’ve heard quite a bit about a strong dollar hurting overseas sales for U.S. corporations. This will only get worse in 2016 the way the Fed and the ECB are headed.

Political Implications

Politics are often overlooked in discussions of what influence a Fed rate hike (coupled with more QE from Europe) will have. Admittedly, politics are secondary to the economic effects, but that doesn’t mean that the political impact will be negligible.

politicianIf nothing else, the diverging policies will highlight the right-vs-left divide on how best to steer the economy. While liberals generally call for greater government involvement in the economy and would support highly accommodative (stimulus-driven) policies, conservatives tend to be more wary of these mechanisms and instead support free market principles and greater fiscal austerity.

These political fractures have been worsening in Europe itself. As the monetary authorities on each side of the Atlantic chart opposite paths, we can expect the political disagreements to become louder and more widespread. This is particularly true because of the years-long duration of these policies.

 

The opinions and forecasts herein are provided solely for informational purposes, and should not be used or construed as an offer, solicitation, or recommendation to buy or sell any product.