Fed vs ECB: two ways of dealing with impending inflation

Two years into the coronavirus pandemic, the world is facing a new negative external shock following Russia’s military invasion of Ukraine. After the uneven pace of recovery in the world’s economies—marked by the effectiveness of national policies in the face of new coronavirus variants, massive public deficits, and inflation—the conflict between Russia and Ukraine has led to increased inflationary pressures (high commodity prices, including Russian oil and gas and Ukrainian cereals, as well as trade distortions in other markets due to sanctions against Russia and other indirect effects), a slowdown in global economic activity, and increased volatility in financial markets (reflected in higher financing costs).

In this sense, although the United States and the European Union face the same global scenario, the economic policy formulas differ and are adapted to the contexts of each economy. On the one hand, the pace of recovery in the first quarter of 2022 is significantly different: the United States shows a faster pace than the European average, where no two countries are alike, even powers such as Germany and Italy. Meanwhile, features that appear to be across the board, such as the high inflation seen throughout 2021, have taken different paths in the two regions: US inflation was mainly linked to demand factors, given the remarkably high direct payments by the government to the population compared to the OECD average, while the predominant factor in Europe has clearly been supply-driven in the wake of the energy crisis.

These economic policy differences can also be seen in the exposure to geopolitical risks. One clear example is Europe’s greater energy dependence on Russian oil and gas (especially Central and Eastern Europe) compared to the United States, which is also a net energy exporter. As a result, Europe and the United States have different nuances to address in their fiscal and monetary policy choices.

Monetary policy

The European Central Bank (ECB) and the Federal Reserve share a flexible inflation target of around 2 percent. However, each body’s capacity to sustain inflation near this level varies, especially given what happened during the pandemic and the high level of debt incurred to deal with it. For example, the structural deficits accumulated in the Eurozone are much higher than what we see in the US economy.

Another determining factor is the confidence in the effectiveness of central banks’ inflation control, where maintaining inflation below target for a prolonged period—not to mention fear of another “Trichet moment” (where the ECB raised interest rates and further worsened the 2008 crisis)—raise the expectations of different economic agents toward higher inflation.

In this sense, joint European action is taking on renewed importance, where the strengthening of pan-European institutions is a key factor in diversifying the asymmetric risks faced as a result of external shocks. Thus, tax harmonization is needed to ensure initiatives, such as the issuance of pan-European bonds to finance the NGEU, find support and can thus become a relevant step in the creation of a secure European asset.

Fiscal policy

It is worth noting the flexibility and speed of the processes for adopting economic policy measures in general in the United States; in Europe, these require reaching a broad consensus in an area where the interests of each country are often opposed. For example, the United States has already tightened its fiscal policy after forgoing Build Back Better and exhausting the stimulus check mechanism, whereas Europe’s implementation of NGEU tranches could result in their use to deal with the current problem.

As on previous occasions, the current dynamics of fiscal policy aim to resume its role as an energy shock absorption mechanism with lesser implications for monetary policy, albeit in a more measured way as this implies greater future pressure (more debt, more deficit, and structurally more vulnerability in terms of potential) under less monetary support.

In turn, and as regards a loss of purchasing power given supply-side inflation, while there is a need to distribute efforts to avoid a price-wage spiral and thus maintain a certain level of competitiveness, with commodities as strong as they are, the strength of the currency used in these exchanges is decisive as it could be another way of losing purchasing power more broadly.

What is MAPFRE Economics assessment?

Against the backdrop of global monetary tightening, lagging behind other central banks can erode the euro's purchasing power. This is already being seen in the West (1.10 with negative remuneration against USD or GBP and with prospects of rising remuneration as a backstop), in emerging economies across the board (ahead in the process), and perhaps most notably in the cases of China (far from joining the global monetary tightening given the domestic situation), and Japan (in late March the central bank re-emphasized its ultra-flexible stance as 10-year JGB yields soared towards the upper limit of its yield curve control corridor).

MAPFRE's Research Department, MAPFRE Economics