August 8, 2008
The crisis: a tale of two monetary policies
By Martin Feldstein
The European Central Bank and the Federal Reserve are facing similar problems but pursuing different policies. The ECB has been raising interest rates while the Fed has been cutting them. The overnight federal funds rate is now 2 per cent while the corresponding ECB rate is 4.25 per cent. Which central bank is doing the right thing? Or could they both be?
Inflation is a significant problem in both the eurozone and the US, with a headline consumer inflation rate over the past 12 months of 4 per cent in the eurozone and 5 per cent in the US. Both economies are also facing declining economic activity with falling employment and lower industrial production.
The sharp rise in the prices of energy and food during the past 12 months will undoubtedly spill over into higher prices for other products in both the US and Europe. The primary challenge for both central banks is to limit this inflationary shock to a one-time pass through, avoiding the rise in wages that would occur if employees attempted to offset the decline of their real incomes. It was that futile wage-price spiral that drove inflation rates in the 1970s to double-digit levels. Preventing a repetition of that requires convincing the public that today’s high inflation rate will soon decline.
The remainder of this column can be read here. Debate from our panel of economists appears below.
Martin Wolf: I agree with Marty. But I would add that the US is the epicentre of this economic and financial storm. While European banks are exposed to US liabilities, the eurozone, as a whole, does not suffer from a collapsing housing bubble or a long history of excessive consumption. So the downside risks, while real, are not as great in the eurozone as in the US. The ECB does not need to take out as much insurance as the Federal Reserve.
Posted by: Martin Wolf | August 8th, 2008 at 7:53 am | Report this commentThis raises the very interesting question: is the UK more like the US than the eurozone? Should the MPC be following the example of the Fed or the ECB? Like the eurozone, the UK has higher density of union membership in the private sector than the US. However, we have more legal constraints on unions and decentralised wage bargaining like the US. I think this suggests that the risks of a wage-price spiral in the UK are as unlikely as they are in the US, if Marty’s reasoning is right. This should free up the MPC to cut rates but maybe this would take a different remit!
Adam Lent is head of economics at the TUC
Posted by: Adam Lent | August 12th, 2008 at 1:20 pm | Report this comment