Those are the same problems the U.S. has now. But instead of thinking about new ways to stimulate the economy, the Federal Reserve is getting ready to do less.
Why? Well, unemployment is half as high here as it is in Europe, so there should be more upward pressure on inflation. Look at that last sentence again, though. That's a lot of faith to put in one of the most dangerous words in the English language-should-when the cost of being wrong is so high. Indeed, inflation isn't increasing at all now even though unemployment is down to a pretty normal level. At the very least, that suggests the Fed would be better off waiting to raise rates until there is some actual evidence inflation is rising-especially now that the ECB might cut them.
Inflation isn't increasing at all now even though unemployment is down to a pretty normal level.
The simple story is that when interest rates go up more than they do in Europe, the dollar goes up against the euro. And if rates go up in the U.S. at the same time that they go down in Europe, well, then the dollar really rises. Think about it like this.
Would you rather buy a German 10-year bond that pays 0.5 percent or a U.S. 10-year bond that pays 2 percent? Investors, especially big European ones, are answering that question by moving their money out of euros and into dollars-which has pushed the latter up. The euro went from being worth $1.26 a year ago to as little as $1.05 in March after the ECB had started buying bonds and it looked like the Fed was going to raise rates.
Since then, though, the Fed has put off its plans to do so, and the euro rose back to $1.13-until this latest news. That made the euro fall 1.67 percent against the dollar to $1.11, and it would continue to do so if the ECB really expands its bond-buying at the same time that the Fed hikes rates, like it's said it might. And, judging at least by Fed Chair Janet Yellen's words, that's more of a possibility than it's been in the past.
Now, a stronger dollar by itself wouldn't have to mean that the economy would be weaker. Insofar as the dollar went up because the ECB's printing presses were gearing up, it could be a wash. That's because even though a more expensive dollar would make our exports, well, more expensive in Europe, it could be offset by the fact that more monetary stimulus would make Europe demand more of our goods. If that were the case, though, long-term interest rates would be rising. That'd be the market's way of saying that this would help growth enough that the Fed would have to hike rates to keep inflation in check. But what we see instead are long-term rates that are still only around 2 percent. In other words, investors think the only way this wouldn't hurt is if the Fed makes up for it by keeping rates at zero.
If two monetary policies diverge even more in, well, not a wood, we might take the path every other country that has tried to raise rates from zero has traveled by-back to where we started.
So if the Fed doesn't, it could slow the economy down more than you'd think.
Consider this: according to Goldman Sachs, just talking about raising rates has already tightened financial conditions as if the Fed had actually raised them around three times. And that was when the ECB was only buying 60 billion euros of bonds a month. It'd be even more of a problem if it was buying more. Now, that alone wouldn't be enough reason for the Fed to hold off, but together with everything else it might be. A stronger dollar would mean lower import prices, and, as a result, lower inflation at a time when it's already too low. And it would also mean a bigger trade deficit at a time when the recovery is starting to look a little wobbly.
If two monetary policies diverge even more in, well, not a wood, we might take the path every other country that has tried to raise rates from zero has traveled by-back to where we started.
