The ECB and Fed: The Impossible Equation of the Central Banks

The same question that the world was obsessed with in 2013 will dominate 2014: What will the Fed do?

The Fed must find a way out of its very generous quantitative easing policy, which has brought it to release $85 billion into the economy each month. That is what we would call tapering. However, the path is narrow: Exiting too quickly and too early could lead to a new recession or a bond shock, and exiting too late could lead to the formation of new bubbles or an inflationary fever.

Janet Yellen, the ‘Reassurer’

Since the new president of the Fed, Janet Yellen, was nominated, markets have calmed. With her reputation as a “dove,” she should maintain the massive buyback policy as long as possible and then gradually reduce this aid.

Therefore, the yields of Treasury bonds would rise equally gradually, but investors and the Treasury could easily cope thanks to the flourishing economy, which offers both financial revenues and investment opportunities. This was – and still is for many economists – the most credible and least dangerous scenario for 2014.

However, the acceleration of American growth in the third trimester and drop in unemployment could alter this scenario and advance the Fed’s calendar. Without a doubt, lively discussions on the subject, which is at the heart of the Federal Open Market Committee, are under way.

And if the Fed steps on the pedal, it risks another scenario. As we saw in 2013, this could trigger a panic and, finally, a shock on U.S. government bond yields. This shock would be particularly harsh for the U.S. financial system and could plunge the world’s largest economy back into crisis. However, the consequences would be global.

And What Are the Consequences for the European Central Bank?

In Europe, the comeback is slow, and deflation threatens many countries. In case of a shock in the United States, the European Central Bank would have no choice other than to accelerate its easing policy in order to avoid contagion on European interest rates and fight deflation by depreciating the euro.

Thus, a European quantitative easing could save the day. However, in this case, Mario Draghi, ECB president, would have a very narrow margin for maneuvers. The Bundesbank and Germany would have a fine game of showing the consequences of the cross-Atlantic QE and will do everything to prevent the ECB from entering into an ultra-expansionist policy.

Conversely, Italy and France would be very interested in this, so that investors would buy their bonds in order to keep interest rates low. And we know that a shock on these countries would be very difficult to handle for the eurozone.

Therefore, the ECB must navigate troubled waters and avoid finding itself in the same position at the end of 2014 as the Fed at the end of 2013: with an impossible equation to solve.