HomeECB vs. FED – What To Expect In the Period Ahead

ECB vs. FED – What To Expect In the Period Ahead

21 September 2020 By Mircea Vasiu

The currency market finds itself in an extremely interesting place lately. Due to the coronavirus crisis, all major central banks slashed their interest rates close to zero. 

In some cases (e.g., ECB, SNB), the interest rates already were sitting below zero. The Fed had more room to maneuver and cut the rates from above 2% to the lower boundary. Some other central banks also contemplate a move below zero, as the Bank of England pointed last week.

This “race to the bottom” created an unusual situation, one not seen on the currency market so far. Lower interest rates in all jurisdictions, coupled with massive quantitative easing, led to zero interest rate differential.

In other words, traders value a currency not by the interest rate set by the central bank, but by all the actions taken. ECB and the Fed are the best examples to illustrate how traders value a currency.

Fed Changed Its Mandate

The Federal Reserve of the United States (Fed) changed its mandate to an Average Inflation Targeting (AIT). It means that it will consider inflation averaging 2% moving forward, effectively letting inflation to overshoot the target in order to bring the average up.

The ECB also announced that it is reviewing its inflation policy. Should we expect that the  ECB will announce an AIT regime as well? Moreover, if the ECB and the Fed had problems creating inflation to the 2% so far, why would the two central banks be successful from this moment on?

Even if the ECB will announce a new way to target inflation, it will likely be different than what the Fed does. The differences between the European banking system and the one in the United States do not allow for the ECB and the Fed to have similar policies. Therefore, traders and investors are likely to focus on the size of the adjacent stimulus rather than on the level of interest rates.

The Fed seems to have more room to ease that the ECB. Judging by the aggressiveness of the bond-buying program in the United States and the promise to keep the rates lower for a long-time, the dollar’s decline seems to be the only solution to the current economic crisis. A stronger dollar policy is not in anyone’s interest, and the Fed, above all, knows it.