Later on this autumn is likely to be decision-making time for central bankers in the United States and in the eurozone. And the Bank of England would then need to take stock of the decisions taken by the Federal Reserve of the US and the European Central Bank and decide accordingly.
What I am referring to is interest rates and quantitative easing. We are coming to the stage where the economic data is pointing towards the need for a decision as to whether interest rates need to increase in the US and whether the quantitative easing programme of the European Central Bank needs to start tapering off.
There are a number of considerations to be made by the Federal Reserve and the European Central Bank before they take their decision. So guessing what they will eventually do is useless. However, there are certain facts that need to be taken into consideration.
The first is the exchange rate between the US dollar and the euro. I cannot help making a comment about all those who said that the euro will implode as its value approached parity with the US dollar. Today the euro is valued at $1.19.
More significantly its value increased by 14 per cent against the US dollar this year. Any movement in interest rates could cause some volatility in the exchange rate and this could in turn serve as a competitive advantage or disadvantage for businesses.
A second fact that needs to be kept in mind is Trump’s plan to reduce corporate tax in the US and to invest significant amounts in the infrastructure. None of these plans have been given any concrete form, eight months into his four-year term. Both of them are likely to have a severe impact on the fiscal deficit of the US. How will markets react to this?
An increase in interest rates could worsen the US Treasury’s position.
Once interest rates rise, this will eat into the purchasing power of borrowers
A third fact is the economic data emerging in the eurozone. It is known that in some countries growth has been fragile and that the risk of a default on sovereign debt in certain members of the eurozone is still quite high.
However, the latest data shows that economic growth is consolidating. For example the data from Italy is showing a growth rate of above one per cent for this year and for 2018.
Fourth, investors have registered significant gains from their holdings in equity since the start of the quantitative easing programme and the low interest rate regime.
Wall Street registered a gain of 245 per cent while stock exchanges across Europe registered average gains of around 220 per cent. With growth rates consolidating and with such significant gains, can the Federal Reserve postpone any further an interest rate increase? And can the European Central Bank not reduce the monetary stimulus?
If interest rates do increase in the US and monetary stimulus is reduced in the eurozone, what would be the reaction of the financial markets? Will equity prices continue to rise?
Fifth, there is the issue of the person in the street, who may not care much about quantitative easing and interest rates. However, one will care if it translates into a reduction in purchasing power. The low interest regime has been with us long enough for it to become part of our way of life.
Once interest rates rise, this will eat into the purchasing power of borrowers. Will this cause an economic downturn?
Sixth, we cannot forget about Brexit. The negotiations on the UK’s exit from the European Union appear to be going nowhere.
The picture may become less blurred in the coming weeks and months but there is nothing to show that this will be the case. Will this uncertainty on the nature of Brexit make it more difficult for the Federal Reserve and the ECB to take a decision on their short term monetary policy?
The coming autumn will be decision- making time for both the European Central Bank and the US Federal Reserve. They may decide to leave everything as is, even if very unlikely. However, if they do, it is not because of any indecision on their part. It is because in their own assessment of the situation, it would not be appropriate to tighten monetary policy.