MONETARY POLICY - ECB v FEDERAL RESERVE
Real Shadow Policy Rate Shows Why Euro Has Been Resilient Versus U.S. Dollar
BLOOMBERG BRIEF: One of the major puzzles that FX analysts and traders have had to contend with in the past couple of years has been the surprising resiliency of the euro versus the U.S. dollar. Consensus forecasts have been calling for a steady weakening of the euro during the past two years, yet the euro has confounded the consensus by marching higher. This has forced the forecasting community to continually play catch-up and adjust their three-, six-, and 12-month forecasts accordingly.
On the surface, forecasters have had several good reasons to expect a steady weakening of the euro.
First, economic-growth expectations have been favoring the dollar versus the euro for some time. Euro area real GDP has been growing at or below a tepid 2 percent pace in each of the six years since the global financial crisis, and projections by private sector economists and the ECB are calling for growth rates of 1 to 1.8 percent for 2014-16. That would be nine consecutive years of sub-2 percent growth. In comparison, expectations are that U.S. real GDP growth will average upwards of 2.7 percent during the upcoming three years.
Second, the euro is estimated to be overvalued versus the U.S. dollar by around 15-16 percent on a purchasing power parity basis. While such an over - valuation reading is not overly excessive, it does suggest that the balance of risks should have been leaning in favor of a weaker euro, not a stronger one.
Third, on the interest-rate front, nominal yield spreads between the euro area and the U.S. at both the front and back ends have been moving in favor of the U.S., not the euro area during the past two years. The nominal 2-year yield spread has moved from a near zero reading to around 50 basis points in favor of the U.S., while the nominal 10-year yield spread has swung from a 30 to a 135 basis-point differential favoring the U.S. in the past two years. One would have expected such spread widening to favor the dollar versus the euro, but that failed to happen.
Why then has the euro proved to be so resilient?
One reason is that the trend in nominal yield spreads described above might not be fully capturing the degree of monetary-policy ease being pursued by the Fed relative to the ECB as policy rates in each of the economies reached the zero lower bound.
Two academics – Jing Cynthia Wu and Fan Dora Xia – have estimated “shadow” policy rates for the U.S. and euro area that capture the path the short-term policy rate would have taken, theoretically speaking, in response to central bank forward guidance and quantitative eas ing measures had those policy rates not been constrained by the zero lower bound ( http://faculty.chicagobooth.edu/jing.wu/ research/data/WX.html ). As shown in the chart above, Wu and Xia’s estimate of the Federal Reserve’s monetary policy stance – combining both conventional and unconventional measures – would have been about equivalent to a series of short-term policy rate cuts that would have pushed the Fed funds (shadow) rate down to around minus 3 percent if the Fed funds rate were free to move into nega tive territory.
The chart also suggests that the ECB’s policy stance has been far less accommodative – its shadow policy rate is shown to be presently hovering around zer percent, not all that different from today’s actual ECB policy rate. It should be evident that the nominal euro area-U.S. shadow policy rate spread has been following a far different path than the actual 2-year and 10-year spreads have taken. Looking at policy rates in real terms, the real shadow policy rate spread has moved even more in the euro’s favor in the past couple of years. This reflects the fact that the euro area inflation rate has fallen relative to the U.S. inflation rate. As shown in the chart (click to view chart), this suggests that much of the firmness in the euro’s value versus the dollar in recent years can be explained by the widening in the real shadow policy rate spread – a reflection of the (inappropriate) relatively tighter monetary policy stance being pursued by the ECB compared to the Fed. Looking ahead into the first half of 2015, a likely gradual move toward a less accommodative monetary policy by the Fed and the possibility of quantitative easing by the ECB could prove to be the catalyst for a trend reversal in the respec - tive shadow policy rates and thus in the euro’s fortunes.