Thursday, July 17, 2014

Are the monetary policies in the US and the Eurozone diverging quickly enough?

There has been a great deal of discussion about the divergence between the monetary policy trajectories of the Fed and the ECB. Is the Fed behind the curve in exiting QE and beginning rate normalization (see story)? Is the ECB not acting aggressively enough to inject the necessary amount of stimulus (see story)?

One place to look of answers is the so-called Taylor Rule. While the inputs to the calculation can be quite subjective, it's a good relative measure of where policy rates should be given current economic conditions and target inflation rates. The two charts below from JPMorgan show that the Taylor Rule (appropriate) rates are now on the opposite sides of the policy (actual) rates. This would suggest that monetary policies of the ECB and the Fed would indeed have to diverge further. The euro area seems to require non-traditional accommodation (since policy rates generally cannot go below zero), while the Fed should begin rate normalization.

Source: JPMorgan

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