What can the ECB learn from the Fed’s experience? – Goldman Sachs

According to the research team at Goldman Sachs, many economists believe that the Fed’s apparent success in nursing the US economy back to health provides a strong prima facie argument for continued highly accommodative ECB policy.  But what are the more tangible lessons? 

Key Quotes

“We offer four observations.”

“First, core inflation is more relevant than headline because it has more predictive power for future (headline) inflation.  Although the statistical outperformance is slightly less pronounced in the Euro area than in the US, our results are strong enough to suggest that the ECB should largely “look through” the recent headline inflation surge (which in any case seems to have peaked now).”

“Second, labor market slack is much more useful than GDP growth for forecasting future inflation, both in the US and—despite a small “speed limit” effect—also in the Euro area.  This implies that it makes sense for the ECB to put more weight on the elevated area-wide unemployment rate than on the recent strength of growth in gauging the inflation outlook.”

“Third, quantitative easing is an effective tool of monetary policy.  Most of then direct transmission seems to occur through a “stock” effect, whose size is similar in the US and Europe.  In addition, however, there is more evidence for “flow” effects in the Euro area, which could reflect stronger fiscal (or credit) transmission effects in Europe.  This suggests that tapering ECB QE could result in a somewhat bigger tightening in financial conditions than what we saw during in the US when QE ended in 2014.”

“Fourth, expectations for the path of the policy rate are the most powerful monetary policy lever.  This suggests that even a small rate increase—e.g., an attempt to get back to zero from below—could tighten European financial conditions significantly by destabilizing future expectations for the ECB’s policy rates, just like the 2013 taper tantrum tightened US financial conditions significantly by steepening expectations for the funds rate.”

“Taken together, our results suggest a strong rationale for continued highly accommodative ECB policy.  This is consistent with the forecasts from our European economics team that asset purchases will only end in late 2018 and that rates will stay on hold until 2019.”