Recently it seems that the world's economic hopes are in central bankers' hands. The market hangs on every word that comes from the Federal Reserve and the European Central Bank, hoping to hear some hint that another round of monetary stimulus is coming down the pike.
This intense focus on the central banks is not entirely surprising. Given how sclerotic the political process has been in Europe and the United States, investors are turning to the semiautonomous entities to give the global economy a push. Certainly, good monetary policy is crucial to getting the economy back on more solid footing. But it alone is not sufficient. Reasonable fiscal policy and some painful corrections are needed, as well. Anyone hoping for a monetary policy miracle will likely find themselves disappointed.
How Much Firepower Does the ECB Have?
So more than four years after the financial crisis, what can the banks do now? The answer is somewhat different on each side of the Atlantic. The Europeans have a stronger claim that their central bank can be transformative in turning around the economy. The ECB has more policy options at its disposable that can plausibly make a difference. But just because they can be useful doesn't mean that they alone can solve Europe's woes or bring the continent back to growth.
The most immediate action the bank is likely to take would be to buy sovereign debt on the open market to help bring down the yields. ECB president Mario Draghi indicated several days ago that the bank is close to doing this in the next couple of weeks. This is a potentially vital operation. Spain in particular has had troubling high 10- and two-year yields recently well more than 7%. At this level, it becomes increasingly difficult for the country to roll over expiring debt, and it further exacerbates the country's sovereign debt problems. The ECB has the firepower to buy enough bonds in the marketplace to send this rate back down to earth and give Spain some breathing room. However, the bond buying will do only that, create some time and space to tackle the underlying issues. Artificially lowering the yield won't magically eliminate Spain's underlying troubles. The country still needs to tackle its competitiveness problem, create a realistic budget, and decrease unemployment among other issues. ECB action will help, but there will need to be political follow-though to finish the job.
Similarly, the ECB will likely play a major role in stabilizing Europe's fragile banking system. The central bank is needed to provide the liquidity that will be crucial in allowing the financial institutions to clean up their balance sheets and prepare themselves for lending again. But the banks actually have to use the opportunity to accept losses and not just use the added liquidity to continue denying reality. In other words, the ECB can yet again be helpful, but it alone won't solve the crisis.
There are of course other things the ECB can do to set the stage for growth. Key rates could be lowered more, and the bank could pursue other unconventional monetary policy. However, investors hoping that the bank is going to pull a lot more arrows out of its quiver are going to be disappointed. The ECB has fought hard for its institutional independence, but it isn't free to do whatever it wants outside of a political vacuum. Much of Europe, particularly Germany, is allergic to inflation. Any sign that the bank is pursuing a hugely inflationary policy will be met with fierce resistance. The bank is unlikely to stick its head out too far from the political consensus.
Not Much Better Stateside
The Federal Reserve is in a similar boat. There are high expectations that chairman Ben Bernanke will do something to help boost a sluggish economy, but the bank's actual capacity to right the economic ship is somewhat limited.
The Fed has been aggressive throughout the crisis. It has implemented an essentially unprecedented zero-interest-rate policy and embarked on two major bond-buying programs among other strategies. The Fed's balance sheet has exploded as Bernanke tries to keep monetary policy very loose. This has been reasonably successful so far in keeping the economy from completely falling off the cliff.
Now there is talk that the Fed will embark on a third round of bond buying to try to bring down rates even more. This might have some impact on the margin, but there are diminishing returns to central bank action at this point. Take housing, for example. Housing is unquestionably a key area that needs to fully recover for the economy to get back on firm ground. From construction jobs, to workforce mobility, to consumer confidence, housing pops its head up time and time again. But the idea that lower mortgage rates will suddenly turn the tide on housing just doesn't seem realistic. Mortgage rates are already at historic lows, and lower rates aren't going to excite that many new buyers. People are waiting on the sidelines for multiple reasons: They are worried about their jobs; they think housing prices are going to fall further; there's a lack of desirable inventory; they are unable to qualify for a loan. Very low rates can help move buyers and sellers closer together, but going even lower than today's levels is not likely to have a drastic effect.
Another potential benefit of the Fed loosening policy even more would be to move more people into risky assets because of the meager returns they would get on Treasuries. Here again, that plan is unlikely to get much traction. If investors are truly worried about Armageddon, they will be willing to accept any rate for safety. Nothing will convince folks to take on more risk. Look at Europe. Plenty of people are now taking a locked-in real negative loss in order to avoid the uncertainty there. So again, it might be helpful on the margin, but the moves won't make a truly dramatic difference.
The Fed certainly can provide the stability needed to solve the country's fiscal issues, allow for the housing market to get back on its feet, and allow for the job market to begin to mend itself. However, the Fed alone can't make these things happen. Congress and the president need to agree on how to fix the fiscal cliff (unlikely before the election). Employers need to feel confident enough to hire more. Consumers need to feel like the housing market has truly stabilized and that it is safe to wade back in.
It is absolutely worth watching what the Fed and ECB say and do. They need to get it right to set the stage for growth. The ECB in particular has a very important role to play in ensuring the short-term stability of Europe. Everyone else has to get it right too in order to transform the current economic climate. Good monetary policy can't make up for governments that aren't able or willing to make fundamental reforms.
Jeremy Glaser is the Markets Editor for Morningstar.com.
