Central banks forgetting lessons learned from Lehman Brothers
In 2008, both the Federal Reserve Board and the European Central Bank (ECB) were caught totally flatfooted by the Lehman Brothers bankruptcy that led to the worst global economic recession in the post-war period.
Judging by their respective decisions this week to tighten their monetary policy stances at this particular juncture, it appears that both the Fed and the ECB risk once again getting flatfooted by a global economic recession.
A striking feature of Wednesday’s Federal Reserve Open Market Committee (FOMC) policy statement justifying the shift to a tighter U.S. monetary policy stance was its deafening silence on the deterioration in the global economic outlook that had occurred since its last meeting.
Instead, in unqualified terms it justified its view that an additional U.S. interest rate hike was now needed in 2018 on the grounds that the U.S. economy was strong and that inflation was now likely to approach the Fed’s target.
The Fed’s seeming indifference to developments abroad is all the more surprising considering how significantly the external situation has deteriorated since the FOMC’s last meeting.
U.S. steel and aluminum tariffs, together with the threat of automobile tariffs, have seriously clouded the European economic outlook. They have done so by dealing a major blow to European investor confidence by raising the specter of a trade war.
At the same time, the installation of a populist government in Rome has put Italy, the eurozone’s third-largest economy and the country with the world’s third-largest sovereign bond market, on a collision course with Europe.
That is all too likely to bring back the eurozone sovereign debt crisis and to raise serious existential questions for the euro. As if to underline this point, over the past month, Italian government bond yields have spiked higher and Italian capital flight has picked up pace.
Also surprising is the Fed’s seeming indifference to a deterioration in the emerging market outlook. This is especially the case considering how important an engine of global economic growth the emerging markets have become.
It is not only the currencies of Argentina and Turkey that are now in free fall. Rather, the currencies of countries like Brazil, Mexico, and South Africa are all now under intense pressure that could threaten their respective economic recoveries.
With contentious elections in all three of those latter countries coming up over the next year, the plight of emerging-market countries would look set to deteriorate further in the period immediately ahead.
If the Fed’s indifference to a deteriorating global economic outlook seems surprising, the decision of the ECB to end its bond-buying program by the end of the year seems particularly ill-advised.
This is especially the case since it comes at a time that the risks of a trade war are increasing and that the new Italian government seems set on introducing budget-busting measures that are bound to heighten questions in the market about the country’s ability to service its public-debt mountain.
One would have thought that the ECB would be better advised to wait to see how the protectionist cycle and the Italian situation played out before it put an end to its bond-buying program. With protectionism on the rise, now would not seem to be the time to be removing a key source of support from the overall European economy.
More importantly, at a time that foreign investors are selling Italian bonds, now would not seem to be the time for the ECB to put an early end to purchasing around €3.5 billion a month of Italian bonds that it does under its overall bond-buying program.
In addition to adding unwanted pressure on Italian bonds, this decision is likely to highly complicate the likely needed shift down the road by the ECB to support Italy if it comes under severe market pressure.
To be sure, both the mandate of the Fed and the ECB is for them to run policies aimed at meeting their respective domestic economic policy objectives. However, the 2008 Lehman crisis should have taught us that no economy today is an island and that events abroad can have a material impact on any country’s economic outlook.
By not focusing on the rapidly deteriorating international economic outlook, both the Fed and the ECB risk failing to deliver on their respective mandates.
Desmond Lachman is a resident fellow at the American Enterprise Institute. He was formerly a deputy director in the International Monetary Fund's Policy Development and Review Department and the chief emerging market economic strategist at Salomon Smith Barney.