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The headquarters of the European Central Bank, in Frankfurt, Germany, on March 12, 2016.Kai Pfaffenbach/Reuters

Investors who obsessively monitor every twist and turn of U.S. Federal Reserve policy as the only key to how world markets play out may risk missing crucial signals from across the Atlantic.

After reading the runes from last week’s central bank gathering in Jackson Hole, stock markets powered back to record highs and borrowing rates ebbed as Jay Powell indicated no rush to wind down pandemic-related emergency bond buying despite what the Fed chief sees as transitory inflation spikes.

But is the Fed as all powerful as it may seem? Shouldn’t increasingly fungible global markets be as concerned about policy at arguably the second most influential central bank?

European Central Bank policy makers meet next week amid some discomfort in their ranks over the scale of its pandemic bond-buying program after the euro zone inflation rate overshot a new ECB fixed target of 2 per cent in August by a full percentage point.

The same argument about temporary inflation factors apply, with monetary hawks also making themselves heard.

Minutes from the ECB’s last meeting showed disagreements over the extent of future policy guidance and Austria’s central bank chief, Robert Holzmann, was reported on Tuesday as calling for the so-called PEPP program to be reduced by year-end.

While annual euro zone economic output may now be some US$10-trillion and US$3-trillion less that the United States and China, respectively, the ECB oversees the world’s second most widely used reserve currency and dictates related euro credit costs.

A paper published this week by Bank of England economist Silvia Miranda-Agrippino and London Business School’s Tsvetelina Nenova details just how much ECB policy shifts affect global financial conditions in similar ways to Fed overspills.

They say risk perceptions, world asset valuations, capital flows and financing costs mean a tightening of unconventional ECB policies leads to falls in global economic activity and trade, a retrenchment of capital flows and a drop in global stock prices and other risk markets.

ECB policy shocks significantly affect the U.S. business cycle and financial conditions, they conclude.

“An ECB monetary policy contraction is followed by a fall in U.S. output and prices, and a significant tightening of U.S. financial conditions,” they wrote.


The impact on the exchange rate is one key part of the transmission. How the dollar or euro respond to Fed and ECB policy quickly feeds through to companies and countries.

While the overall ECB overspill is less than that of the Fed, it could widen the more the euro is used worldwide.

“Were the euro to be used as widely as the dollar in international trade and cross-border financial activity, the effects of the two central banks’ actions could have much closer magnitudes,” Ms. Miranda-Agrippino and Ms. Nenova said.

This speaks to some poorly understood aspects of how markets and economies have behaved in recent years and the need to assess global liquidity gauges rather than single central bank actions.

It also informs how the “global savings glut” depresses long-term equilibrium interest rates everywhere, including the effect of central bank reserve managers dividing asset stockpiles into the main reserve currencies.

And within that, there is the question of how extensive ECB bond buying has reduced the free float of “safe” euro zone sovereign assets – a factor some suspect caps long-term Treasury yields by forcing global funds into U.S. bonds.

Also possible is that the Fed and ECB dampen each other’s policies when they are going in different directions.

That’s not the case just now. They both seem to be discussing some COVID support reduction while hesitant until they see a more sustained recovery and end to the pandemic.

Axa Investment Managers chief economist Gilles Moëc said this week the Fed seems keen to allow the exact timing of its tapering to evolve and the ECB is similarly in no hurry to “clarify the ambiguities” of its revised guidance.

But it may pay to keep equally close tabs on both banks and not to abandon all caution in chasing stock markets higher with a green light from just one.

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