Comparing Fed and ECB monetary policies
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2.2. Other economic indicators
Forecasting the economy is hard and inflation has historically been particularly difficult to forecast.
Some of the most important factors influencing the future path of inflation are innately unpredictable.
For example, a serious conflict in the Middle East could produce an even larger supply shock than the
ones just experienced. But, absent such a shock, the key influence on inflation over the next few years
is likely to be the state of the economy. Here again, there are some clear differences between the US
and the euro area.
The euro area economy has proved more resilient over the past year than I had anticipated. In the
September 2022 briefing paper, I wrote that the euro area was likely to enter recession in 2023 under
the pressure of higher energy prices and monetary tightening.
4
This didn’t happen as quickly as I
thought it would but the latest data show the euro area economy has flattened out over the past year
and now seems likely to enter recession this quarter.
5
(See Figure 9). Readings for leading indicators
that tend to forecast GDP, such as purchasing managers indices, are consistent with economic
contraction. Indeed, as Figure 9 shows, each of the previous times the euro area economy’s growth has
decelerated to zero, the result has been recessions lasting at least a few quarters.
In contrast, the US economy has continued to surprise people by performing well despite a substantial
monetary tightening from the Fed. The most recent data show real GDP in the third quarter up 3%
relative to a year earlier and the monthly payroll reports continue to show increases in employment.
There are some areas of weakness such as construction sector and the delayed effects of the Fed’s
interest rate increases may well tip the US economy into recession in the coming months but, as of
now, there is a definite risk that the strong economy results in US inflation remaining higher for longer
than the Fed is currently now anticipating, triggering further policy rate increases.
The contrast in economic performance between the US and the euro area likely has a number of
sources. First, US fiscal policy has been highly expansive in 2023. As shown in Figure 2, the IMF’s
estimate of the US structural budget balance increased from a deficit of 6.5% of GDP in 2022 to 8.8% of
GDP this year, implying an additional 2.3% of fiscal stimulus. This unusually procyclical fiscal policy
stems from the spending commitments in President Biden’s Inflation Reduction Act and CHIPS and
Science Act, both of which were passed in August 2022.
6
The Inflation Reduction Act has provided
substantial tax breaks to the private sector to encourage investment in green energy technologies and
the CHIPS and Science Act is providing subsidies for investments in the semiconductor sector. This has
lead to a boom in construction of manufacturing plants, which was up 60 % year on year in September.
7
In contrast, the IMF estimates the structural budget deficit for the euro area is effectively unchanged
this year at 2.7% of GDP, so European fiscal policy is not offsetting the contractionary impacts of fiscal
policy.
Second, the euro area is a net importer of energy while the US has become a net exporter of energy in
recent years. While US households have been hurt by higher energy prices, these higher prices are
benefiting firms and workers in the energy sector. In the language of economists, Europe has had a
large “terms of trade” shock because of an increase in the price of its imports relative to its exports.
4
Whelan (2022).
5
I should perhaps have factored in the legendary economist Rudi Dornbusch’s warning that “In economics, things take longer to happen
than you think they will, and then they happen faster than you thought they could.”
6
https://www.thetaxadviser.com/issues/2023/jun/what-the-inflation-reduction-and-chips-acts-could-mean-for-us-
importers.html
7
Data on this is available from the St. Louis Fed at https://fred.stlouisfed.org/series/TLMFGCONS