The ECB and the FED: A Difference of Approaches

I find it very interesting to observe the different approaches of the two most influential central banks in the world to the current slowdown or recession (choose whatever you think is appropriate). Both the US and Europe are showing an increasing number of negative economic indicators which point to an economic slowdown. The two banks are currently struggling with the same two generic problems:
1. An economic slowdown and fear of recession
2. Rising inflation and rising commodity prices

The FED has taken quick action so far and reacted in a resolute manner to the situation in the markets by both reducing interest rates sharply and increasing the flow of funds dramatically. Just this past week the FED announced plans to inject $200 billion into ailing credit markets by offering to swap high-quality Treasuries to banks and investment houses for beaten-down mortgage-backed securities. The Fed is also expected to lower interest rates by an additional 0.75%-1.5% (estimates vary). It seems the FED is determined to fight the slowdown and credit crisis first and deal with the price levels next.

The FED’s quick actions stand in sharp contrast to the European Central Bank’s (ECB) decisions so far. This past couples of months have shown the ECB, headed by Jean-Claude Trichet, is in no hurry to reduce interest rates and is more concerned with rising price levels. The ECB was expected to reduce interest rates by at least 0.25%-0.5% during the last two meetings and has chosen so far to leave the interest rates untouched.

I believe these fundamental differences in approach stem from the nature of the markets these central banks are responsible for. The US is characterized by a far less rigid employment market and regulations which enable corporations to act more swiftly to times of slowdown by cutting jobs and reducing the workforce. This, for good and bad, enables the US market to adapt more quickly to recessions and economic slowdowns which in turn enables the central bank to act as swiftly.

The European market, on the other hand, is characterized as having a more organized and rigid workforce (also due to the large number of employees in the government and public sectors). This rigidity forces the central bank to be extra careful when dealing with inflation since salaries and purchase power do not respond to economic slowdown as fast.

This ofcourse is simplifying the matter but it seems this fundamental difference has significant importance.

I’d like to take this opportunity to thank Mike from Four Pillars on including me in the #143 issue of the carnival of personal finance.