Although the Great Recession was viewed – especially in Europe – as mainly a US problem, the Eurozone has been implicated from the start and felt virtually the same impact in the early stages (Figure 1). The US economy, however recovered much faster. US stock prices and GDP regained their pre-crisis levels by late-2011; the Eurozone barely reached that stage in 2015.
Figure 1. Stock and GDP price movements
The US policy response was much more proactive (de Grauwe 2010). Fiscal stimulus was greater than in the Eurozone in 2008-9; the US also returned to fiscal austerity later, in 2011 rather than in 2010 as the Eurozone did (Mody 2015). More important was the US authorities’ active resolution of banking stress; Eurozone banking problems were allowed to fester. And throughout, US monetary policy was much more aggressive. In a recent paper, we used a narrative approach to identify the role of monetary policy during the Great Recession (Kang et al. 2015).
The US Federal Reserve lowered its policy interest rate (the Fed Funds rate) from 5.25% in September 2007 to 0-0.25% in December 2008 (Figure 2).1 At that point, the Fed also initiated quantitative easing and began ‘forward guidance’, making public its intention to keep interest rates low ‘for some time’. The ECB’s first reaction to the Great Recession was in July 2008, and it was to raise the policy rate (the main refinancing rate).2 After the Lehman bankruptcy in September 2008, the ECB joined an internationally coordinated rate reduction on 8 October. But then the ECB’s slow pace of rate cuts was interrupted by two more hikes—in April and July 2011. The policy rate was brought to near-zero only in November 2013; modest quantitative easing began in September 2014 and was expanded in January 2015.
Figure 2. Policy rates: The US Federal Reserve and the ECB
Our narrative tracks the stated policy intent, the stock market response following the announcement, and the immediate market commentary. To examine the stock market’s response to the announcement of interest rate cuts, we used an event-study methodology similar to that of Ait-Sahalia et al. (2012). First, the ‘abnormal difference’ was computed for each day following the announcement. This is measured as the change in the stock price minus the average daily change over the 20 days before the announcement (the presumption is that absent the announcement, stock prices would have continued to change at the same pace over the next five days). Adding up the daily abnormal differences, the cumulative abnormal difference shows the post-announcement divergence in the stock price movement from the trend in the preceding 20 days. The results are summarised in Figure 3.
Figure 3. Stock market reactions to the reduction of interest rates
Note: In computing the average ‘abnormal’ reaction between 2007 and 2009, we do not include the market reaction on 8 October 2008 because of high volatility in the days following. The results remain unchanged.
The stock market responded positively to the Fed’s rate cuts. In contrast, the market’s reaction to the slower-moving ECB was, on average, negative between 2007 and 2009 and also between 2011 and 2014. Consistent with our findings around the announcements, US stock indices moved ahead of those in the Eurozone, as seen in Figure 1. Moreover, as Figure 1 also shows, stock prices tracked relative differences in GDP performance, in line with Akerlof and Shiller’s (2009) view that improved investor sentiment helps stem the fall and begin the recovery.
The anticipation of the announcements was not the primary influence on stock prices. In the US, the one unexpected announcement did trigger a strong response; but even the anticipated rate cuts were viewed favourably, especially if they were 50 basis points (0.5%) or larger. Researchers at the Chicago Fed find that anticipated policy actions have positive stimulative effects if they signal deviation from historical policy (D’Amico and King 2015, pp. 2-3). Thus, while formal ‘forward guidance’ came only on 16 December 2008, the actions up until then established a presumption that the Fed was pursuing a risk management approach and creating a safety net.3 Specifically, the larger rate cuts and accompanying statements signalled that the Fed was trying to ‘forestall’ financial turmoil from spiralling out of control.
In contrast, even the ECB’s larger rate cuts were seen as ‘too little, too late’. The ECB was reacting to news—building its shelter amidst a raging storm. ECB statements also mused endlessly about rising inflation and hence almost never promised more forthcoming action. The Bank of England was also late, but made up with quicker and much larger rate cuts, followed by quantitative easing.
It is true that the Fed has a clear dual mandate to support employment and maintain price stability. However, the central banks’ differing mandates were not the reason why they acted differently in the Great Recession. The ECB—despite its primary focus on price stability—had previously responded as if it had a dual mandate. Indeed, as Lars Svensson has pointed out, the ECB’s goal of medium-term price stability (over a two-year horizon) implied that it would not seek to bring inflation down instantly since attempting to do so would cause an unreasonable drop in output (Svensson 1999, pp. 83, 96, and 107). The result, Svensson argues, is that the ECB’s stated objective is indistinguishable from that of central banks with dual mandates, as studies have confirmed (Taylor 2010 and Nechio 2011).
Rather, as Alan Blinder pithily states, the Fed operated during the Great Recession on the ‘dark’ view that a huge loss of wealth could tip the economy into a free fall (Blinder 2013, p. 94). The priority was to prevent or manage that risk. Between 2007 and 2009, the Fed made the judgement that inflation risk was low and the main task was to prevent a downward output spiral. Later, the Fed used the same risk management approach to fend off the risk of price deflation.
By contrast, the ECB concluded that a temporary scare had caused banks to hoard cash and restrict lending to other banks (Blinder 2013, p. 94, Stark 2008). Thus, the ECB provided ample liquidity to banks, although no more so than the Fed. As the Fed understood, such passive provision of funds to banks was insufficient to induce banks to lend more and stimulate economic growth (Hetzel 2012). The loss of confidence and severe demand contraction required active monetary stimulus. The ECB insisted that foreign demand would ‘support ongoing growth’ in the Eurozone (e.g. Trichet and Papademos 2008).
The essential difference between the Fed and the ECB, therefore, boiled down to how each institution viewed the evolution of the economy. Even though inflation rates in the US and the Eurozone were nearly identical (Figure 4), the ECB overemphasised the risk of a commodity price-wage spiral and underestimated the financial and economic risks (Hetzel 2014). Market commentary repeatedly sent this message, as we document in our paper.
Figure 4. Headline inflation and core inflation for the US and Eurozone
The Fed transitioned to worrying about deflation risk as early as June 2010, even though inflation was rising in tandem with the European inflation rate (Figure 4) (Federal Reserve System 2010). The Fed’s main tools now were quantitative easing and forward guidance. As is well known, in this inglorious interlude, the ECB twice raised interest rates. But even past that point, the ECB continued to reject a risk-management approach and followed rather than anticipated the deceleration in inflation. Because it had delayed stimulus during 2007-9, the ECB needed more aggressive action rather than a continued wait-and-see approach. At a November 2013 press conference, a journalist described the ECB as a “pea-shooter dealing with an approaching deflationary tank”. ECB President Mario Draghi responded that the ECB was waiting for more data, and would do more “if needed” (Draghi 2013). Thus, the ECB acted asymmetrically: rising commodity prices were expected to feed persistent inflation, but falling commodity prices were expected to reverse course. Once again, markets and analysts reacted impatiently. Interest rate cuts were not enough. The question was why more aggressive ‘non-standard’ actions were not being taken.
We conclude also that the Fed gained credibility even though it appeared to temporarily suspend its commitment to price stability. Bordo and Kydland (1995) have argued that setting aside a policy rule to deal with extraordinary contingency is consistent with a commitment to long-term goals. The Fed made clear its objective of preventing a meltdown and, as Blinder (2012) has emphasised, credibility principally requires that words be matched with deeds.
In the Eurozone, words were often a substitute for deeds. Markets and investors reacted to the tight monetary policy, which added to the economic drag and deflationary tendencies due to fiscal austerity and lingering banking problems. By mid-2009, Eurozone output had fallen behind that of the US, and it never caught up. Delays in stimulating economic recovery have permanent consequences, as recent analysis reaffirms (Fatas and Summers 2015). For all its rear-guard action, the ECB misread the Crisis and will be associated with the legacy of a weak recovery and more entrenched deflationary tendencies. If, as is entirely possible, the Eurozone’s core inflation rate remains below 1% a year, the ECB’s credibility will be twice hurt. Not only would it have failed to provide stimulus when needed, but it would have allowed the EZ to slip into a low inflation trap, well below its stated target of 2% a year.
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1 The US Federal Funds rate determines the rate at which banks lend to each other.
2 The Eurozone’s main refinancing rate is the interest rate banks pay to borrow from the ECB. Normally, this rate also determines the euro overnight index average (EONIA), the rate at which banks lend to each other in the ‘unsecured’ market. But banks relied principally on the ECB for their funding through much of the Crisis; the limited lending in the banks’ unsecured market was a substitute to depositing money at the ECB (ECB 2010 and 2015b).
3 See Woodford (2012) on the distinction between policy response to news and a change in the policy.