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What should the central bankers do now?

Written by A Forex View From Afar on Thursday, September 04, 2008

The financial world is now split in two over who is right: the Fed, which decided to cut or the ECB, which raised in front of the credit crunch and an imminent global slowdown.

At a time when the Federal Reserve has cut 325 basis points, the ECB has been bullish and finally decided to raise interest rates by 25 basis points. Over the same period, the Euro-area economy plunged, while on the other side of the Atlantic, things appeared to have bottomed.

However, even if the Fed and the ECB implement their decisions in the same financial markets (actually every central bank does this) they chase different objectives. The ECB’s objective is limited to assuring price stability over the medium term by way of keeping the CPI close to 2%. On the other side is the Fed, with a range of objectives from full employment to price stability and moderate long-term interest rates. From the academic part of central banking, there is a full range of research papers that say a central bank should exclusively focus on inflation targeting.

Since the two banks have different objectives, quantifying and comparing the two results is a little harder. Nevertheless, what is certain is that both banks have failed in reaching any of their objectives. The Fed has failed in securing the labor market, inflation is running wild and the economy is moving at a sluggish pace. The ECB has failed also, by not keeping inflation under control, having the CPI running twice as big as the target and second round effects are knocking on the back-door.

One of the things the two banks agree on is that growth will pick up somewhere in 2009, while inflation will moderate in the coming quarters. It will be interesting to observe if this comes true, as most of the banks’ estimates, until now, have notoriously failed. (remember “the credit crisis is contained”?). About who was right in dealing with the credit crunch, we will be able to judge only from the economic results in the following quarters.

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