Fed, Europe Should Get in Sync on Rates

Absolute and Relative

We only have one episode in the euro's short history of a prolonged period of euro rates rising faster than dollar rates: the two-year period between mid-2000 and mid-2002. This rate gap occurred within the context of a global bear market in equities, and it was driven more by the Federal Reserve's rate-cutting than by anything the ECB did.

American investors fared better -- if we wish to include losing less money in Europe than in the U.S. as "faring better" -- by holding European stocks during this period. This is a relative measure; the absolute returns were negative in both markets.

Now that the world's central banks are in apparent agreement on the need to raise rates and fight inflation, should we expect the European markets to start outperforming their American counterparts on the basis of a narrowing rate gap alone? And even more important than this relative basis, can we state in advance whether rising global short-term rates will be sufficient to stall all equity markets?

The answers to both questions are maddeningly indeterminate. The inflation now being combated is the culmination of several years of monetary ease. The Federal Reserve eased more and has been tightening more, and these actions produced both the 2002-04 rally in the euro and its weakness relative to the dollar in 2005. If the market senses the ECB is further behind the curve on inflation and will either stay that way or start raising rates too fast, the European markets will suffer on both an absolute and a relative basis.

If we go through the various policy combinations, we start to conclude the best course of action for the Federal Reserve is to stay on its measured pace and for the ECB to start talking this talk in its various languages. That is the only form of policy coordination that will benefit all markets. Is this asking a lot of the central banks? Yes, but as Benjamin Franklin noted, they had best hang together or else they surely will hang separately.