Tuesday, February 26, 2008

Why are the Fed and the ECB acting so differently?

Bernanke and the Fed have been cutting rates like there's no tomorrow. Frequent, large cuts. Trichet and the ECB have been standing pat. No cuts and rhetoric like there's not going to be cuts. Last month I mused that this was an interesting natural experiment about which way was the best way.

Could it be that the ECB is more independent? After all, they have an explicit inflation target and they don't face the same kind of election year pressures that the Fed faces. Or maybe they don't forecast the same looming disaster that the Fed might be forecasting, being relative rookies to the central banking game and all.

An intriguing third possibility now comes from Finnish economist Mika Widgrén via VoxEU. He argues that the unwieldy nature of the ECBs Executive Board (their analog to the FOMC) introduces inertia and status quo bias, preventing the institution from acting as "nimbly" as the FED.

"In the Governing Council, the one-national-central-bank-one-vote principle was intended to ensure that governors of national central banks would participate as independent actors, not as national stake-holders. Nothing guarantees that, though. Moreover, expanding EMU membership increases the voting share of the Central Bank Governors and makes the consequent numbers or inefficiency problem more severe. Indeed, in earlier studies (see footnote 3), co-authors and I argued that in an expanding Euroland it would become highly unlikely that Governing Council could pass optimal policies correspond to Euroland’s aggregated preferences. Moreover, there would be substantial risk of sticking to status quo when facing asymmetric shocks. In sum, Governing Council decisions might be too conservative and biased towards the status quo."

Interesting. Which policy road is rights and why are the two authorities differing so dramatically?

1 comment:

Norman said...

I would add to that question this one: If both caving to pressure and having a status quo bias involve costs, are these costs symmetric, or is it better to err toward one or the other?