Risks and rewards: Rates heading up in US and down in Europe

AP News
|
Posted: Dec 03, 2015 3:22 PM
Risks and rewards: Rates heading up in US and down in Europe

WASHINGTON (AP) — The European Central Bank is cutting interest rates. The Federal Reserve is poised to raise them.

Their conflicting policies reflect clashing realities on opposite sides of the Atlantic: The U.S. economy is looking healthier — a diagnosis likely to be confirmed on Friday, when the U.S. Labor Department reports on job creation and unemployment in November.

And the European economy? It needs help: The 19-country eurozone is struggling with weak growth and alarmingly low inflation.

Here's a guide to the central banks' divergent approaches — what they're intended to do and what they're likely to do:

___

WHAT IS THE ECB DOING?

On Thursday, the ECB cut a key interest rate and extended a bond-buying program through at least March 2017. The moves are meant to raise excessively low inflation, ease borrowing costs and prod consumers and businesses to borrow and spend. They're also designed to reduce the value of the euro currency compared with other currencies, thereby making European goods cheaper overseas and giving exporters a price edge in foreign markets.

To get banks to lend, the ECB is actually penalizing them — more than it did before — for parking money at the central bank. Banks will now receive negative interest rates of minus 0.3 percent, down from minus 0.2 percent. So they will effectively be paying more for the privilege of letting the ECB hold their money.

The ECB also pushed back the deadline for its 60 billion euro ($66 billion) monthly bond-buying program, which had been set to expire as soon as September 2016. The bond purchases are meant to lower longer-term rates and stimulate more borrowing.

___

WHY DOES EUROPE NEED THE ECB'S HELP?

The eurozone has been stuck in a funk for years. Its economy shrank in 2012 and 2013 and grew less than 1 percent last year. It's expected to grow an anemic 1.5 percent this year, according to the International Monetary Fund. The unemployment rate is a punishing 10.7 percent.

Banks, damaged by the financial crisis, have been reluctant to lend. Businesses and consumers have been too cautious to borrow.

The head of the ECB, Mario Draghi, is also concerned about too-low inflation. The central bank foresees just 1 percent inflation next year; it wants it to be roughly twice that high.

Low inflation damages the economy in part by making it costlier for borrowers to repay their debts. It also gives consumers and businesses an incentive to delay spending and investing, on the assumption that prices will go down in the future.

Still, investors were underwhelmed by the ECB's moves Thursday. They had expected more. European stocks fell, and the euro rose.

___

AND IT'S A DIFFERENT STORY IN THE U.S.?

Definitely. The U.S. economy is finally returning to near full health 6½ years after Great Recession officially ended. Employers have added 2.8 million jobs the past year, and Friday's jobs report is expected to show an additional 200,000 for November.

The IMF expects the U.S. economy to expand a solid 2.6 percent this year and 2.8 percent next years.

Even wages, the weak link in the American recovery, have begun to show signs of improvement.

___

WHAT DO THOSE GOOD TIDINGS MEAN FOR THE FED?

In December 2008, at the lowest depths of the financial crisis, Fed policymakers cut the short-term rate they control to a record low near zero. They've kept it there ever since.

But the financial crisis has long since passed. And the unemployment rate has reached a seven-year low 5 percent, pretty much at the level the Fed considers full employment.

In testimony Thursday to Congress' Joint Economic Committee, Chair Janet Yellen reiterated that the Fed would likely begin raising rates at its next meeting, Dec. 15-16, barring a surprise shock that undermines confidence.

A rate hike, Yellen said, would amount to a "testament ... to how far our economy has come in recovering from the effects of the financial crisis and the Great Recession. In that sense, it is a day that I expect we all are looking forward to."

She also warned that delaying a rate hike carried risks. If the Fed waited too long and allowed inflation to get out of control or allowed dangerous bubbles to form in assets such as real estate, it might have to raise rates "abruptly" and "perhaps even inadvertently push the economy into recession."

___

WILL THE DIVERGENCE BETWEEN ECB AND FED HAVE CONSEQUENCES?

Probably. Rising U.S. rates will likely lure global investors into dollar-denominated Treasurys in search of higher returns. That would send the U.S. dollar up and the euro down. The dollar has already climbed 11 percent against the euro this year.

A strong dollar hurts American exporters by making their goods costlier overseas and gives European companies a price edge in the United States.

In her congressional testimony Thursday, Yellen acknowledged that the strong dollar is "something that makes us much more cautious in terms of raising rates."

But she noted that exports play a relatively small role in the U.S. economy. According to the World Bank, exports accounted for just 13.5 percent of U.S economic activity in 2013, one of the lowest shares in the world.

In theory, higher U.S. borrowing rates could squeeze economic growth. But current rates are extremely low, and Yellen said any increases would likely "follow a gradual path," thereby limiting potential damage to the economy.

Overall, Yellen said the U.S. economy looks robust.

"We're on a solid course," she said.

___

Follow Paul Wiseman on Twitter at https://twitter.com/PaulWisemanAP