Monetary policy is responsible for economic stability

Clearly, the Fed has not been able to hold inflation down. Statements by Fed officials last week are recognizing that difficulty, admitting that inflation will be rising above 2 percent.

A strange “market guidance” indeed. Consumer prices in July and August have already been pushing up at an average annual rate of 2.8 percent.

It sounds like the Fed is saying that prices of a typical American consumer basket are irrelevant to its policy settings. But that’s not how bond markets see that most painful cut to real incomes: Inflation expectations have been fired up, the yield curve has steepened sharply, and the benchmark 10-year Treasury note closed at 3 percent last Friday — 14 basis points above the yield at the beginning of this month.

Please remember: Whenever bond market investors vote with their feet, they are casting a resounding vote of no confidence in a central bank’s commitment to price stability and in the currency’s real purchasing power.

The European Central Bank is in a much better harmony with asset markets. The euro area’s 1.2 percent core rate consumer price inflation offers quite a bit of scope to maintain a vastly accommodative monetary policy to support the economic growth in the range of 2 to 2.5 percent.

The euro area’s changing credit market trends are also signaling significant structural improvements. Bank credit to the private sector continues to grow at a steady rate of about 3 percent, while lending to governments has been reduced to an average annual rate of 3.7 percent in the three months to July. That is a sharp decline from growth rates of 7 percent in the closing months of last year, and a clear sign of a roughly balanced budget for the euro area as a whole.

Responding to those developments, the ECB plans to wind down its bond purchase programs by the end of the year, but it intends to maintain zero interest rates through next summer.

A huge effort made by the euro area governments to consolidate their public sector accounts has made the ECB’s job easier and more effective. There is now the possibility to loosen up the fiscal restraint in a number of countries (Germany, the Netherlands and some smaller economies) to support economic growth, even as the ECB begins to withdraw some of its extraordinary accommodation.

And in case of any weakening of external demand, the fiscal and monetary policies in the euro area have enough room to offset that with stronger domestic spending.