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The Fed can save the euro

David Beckworth has a excellent comment on the correlation between NGDP in the US and the euro zone.

David shows that US NGDP growth leads NGDP growth in the euro zone. This means that if the Federal Reserve were to move to push NGDP back to the pre-crisis trend level then it would likely lead to a similar increase in the NGDP level in the euro zone.

Hence, if the Fed were to introduce a NGDP level target then because the US is a “global monetary superpower” then the ECB would effective be forced to do the same thing. Interestingly this would probably mean that the ECB would overshoot it’s 2% inflation in the short-run as NGDP shifts from on level to another. How would the ECB react to that? Well, first of all the EUR/USD would undoubtedly spike, which would curb short time inflationary pressures and the question is really whether the ECB would have time to do anything about the jump in NGDP. Paradoxically because the ECB is targeting future inflation then it could say “well, inflation is now at 5%, but that is really not something we can do anything about and inflation nonetheless be back to 2% once US NGDP settles down at the new (old) NGDP trend level so no tightening of monetary policy is needed”.

For now the ECB refuses any easing of monetary policy, but if the Fed were to act decisively then the ECB probably would import an easing of monetary policy – and that would probably save the euro. So please Ben can you help us?

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