Asset prices in the trans-Atlantic community are changing according to market conditions created by monetary and fiscal policies.

In the United States, the key policy interest rate – the effective federal funds rate – is 3.62 percent while the current inflation rate is 4.2 percent.

Corrected for inflation, the interest rate reflecting American monetary policy is a negative 0.58 percent. And that is the situation at a time when the official U.S. inflation target is 2 percent.

Financial markets are treating that target as an irrelevant statement with no credible policy commitment. To show that, during the last week’s sale of $743 billion of the U.S. government debt investors required, and got, a 4.58 percent yield to buy the bellwether ten-year Treasury note.

A negative real policy interest rate is an obvious error of monetary management.

Another glaring policy mistake is a loose credit stance at a time of an exceptionally large fiscal stimulus, with a budget deficit of 8 percent of GDP.

U.S. must restore price stability

A negative real policy interest rate, coupled with government’s huge borrowing requirement and a virtually out of control public debt of $31.9 trillion is an explosive policy mix that accommodates and magnifies unfolding imbalances in U.S. labor, product and service markets.

To reinstate its credibility, the U.S. monetary policy should respect its statutory mandate to deliver “maximum employment, stable prices, and moderate long-term interest rates.”

On current evidence, a 4.2 percent unemployment rate in June is the U.S. economy’s “full employment unemployment rate.” That is not a consensus view, although empirical research shows that a U.S. jobless rate below 5.5 percent indicates full employment. A more elastic definition was also provided by the OECD in a research note estimating that a U.S. unemployment rate between 4 percent and 6.4 percent is a full employment.

So, regardless of possible debates about what actually means full employment, the U.S. monetary policy has unambiguously fulfilled its labor market mandate.

Inflation, a quintessential monetary phenomenon, is a completely different story. The U.S. price stability must be restored – and there is a long way to go from an accelerating inflation of more than 4 percent to stabilized prices around an annual inflation rate of 2 percent.

That widening demand-supply gap in U.S. labor and product markets can only be narrowed by slowing household consumption, residential and business investments and government spending in an economy whose most recent surveys show a significant forward momentum.

Eurozone’s epochal changes

The euro area will have a much easier task of stabilizing its inflation rate around 2 percent. Last month, the monetary union reported an energy and food driven inflation rate of 2.8 percent. Stripped of those two volatile components, the core inflation was 2.4 percent.

Apart from that, the euro area economy has virtually stopped growing in the first quarter of this year. And its policy mix is roughly balanced: The key interest rate is 2.4 percent, while the budget deficit and public debt have declined, respectively, to 3 percent and 87.8 percent of GDP.

In spite of that, the European Central Bank (ECB) has warned that it would not accommodate future energy price shocks. That will be quite a challenge, though, because energy prices soared 9 percent in the second quarter.

More generally, policy adjustments in the euro area will be complicated and politically difficult.

Germany, approximately one-third of the monetary union, should stimulate its domestic demand and stop living off its European trade partners. But instead of cutting taxes to increase household spending, Germany is now pouring money into its own arms manufacturers, while the growth of private consumption is expected to virtually grind to a halt.

Meanwhile, Europe remains Germany’s biggest export market. In the first five months of this year, Europe accounted for nearly three quarters of total German exports, an increase from 70 percent recorded last year.

France is facing general elections in May and April of next year, with RN, the rightwing political party, looking like an unbeatable frontrunner. Paris must urgently implement painful decisions to stop runaway public debts and deficits. The likely new French rulers seem determined to put an end to the disingenuous French-German bonhomie. They are also resolved to take back part of sovereignty transfers to the European legislative and executive authorities.

Europe’s forthcoming epochal changes are dwarfing America’s inevitable interest rate hikes to restore price stability and reassert the independence of its monetary policy.