by Balazs Koranyi and Francesco Canepa
(Reuters) – The fall of the euro against the dollar which brings it closer to parity with the greenback, the first not seen for 20 years, puts the European Central Bank (ECB) in an uncomfortable situation because the options at its disposal are inevitably painful and costly for the economy.
Allowing the euro to depreciate would only fuel inflation, already at a record level, at the risk of anchoring expectations at a level well above the 2% target set by the ECB.
But trying to stop the decline would mean bigger rate hikes, adding to the difficulties of eurozone member countries, already threatened with recession amid gas shortages, soaring oil prices and degrading power. of purchase.
The ECB has so far dodged the subject by emphasizing that it has no exchange rate target while ensuring that it monitors the evolution of the currency. The minutes of its June monetary policy meeting published on Thursday also show that the subject was not considered particularly worrying by the members of the Governing Council.
But the market moves have since become too big to understate.
“The weakness of the euro reinforces the idea that the ECB is lagging behind,” comments Dirk Schumacher, director of macro research Europe at Natixis CIB. “Given the level of inflation, a stronger euro would be welcome because it would reduce inflation.”
Now down below $1.02, the euro has lost more than 10% of its value against the US currency since the start of the year, even though its trade-weighted decline is only 3.3 %.
THE DIVERGENCE WITH THE FED IS A PROBLEM
This depreciation has as its corollary an increase in the cost of imports, in particular those of energy and other raw materials invoiced in dollars. According to studies regularly quoted by the ECB, a 1% depreciation of the exchange rate translates into an increase of 0.1 point in the inflation rate over one year, an impact which can reach 0.25 point over three years.
However, the current economic and monetary fundamentals suggest that the weakness of the euro could well persist.
First, the ECB and the Fed have divergent strategies: the president of the American central bank, Jerome Powell, has clearly indicated that he is ready to run the risk of a recession by accelerating the rise in interest rates, whereas that the ECB prefers to step out of a decade of ultra-accommodative monetary policy.
While the Governing Council is due to approve a first rate hike in two weeks, the deposit rate is expected to remain negative until September and the next step will depend on the evolution of the economic landscape.
However, this has already darkened so much since mid-June that the market has already lowered its expectations: it is only counting on a rise of 135 basis points in ECB rates while it is betting on 180 additional points of increase for the Fed, which has already raised its rates several times.
This spread is prompting investors to leave Europe behind in search of better returns across the Atlantic, a trend that is weakening the euro in the process.
RUSSIAN GAS ADDICTION COMPLICATES THE ISSUE
Second complication: the very strong energy dependence of the euro zone, above all on Russian gas, increases its exposure to the fallout from the war in Ukraine, which penalizes the euro.
“Faced with the risk of recession which hovers, and because the euro is a pro-cyclical currency, the ECB risks seeing its ability to brandish the threat of more offensive rate hikes to defend the euro hampered”, explains ING in a note to its customers.
Finally, the increase in the energy bill of the 19 is driving up import prices, which translates into a deficit in the euro zone’s current account balance. An unusual situation that risks weakening the currency a little more if it continues.
To support the euro, the ECB could hint that it will accelerate rate hikes, which would include a 50 basis point hike in September and further hikes in October and December.
But since the markets are already anticipating a change in this direction, the institution should also align itself at least in part with the discourse given by the Fed according to which the fight against inflation prevails for the moment over all the others. stakes, even if it leads to a recession.
Such a message, certainly favorable to the euro, would undoubtedly cause a new massive sell-off on the public debts of the so-called “peripheral” countries of the region, with the threat of a new crisis as a result.
Hence the urgency of unveiling the new instrument being developed which is supposed to prevent an exaggerated increase in the bond yields of the most indebted countries, Italy, Spain, Portugal and Greece.
“Spoiler: yes, parity is at stake,” said Jim Reid, multi-asset strategist at Deutsche Bank.
(Report Balazs Koranyi and Francesco Canepa, French version Marc Angrand)
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