The recovery is on. Economies across the eurozone are reopening and business is returning to normal, or at least as close to normal as it can get.
It puts Christine Lagarde and her colleagues at the European Central Bank in an unusual position.
pretty much to the floorboard on the accelerator, and GDP is going to grow at a record pace in the third quarter as much of the damage of lockdown is undone.” data-reactid=”28″ style=”margin-bottom: 1em; color: rgb(0, 0, 0); font-family: “Yahoo Sans Finance”, “Helvetica Neue”, Arial, sans-serif; font-size: 16px; background-color: rgb(255, 255, 255);”>Her foot is already down pretty much to the floorboard on the accelerator, and GDP is going to grow at a record pace in the third quarter as much of the damage of lockdown is undone.
Yet the economy will remain significantly smaller than it was, with a return to its full pre-Covid size only taking place over an unknowable period, not least because the virus appears to be flaring up in some areas.
Lagarde is not expected to make any big decisions tomorrow, but it is also hard for her to do nothing.
One target in her sights could be the exchange rate.
against the dollar in the past four months, a steep rise in a short period and one that is raising eyebrows in Frankfurt. ” data-reactid=”32″ style=”margin-bottom: 1em; color: rgb(0, 0, 0); font-family: “Yahoo Sans Finance”, “Helvetica Neue”, Arial, sans-serif; font-size: 16px; background-color: rgb(255, 255, 255);”>The euro has risen by almost 10pc against the dollar in the past four months, a steep rise in a short period and one that is raising eyebrows in Frankfurt.
Typically the ECB, like the Bank of England, does not target a particular exchange rate.
But it is an issue for inflation and for economic growth. A stronger euro depresses import prices, and can slow down the economy by making its exports less competitive internationally.
If the currency strengthens because the economy is booming, it is not usually seen as a problem. Indeed the economy is now in the recovery phase, so that could be behind the strengthening.
the US Federal Reserve switching the way it targets inflation, causing markets to anticipate looser policy for longer – then a stronger currency is unhelpful. The US’s gain is the eurozone’s loss.” data-reactid=”36″ style=”margin-bottom: 1em; color: rgb(0, 0, 0); font-family: “Yahoo Sans Finance”, “Helvetica Neue”, Arial, sans-serif; font-size: 16px; background-color: rgb(255, 255, 255);”>But if it is caused by another factor – for instance, the US Federal Reserve switching the way it targets inflation, causing markets to anticipate looser policy for longer – then a stronger currency is unhelpful. The US’s gain is the eurozone’s loss.
That makes the exchange rate fair game, particularly when the central bank is running short of other policy tools to gee up growth.
Philip Lane, a policymaker at the central bank, last week said “the euro-dollar rate does matter” and factors pushing it around “feed into our monetary policy setting”.
Sven Jari Stehn, an economist at Goldman Sachs, sees three options. Cutting interest rates, ramping up quantitative easing again, and giving forward guidance on future low rates could weaken the currency, while the effect of extra QE “is not clear cut”.
With the ECB’s deposit rate already at minus 0.5pc, he sees a “high hurdle for policy action (such as a rate cut) to limit the euro strength at this point. But we do see scope for further ECB communication on the euro to slow a further rise”.
So how could the ECB “talk down” the euro?
It all comes down to careful presentation.
“While the ECB does not really have any effective policy options in its tool kit to stem euro appreciation in the near term, there is a case for continued verbal intervention, possibly in both the ‘introductory statement’ and the press conference” at Thursday’s announcement, says Spyros Andreopoulos at BNP Paribas.
“For this pushback to be credible, the overall tone of the Council’s September communication… should remain cautious. This element could be underscored by comments on the impact the exchange rate has on the inflation outlook.”
“monitoring” the currency, then eventually implying that it is the rationale for a policy change, for instance by warning it imperils the goal of price stability.” data-reactid=”45″ style=”margin-bottom: 1em; color: rgb(0, 0, 0); font-family: “Yahoo Sans Finance”, “Helvetica Neue”, Arial, sans-serif; font-size: 16px; background-color: rgb(255, 255, 255);”>Analysis by Shinya Harui at Nomura indicates that the ECB typically begins by mentioning its traditional policy on exchange rates, before moving on to “monitoring” the currency, then eventually implying that it is the rationale for a policy change, for instance by warning it imperils the goal of price stability.
Even if the central bank guides the market to expect long-term low interest rates, Harui warns it will be “difficult to change the euro’s upward trend” because “the market is already pricing in the risk of rate cuts down the line” and the changes in the currency are driven in part by changes in the global economy.
Eventually policy changes could make the difference.
The ECB’s policy review has been delayed by the pandemic, but ultimately it could end up matching the Fed by adopting average inflation targetting. Under this policy, the central bank does not simply try to get inflation back up to its target then stop stimulating the economy, but can instead keep interest rates low to overshoot the goal somewhat, to achieve its target on average over a longer period of time.
This is not a guarantee that the euro will be restrained and the past exchange rate restored, however.
Unfortunately for policymakers, currency strength is a zero sum game – if one currency falls, the other rises in tandem.
That means the Fed and the ECB could each continually take steps to weaken their currency, but in effect stand still as the currencies are priced against each other.
– The Telegraph UK