The European Central Bank has dashed hopes of fresh stimulus to buttress the faltering recovery and to restrain the surging euro, sending the single currency rocketing higher against sterling, the dollar, and the yuan.
The relentless rise of the euro is pushing large parts of the eurozone into a Japanese deflation trap, threatening a fresh banking crisis and playing havoc with debt dynamics in a string of vulnerable countries already reeling from the shock of Covid-19.
Christine Lagarde, the ECB’s president, said there is “no need to overreact to euro gains”, distancing herself from a spate of warnings by senior officials that the rising exchange rate is tightening monetary policy pro-cyclically and compounding woes in the midst of a deep economic crisis.
The euro jumped instantly to $1.19 against the dollar and hit a one-year high of £0.92 against the pound. The ECB’s trade-weighted index has risen 7pc this year and 22pc since touching bottom at the onset of quantitative easing in 2015.
Mrs Lagarde’s surprisingly hawkish tone came despite a fall in headline inflation to minus 0.2pc in August, touching -2.9pc in Cyprus, – 2.1pc in Greece, -0.6pc in Spain, and -0.5pc in Italy. Core inflation collapsed to an all-time low of 0.4pc.
Melissa Davies from Redburn said there are mounting risks of endemic deflation and a “Greek-style depression” across Southern Europe. The North-South gap is returning as a perennial EMU headache.
The ECB governing council offered no crumbs to the markets at its policy meeting on Thursday, sticking to its scheduled €1.35 trillion plan of pandemic QE and remaining silent on the prospect of future rate cuts. It vowed only to “monitor” the currency.
The ECB leadership appears as divided as ever, with German-led hawks adamant that there is no need for further stimulus after this year’s explosive surge in the M1 and M3 money supply – usually a harbinger of future inflation, though the current circumstances are sui generis.
Doves centred around the chief economist, Philip Lane, are much more concerned about euro appreciation. They fear a truncated recovery once the low-hanging fruit is picked and the initial ‘V’-shaped rebound from Covid-19 fades, leaving a shrunken economy with mass unemployment and thousands of crippled companies.
The great unknown is how much structural damage has been done by the 12.1pc contraction in the second quarter. Industry has yet to recover and large sectors such as aviation are in dire trouble. There are risks of an ‘echo crisis’ this winter as the long-tail effects of a business capex freeze and lost jobs do their worst.
Oxford Economics said its real-time tracker suggests that eurozone growth is already “petering out”, with consumption sliding as rising cases of Covid-19 threaten a second wave of the pandemic.
The EU’s €750bn Recovery Fund does not kick in until the middle of 2021 and is then spread thinly until 2026. It is too small to move the macro-economic needle.
There is little that the ECB can legally do to drive down the currency even if it tries. Interest rates are already minus 0.5pc and arguably at the ‘reversal rate’ where further cuts do more harm than good, eroding the net interest margin for banks and making it harder for insurers to match their liabilities.
The ECB has sought to limit the fall-out for lenders by a technical device known as ‘tiering’ but small German savings banks that provide 90pc of total credit to Mittelstand family firms say their business model is being destroyed.
Diminishing returns set in long ago for QE. Bond yields are already steeply negative on long maturities across the eurozone core. There is almost nothing left to squeeze out of the yield curve. “Beyond verbal intervention, we think the ECB has limited options to weaken the euro,” said Bank of America.
Mr Lane attempted to talk down the currency last week with veiled intervention, briefly lowering the exchange rate 2pc with a comment that the “euro-dollar does matter”.
But his words came close to currency manipulation and appear to violate a solemn accord by G7 central banks to remain silent on exchange rates. Such a demarche risks a hot retort from Washington if repeated.
“Lane committed a cardinal sin and it is dangerous,” said Dr Ulrich Leuchtmann, Commerzbank’s currency chief in Frankfurt. “He must have known that what he said would weaken the exchange rate. It is exactly what the G7 promised each other that they would not do.”
The worry in Germany is that Donald Trump will vent his fury by retaliating with punitive tariffs against the car industry, pushing the sector into an even deeper crisis.
It is understood that Berlin made it crystal clear to Mrs Lagarde that she must rein in her officials and desist from further currency interventions, hence her awkward attempt to talk up the recovery and sound hawkish at her press conference.
The ECB has other problems. It suddenly faces a systemic policy broadside from the US Federal Reserve, which has shaken up the world of central banking with a new regime of flexible inflation targeting – academic jargon for looser money and a greater willingness to ‘run the economy hot’ in order to boost jobs.
Krishna Guha from Evercore says no major central bank can run a tighter policy than the Fed without seeing its currency ratchet up. “This puts immense pressure on other central banks.The ECB is on the front line of these dynamics,” he said.
The problem is doubly serious because the eurozone is “much further along the path of Japanification than the US” and therefore even more vulnerable to an exchange rate squeeze.
Mr Guha said the ECB may be fated to relive the unhappy episode after the Lehman crash, when the Fed came in harder and faster with emergency stimulus. The divergent course of action on each side of the Atlantic queered the currency markets. It left the eurozone exposed to a chronically higher euro and a slow deflation crunch, ending in a double-dip recession.
The ECB is now paying the price for errors made long ago. It went through an entire global cycle after 2008-2009 without ever doing enough to meet its inflation target, ultimately finishing the 11-year expansion with rates still below zero.
It therefore had no safety buffers left to protect against deflation when the next shock came. The shock has now hit.
– The Telegraph