ECB View: Central bank concerned euro surge may continue – The surge in the euro over recent weeks seems to have finally caught the attention of the ECB. Chief Economist Philip Lane noted yesterday that although the ECB does not target the euro it does matter for monetary policy as ‘we have an inflation mandate and we care about the overall performance of the European economy’. This reflects the typical first stage of the central bank’s reaction to sharp movements in currencies, namely verbal intervention. Not only has the EUR/USD rate risen, the effective exchange rate (the euro rate against the currencies weighted by their importance to the eurozone’s foreign trade) has also jumped. So what impact will the rise in the euro have on the ECB’s inflation outlook and monetary policy?
The rise in the euro will have a downward impact on the ECB’s inflation forecast as, if sustained, it would reduce import prices and eventually core goods prices. The ECB’s June projections assumed that the trade-weighted index would rise on average by 1.4% this year. At the moment the annual change is closing in on 4%. If the euro were to stay at the current level, it would reduce the ECB’s projections for inflation by around 0.1-0.2 percentage points over the next year. This is not a huge amount, but it is an extra disinflationary pressure at a time when inflation is moving further away from the ECB’s goal. Indeed, the Covid-19 economic shock has meant lot of labour market slack and excess capacity is opening up, which will reduce wage growth and underlying price pressures for a considerable time.
The ECB’s assumption for the trade-weighted euro and recent development
Source: ECB, Thomson Reuters Datastream, ABN AMRO Group Economics
We think the rise in the euro makes it more likely that the ECB will step up monetary stimulus later this year, in the form of a further increase in the PEPP envelope. In the event of a further sharp surge in the euro, the ECB could also consider a more aggressive step to stem the single currency’s rise. The most powerful tool it has (outside of currency intervention) to do this is a policy rate cut. Obviously there are pros and cons to even more negative rates, but a much stronger euro at some point in the future could change the balance of its assessment. (Nick Kounis & Aline Schuiling)