ECB : The euro is our currency, and it’s our problem
By Christophe Morel, Chief Economist
The publication of the minutes of the last meeting of the ECB monetary policy committee (held in mid-July) shows that European central bankers remain positive regarding the prospects for growth. Firstly, they are still expecting robust growth and asses that the recovery of investment is now self-sustaining. Secondly, they consider that the risks surrounding euro area growth are broadly balanced, even though downside risks relating to international economic factors continue to exist (in particular due to the uncertainties regarding American economic policy and the consequences of Brexit). However, they express concern regarding the risk of excessive gains in the value of the euro.
On the subject of the variations in the value of the euro and the implications for ECB monetary policy, our analysis is as follows:
- The effective exchange rate of the euro has increased by about 6% since early May, including 2% since the last meeting of the ECB in mid-July. Given those gains, the ECB is forcibly more concerned today than it was at its last monetary policy meeting.
- This concern is justified. Econometric estimates suggest that an increase of 10% in the effective exchange rate of the euro would cost an average of 1% of growth in the Eurozone over 2 years (the variance between the estimates is large, with figures ranging from 0.5% to 2%). So, the rise in the euro’s value since spring is liable to cost approximately 0.6% in growth over the next 2 years (see graph 1). A EUR-USD parity of 1.3 would double the cost for growth!
Eurozone: impact of a gain in the value of the euro on GDP growth.
- The ECB is not “targeting” the EUR-USD exchange rate. That is not its mandate, and the ECB does not have the means to do so (except by undermining its credibility). On the other hand, while the euro is not an output of monetary policy, it is a very important input. In other words, any significant increase in the euro is offset in one way or another by a loosening of monetary policy. In view of the size of the gains mentioned above, it is clear that the parity of the euro is now the most important variable for the ECB’s monetary policy. Any additional increase in the value of the euro will forcibly induce the ECB to consider postponing the start of its tapering program.
What can we say about the recent movement of euro-dollar parity? Firstly, we should remember that in an environment where central banks “control” the yield curves, currency will be increasingly called upon as an adjustment variable (see graph 2, with the ratio of implicit currency volatility to implicit interest rate volatility, which is extremely high).
Implicit volatility of currencies versus implicit volatility of US interest rates
The rise in the euro against the dollar is due to a combination of factors:
- the gain in the euro is linked to the flood of macroeconomic statistics in spring, which were more favourable to the Eurozone compared to the United States (see graph 3). However, this factor alone does not explain everything, given that the relationship between the euro-dollar exchange rate and economic surprises is not stable over time and that, at present, the evolution of this parity is not reflected in the real interest rate differential (see graph 4).
Euro-dollar parity and deviation between economic surprise indexes
Euro-dollar parity and interest rate differential
- ) whereas there is an upward trend of the euro, there is also a downward trend of the dollar, which seems to be linked to the uncertainties regarding American economic policy, as suggested in graph 5 showing the correlation between the variations in the dollar and variations in opinion polls on Donald Trump’s economic policy. The gain in the euro was powerfully fuelled by speculative buying positions, which are today “very” long (see graph 6).
The dollar and opinion poll regarding Donald Trump
EUR-USD and speculative positions
- Finally, and most importantly, the rise in the value of the euro – and the mirror-image fall in the dollar- is consistent with the fundamentals and operation of the foreign exchange market. The American current account deficit remains too high. This deficit is not totally justified by the economic fundamentals (see graph 7, showing that, compared simply to the “demographic” factor, Germany is considered to have an “excessive” current account surplus, while the United Kingdom, Canada and the United States are judged to have an “excessive” deficit). In the United States, consumer spending is fundamentally “too” high, and so savings are “too” low, causing the external imbalance (of the current account) to be too” high, and this imbalance can be partly absorbed by a fall in the dollar. Also, in an environment where nominal adjustment cannot be fully exercised against the Yuan, it is applied against the euro…
Demography and national current accounts
“Excessive”: current accounts (in % global GDP)
Finally, the movement of euro-dollar parity is perhaps dictated more by “structural” reasons than by reactions to the current economic situation. Under these conditions, the famous adage of Nixon-era US Treasury Secretary J. B. Connaly (“The dollar is our currency, but it’s your problem”) could become increasingly re-appropriated by the ECB: “The euro is our currency, and it’s our problem”.
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