Analysis – Euro’s 20-year lows have put costly decisions on the ECB

Currency divergence pushes the euro down

The high oil and gas bill is a heavy burden

* Expect more sharp increases in interest rates

By Palaz Kurani and Francesco Canepa

FRANKFURT (Reuters) – The euro’s slide toward parity with the dollar has put the European Central Bank in a very difficult confrontation, leaving its officials with only painful and financially expensive choices.

Letting the currency slide would fuel inflation that is already at a record high, raising the risk that price growth will remain well above the European Central Bank’s 2% target.

However, fighting the euro’s 20-year lows would require faster rate hikes, which could add to the problems of an economy already facing a potential recession, looming gas shortages and rising energy costs, reducing purchasing power.

Until now, the bank has played down this issue, arguing that it has no target for the exchange rate, even if the currency is important. Even the accounts of his June political meeting, which came out on Thursday, did not indicate any particular concern. But market moves are now too strong to underestimate.

“A weaker euro reinforces the idea that the ECB is behind the curve,” said Dirk Schumacher, head of European macro research at Natixis CIB. “Given how high inflation is, a stronger euro would be very beneficial as it reduces inflation.”

The euro is down 10% against the dollar this year, but the trade-weighted currency is down just 3.3% so far.

This raises the cost of imports, especially energy and other essential products that are traded in dollars, making everything more expensive. Frequently cited studies by the European Central Bank show that a 1% exchange rate depreciation increases inflation by 0.1% in one year and up to 0.25% in three years.

More weakness?

The problem is that the economic fundamentals point to further weakness in the Euro.

First, the European Central Bank and the Federal Reserve are moving at very different speeds.

While Federal Reserve Chairman Jerome Powell has made it clear that it was willing to risk a recession with significant rate increases to cut inflation, the European Central Bank continues to take small steps to reverse the exceptionally accommodative monetary policy of the past decade. a little.

He will raise interest rates for the first time this month, but he does not expect to bring the deposit rate out of negative territory until September, and any further measures will cloud the risks of a recession.

The outlook for the Eurozone has deteriorated so much since mid-June that a rate hike has been ruled out and markets are now only seeing 135 basis points of tightening from the European Central Bank.

The Federal Reserve, which has already raised rates several times, including by 75 basis points last month, is expected to raise another 180 basis points.

This results in higher profits for investors across the Atlantic, so they are pulling money out of Europe and weakening the Euro in the process.

Second, the eurozone’s massive dependence on energy, especially on Russian gas, makes the economy more vulnerable to the fallout from the war in Ukraine, which is a natural drag on the currency.

“Faced with the imminent risk of a recession – and with the euro being a procyclical currency – the ECB may be constrained in its ability to threaten more aggressive rate hikes in defense of the euro,” ING said in a note to clients.

Finally, the bloc’s energy bill has driven up import costs, leaving it with a rare current account deficit. These exits also weaken the currency over time.

With each of the 19 eurozone countries affected differently, it will likely be difficult to reach consensus on any withdrawal.

To strengthen the euro, the European Central Bank could signal a sharper tightening of monetary policy, with a 50 basis point hike in September and more measures in October and December.

But with markets already anticipating these decisions, the ECB must also agree, at least in part, with the Fed’s message that lowering inflation comes before all other priorities, even if it means forcing a recession.

The message, even if positive for the euro, is likely to encourage bond selling from the periphery of the currency block, raising questions about debt sustainability.

For this reason, the European Central Bank should also launch a bond purchase scheme, in order to limit the increase in borrowing costs in Italy, Spain, Portugal and Greece.

“Spoiler alert: Yes, parity is at stake,” said Jim Reed of Deutsche Bank. (Reporting by Palaz Curani and Francisco Canepa, Editing in Spanish by Javier Lopez de Lleida)

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