One of the hottest topics in global markets over the past month has been the euro’s surge in value against other currencies like the U.S. dollar and the Japanese yen.With the Federal Reserve and the Bank of Japan engaged in monetary easing and ECB President Mario Draghi squashing hopes of an imminent interest rate cut at last month’s policy meeting, analysts have gone so far as to speculate that the ECB is actually beginning to stage an exit from the loose monetary policies it has pursued in recent years.
However, leaders in Germany don’t like the strength in the euro, leaders in France don’t like it, and it’s even prompted the Greek finance minister to warn of the dangers it poses.
The general consensus view is that a strong euro means reduced competitiveness in the euro area on a global level because global trade partners will have to pay more to purchase exports from the currency bloc.
Mario Draghi’s response to the euro’s recent rise at tomorrow’s press conference will be crucial.
While exchange-rate intervention is not part of the ECB’s mandate, that doesn’t mean Draghi has no options for weakening the euro, should it come to that.
BNP Paribas economist Paul Mortimer-Lee says this could happen perhaps “as a result of political pressure, but maybe as a result of worries about where [the euro] might otherwise go.”
According to Mortimer-Lee, Draghi essentially has seven options. In a note to clients, he writes:
- Cut official rates in order to cut market rates and lower the EUR. The problem is that the ECB seems loath to lower the deposit rate below its current zero and cutting only the refi rate would have limited effect on market rates. Moreover, firing the last rate-cut bullet could embolden markets.
- Feed rate-cut expectations by talking about low inflation. The problem is that lower inflation justifies, for the same equilibrium real rate, a stronger nominal rate. This is a double-edged sword.
- Direct FX intervention. The ECB will not do this unless the move in the exchange rate becomes disorderly. To be effective, exchange-rate intervention needs to be unsterilised – in other words, the increased supply of EUR must be allowed to lower market rates and increase the liquidity in the banking system. There are other ways of doing this. In any case, the ECB will not want to subject itself to the USD.
- Fight fire with fire and go for balance-sheet expansion à la Fed or BoJ. The problem is that buying government bonds is a no-no for the ECB under the Treaty. The risk is a legal challenge by the Bundesbank or in the German Constitutional Court. That other central banks are monetising their debt is not a good defence.
- Do a Bank of England and opt to help create credit and boost money supply by buying or subsidising private assets. This would be our preferred route.
- Talk down the exchange rate. The problem is that the exchange rate is not overvalued and the ECB does not want to appear, as a large central bank with its own policy, to be targeting USD values and letting Fed Chairman Ben Bernanke set EUR monetary policy. This is especially the case as QE is anathema to some on the ECB Council. But our feeling is that this is the most likely course of action near term.
- Aggressive open-market operations. Stop the tightening of monetary policy that is implicit in the reduction of LTRO money that we saw in January and which will be repeated in February. To us, bemoaning the appreciation of the exchange rate when the central bank has just allowed a tightening of monetary policy makes no sense at all. This would require the ECB to determine the quantity of funds (i.e. floating price, fixed amount, not fixed price, full allotment) supplied to the market and let the market determine the price.
We will be covering Mario Draghi’s press conference LIVE on Thursday morning. The ECB’s decision on interest rates is due out at 7:45 AM ET, followed by the presser at 8:30. Follow it all on Business Insider >
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