Tuesday, January 31, 2023

Strong euro shows the limits of the ECB’s power in the fight against deflation

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The strength of the euro is a sign that the European Central Bank is not doing enough to push up stubbornly low inflation, investors say, noting how a rising currency could become an increasingly heavy burden on policymakers.

Despite a slight pullback in January, the euro is now almost 9 percent stronger against the dollar than a year ago. The strength of the euro is not simply a reflection of the weakness of the US dollar: it has also gained against the pound and a host of emerging market currencies.

The rally poses a challenge for the ECB. This could hamper exporters at a delicate time for the region’s economic recovery after the coronavirus. But it also highlights the limits of the central bank’s ability to fulfill its mandate. Not only has the eurozone experienced five consecutive months of falling prices, but long-term inflation expectations remain well below the ECB’s target of almost 2%.

“Normally, you would see low inflation cause a currency to fall,” said Robin Brooks, chief economist at the Institute of International Finance. “But that is only if the markets expect the central bank to react, and at the moment the ECB is not getting the memo.”

The ECB has sparked unprecedented efforts to fight against the effects of the coronavirus since March, with in particular an asset purchase program of 1.85 billion euros. But despite the central bank’s success in taming a financial market crisis, these measures have failed to address the bloc’s chronic low inflation problem.

The strength of the euro shows that markets believe that the ECB will not cut interest rates again, or at least will not be able to cut them much. Meanwhile, although bond purchases keep long-term yields lower, there is little scope to reduce them further.

This means that real yields – long-term interest rates adjusted for expected inflation – have not fallen during the pandemic, unlike a dramatic drop in the United States. Relatively high real returns make euro assets more attractive to investors, thereby boosting the currency. Germany’s 10-year real yield, a benchmark for the eurozone, is currently trading at minus 1.6 percent, roughly where it was a year ago. While remaining higher at just above negative 1 percent, real 10-year yields in the United States have fallen almost a percentage point over the same period.

The relationship between currency strength and deflation can be mutually reinforcing, as a strong currency dissipates at import prices, stifling inflation. Mr Brooks equates the ECB’s predicament with that of the Bank of Japan following the financial crisis, when a disinflationary outlook spiked the yen, in turn fueling fears of deflation. The only way to break this vicious cycle is with much more aggressive monetary easing, with even larger asset purchases being the best tool, according to Brooks.

The problem with the ECB is that it has been left behind by more aggressive central banks – notably the Federal Reserve, which has cut interest rates and bought bonds at an even faster pace.

Line chart of 5y5y (%) forward inflation swaps showing inflation expectations rebounding faster in the United States than in the euro area

“In currencies, it’s the relative game that matters,” said Salman Ahmed, global head of macro at Fidelity International. “You can say that the ECB has been very aggressive in its policies, but has it been more aggressive than others. If the ECB wants to lower the euro, it will have to overtake the Fed – there is no other way.

Mr Ahmed said the ECB could tame the euro yet again by dropping hints at its meeting on Thursday that interest rate cuts are a possibility.

ECB officials have previously signaled concern over the strength of the euro, and the euro remains “extremely attentive” to the impact of the strengthening euro on inflation, the president said last week. Christine Lagarde. More than half of 33 economists polled by the FT last month said they expected the euro to continue to grow against the dollar this year, while most of the rest said they would ‘expected it to stay at current levels. Only two expect him to fall.

But if it wants to change market expectations for future price hikes, the central bank will have a job in its hands, fund managers say.

“The trajectory for inflation remains bleak,” said Konstantin Veit, portfolio manager at Pimco. According to its own projections, the ECB should miss its target for the next three years by far, suggesting the possibility of a “Japanese-style de-anchoring of inflation expectations in the euro zone,” he added.

Some analysts believe that the euro’s level – especially given its fall of more than 1% in January – is not yet high enough to raise the alarm in Frankfurt.

“The ECB’s view will be that a stronger currency is essentially the product of a rebound in growth expectations,” said Frederik Ducrozet, economist at Pictet Wealth Management. “If we get to $ 1.30, that’s another story, but I think they’ll be comfortable where they are.”

The common currency traded just below $ 1.21 on Monday.

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For many investors, the ECB’s apparent inability to lower real interest rates or bond yields is a green light for further appreciation of the currency, especially in a world where most analysts expect dollar weakness again as growth resumes in the United States. The markets are very skeptical about whether more aggressive ECB easing would have a significant impact on inflation expectations, as previous cycles did little to push them up.

Even so, greater monetary strength could force the ECB to try.

“With the euro, we are talking about a currency that becomes a deflationary currency,” Ahmed said. “And we’re near the point where it gets painful.”

Additional reporting by Martin Arnold

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