Strong euro poses dilemma

Decisive moment for ECB's QE

If last week’s Jackson Hole symposium was a contest among central bankers of who could deliver the speech least relevant to monetary policy, the result could be described as a 0-0 draw between Janet Yellen, Federal Reserve chair, and Mario Draghi, European Central Bank president. Yellen focused on praising the financial regulations put in place in the US after the 2008 financial crisis and warned against their dismantling. Draghi used his time to defend the importance of countries’ openness to trade, threatened by a drift towards economic protectionism.

This is in contrast with the last time Draghi attended the Jackson Hole meeting in August 2014. His remarks then hinted towards easing monetary policy, with the ECB’s asset purchase (quantitative easing) programme officially announced a few months later in January 2015 and launched in March of that year. The programme has played an important role in supporting economic recovery in the euro area. GDP across the currency union grew by 2.2% year-on-year according to the latest data for Q2 2017, double the pace recorded in the same quarter of 2014. Unemployment across the euro area stood at 9.1% in June, down from 11.5% in August 2014. Inflation, while still below the ECB’s target of close to 2%, is 1.5% and the threat of deflation has receded.

The transmission of QE and its impact on the real economy and inflation occurred mainly through the exchange rate channel, as the ECB’s credible commitment to accommodative policy pushed down bond yields and led to the depreciation of the euro. This, in turn, supported exports and brought about a rise in imported inflation.

But these exchange rate benefits are quickly fading. Over 2017 so far, the euro’s appreciation in trade-weighted terms is almost 9%, the strongest eight-month rise since the currency’s introduction in 1999. On Tuesday the euro-dollar rate rose above $1.20, the highest level since QE began in March 2015. This is partly a correction from a relatively long period of euro weakness and dollar strength – in level terms, the euro-dollar rate is still far below its historical highs – suggesting the euro still has some way to progress. The fundamentals imply it might do so.

The euro’s appreciation in trade-weighted terms has been due to a mix of external factors that are likely to linger. These include sterling weakness arising from uncertainty on Britain’s negotiations with the European Union; emerging markets’ slowdown led by China and commodity price weakness; and the dollar rally’s correction in the face of weak US economic data and policy ambiguity.

Internal developments, too, have supported the euro’s strength. Political risk has subsided following the failure of anti-establishment politicians to rise to power, economic performance is strengthening, Italy is repairing its troubled banks and Greece returned to the bond markets last month. Leading indicators for the euro area have been exceptionally strong. Purchasing managers index data released last week showed manufacturing activity growing at the fastest pace since April 2011, and data released on Monday showed the biggest jump in bank lending to euro area corporates in nine years in July.

However, while the euro area’s economic strength is good news, the resulting euro appreciation is problematic for the ECB. While the euro is not an explicit policy target for the Bank, it has been the main channel through which QE has worked and can affect price stability over the medium term. The ECB’s governing council expressed concern about the risk of overshooting in its July meeting.

A continued appreciation risks delaying the return towards the Bank’s 2% inflation target even as the economy is recovering, and this at a time when the ECB is running out of measures with which to respond. The self-imposed limit which prevents the ECB from holding more than 33% of any country’s outstanding debt means, in the absence of adjustments to the rules – which would be politically difficult ahead of the German elections – the Bank could soon run out of eligible bonds to buy.

The political sensitivities around the dilemma between doing ‘whatever it takes’ to reach the inflation target and implementing further unconventional and increasingly unpopular policies could become especially acute when Draghi’s successor takes over in 2019.

While many believe this was Yellen’s final Jackson Hole appearance, given her slim chances of reappointment under Donald Trump, it could very well be Draghi’s last as well, as he does not attend all Jackson Hole symposiums and his term ends in 2019. This month’s OMFIF advisers network poll gives Jens Weidmann, president of the German Bundesbank, a 61% chance of taking over as head of the ECB. However, the German government is keenly aware that Weidmann would be an unpopular candidate and would be difficult to push through without Berlin having to make concessions in many key areas. Governor François Villeroy de Galhau of the Banque de France is a strong contender.

Danae Kyriakopoulou is Chief Economist and Head of Research at OMFIF.

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