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The euro is not the ECB's biggest problem

14 Sep 2020 12:08 PM

The European Central Bank has a problem. It is not related to the euro’s recent headline-making appreciation against the dollar, and it pales in comparison the broader challenges the pandemic places on monetary policy.

Instead of talking about the currency, the ECB should take more fundamental steps to support economic growth and raise inflation to target levels.

The euro recently rose to 1.20 levels, its highest in more than two years. A strong euro could damage economic growth, as it makes eurozone exports more expensive compared to other foreign goods. It would likely also make imports cheaper, which leads to lower inflation.

Last Thursday, Christine Lagarde, President of the ECB, presented a set of new forecasts for growth and inflation as she explained that the rise in the euro is one of the reasons why inflation is expected to remain below the bank’s target level of 2% in the coming years.

In the opening statement of Lagarde’s press conference, the Governing Council of the ECB indicated that the euro exchange rate had reached its highest levels in more than two years, and Lagarde received some criticism for not reassuring traders that the central bank might intervene if the euro did not limit its gains.

However, the fact that ECB was silent on the current strength of the single currency was undoubtedly the right approach. The Bank is not setting a target for the exchange rate, but the Bank is rather including currency strength in its inflation analysis, according to Lagarde. Senior central bank officials around the world have always avoided explicit references to devaluing their currencies for fear of provoking retaliation from other countries, and thus causing a currency war that would destabilise the global monetary system.

Besides, the euro is far from being the biggest threat to Europe’s economic recovery. What is even more worrisome is the re-emergence of the virus on the continent and the risk of renewed lockdown measures. This would have a huge negative impact on consumer and corporate confidence, and the ECB should consider the effectiveness of the various governments’ domestic fiscal plans.

Even if the focus is on the eurozone’s ability to export, the strength of external demand and the state of global trade will be more important than the future path of the exchange rate.

This raises the question of why a new set of measures has not been announced yet? Despite the ECB’s admission that it will fail to reach its inflation target by 2022., it may want to see stronger evidence of what is happening to the eurozone economy, and this is what the coming weeks’ data will provide.

Until policymakers decide how to act, the exchange rate should not be targeted alone. One possible approach might be to reduce the deposit rate from its current level of -0.5% to -0.6%. This is the best way to influence the currency market, as lowering the interest rate on deposits will make money more expensive for borrowers to keep, which will push them to transfer their money abroad.

However, if the general weakness in domestic and foreign demand continues, the better option would be to expand the asset purchase program launched to deal with the epidemic.

It is fair to criticise the ECB for its failure last week, but exchange rate is not the primary concern, and the eurozone will be fortunate if a strong euro is its primary concern.


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