Europe | FX | Monetary Policy & Inflation
Euro strength and the current bout of deflation are set to dominate this week’s ECB meeting. We expect no policy announcements, but, with the slowing pace of recovery and rising COVID cases in Spain and elsewhere in Europe, we do expect a commitment to loosen policy further if needed. We will also be watching any clues on the ECB’s reaction to the Fed’s shift to average inflation targeting (AIT).
Stronger Currency Impacts Updated Forecasts
The ECB’s updated GDP growth and inflation projections will be viewed through the prism of recent euro appreciation. At last week’s high of $1.20, the euro was up by more than 6% versus the dollar since the start of the year and even more in trade-weighted terms. The ECB’s June projections already expected inflation to remain well below target throughout its forecast horizon, with a low of 0% in Q4. The release of August inflation at a lower-than-expected -0.2% YoY (the lowest in four years) will likely mean the lowering of these forecasts yet again. That core inflation fell sharply to an all-time low of 0.4% (from 1.2% in July) will also be of concern. Germany’s temporary VAT cut in July is one factor behind the recent weakness, but it does not account for all of the drop, with several countries seeing even larger declines.
In contrast to inflation, GDP growth data for the Euro area has been slightly better than the ECB’s June forecasts expected. The -11.8% QoQ decline in Q2 was above the ECB’s 13.0% projection, and any significant change to the -8.7% and 5.2% expected for this year and next is unlikely. The impact of a strong currency on Euro area exports is likely to have been debated during the forecast revisions however, since the highly open economy leaves the exchange rate with a significant weight in overall monetary conditions.
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