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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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.
We expect the ECB to stress that domestic conditions are improving but that the outlook remains uncertain and uneven, both across the bloc and within sectors. Retail sales dropped unexpectedly in July, down 1.3% MoM following two months of gains, with non-food recording declines across a number of components. Germany’s recovery is also slowing: July IP was up just 1.2% MoM (and -10.0% YoY), a much lower monthly gain than the previous two months. Ongoing fiscal support, including furlough extensions in several Euro area countries plus the ECB’s accommodative stance, should continue to support the near-term recovery. Meanwhile, the €750bn EU Recovery Fund will kick in from next year.
Will Lagarde Try to Talk the Euro Weaker?
As the euro has now relinquished some of the earlier gains, we expect President Christine Lagarde to venture no further than that which ECB Chief Economist Philip Lane has already said: ‘the euro-dollar rate does matter’. His comments followed shortly after Executive Board Member Isabel Schnabel said recently that she was ‘not worrying too much about exchange-rate developments’ and that a weaker dollar ‘tends to boost global trade and global growth’. Several other unnamed governing council members were also quoted as saying that the recent appreciation would hamper the economic recovery, while the Fed’s move to AIT was also set to make life more difficult by cementing low real yields in the US.
We expect Lagarde will present some of the euro’s appreciation as a reflection of positive factors such as Europe’s ongoing recovery, as well as the move to a common fiscal stance agreed in July.
The ECB does have a history of verbal intervention under several different thresholds.
– Former president Trichet warned of ‘brutal’ FX moves during periods of currency strength in late 2007 with the euro at $1.4966. The currency weakened by around 0.3% after the comments, but this was fairly short-lived. Appreciation resumed, and the euro reached its strongest level at $1.59 by April 2008. Trichet had made similar comments in early 2004 following rapid currency appreciation that had pushed the euro to around $1.29. Again, the currency dropped back, this time to $1.23 over the following week, but by the end of the year it had appreciated again to around $1.36.
– Former president Draghi described the exchange rate as a ‘serious concern’ in May 2014 when the currency was at its strongest level in more than two years at just below $1.40. He also stated the exchange rate was ‘increasingly relevant in our assessment of price stability’. The euro dropped 0.5% immediately after the comments and continued to weaken over the next 12 months until it was at around $1.05 by early 2015. In September 2017, Draghi said the exchange rate was a ‘source of uncertainty’ following a 14% appreciation that took the euro back to $1.20. The currency continued to appreciate past this, reaching $1.25 by early 2015.
– Some ECB verbal intervention has not been intended to weaken the currency after bouts of appreciation but instead serve a broader purpose. In May 2015, then executive board member Coeure triggered a 1% drop in the euro by stating that the ECB would front-load QE with the currency dropping to $1.12505. Later that year he triggered a similarly sized drop to 1.1298 after stressing divergence between ECB and Fed policies. Draghi’s famous ‘whatever it takes’ comment in July 2012 was, however, the ultimate effort at shoring up concerns over the future of the euro.
ECB’s Response to Fed’s AIT Announcement Limited For Now
Lagarde had initially pencilled in an optimistic date of year-end to complete the ECB strategy review. This has since been pushed out to mid-2021 given the delay from the COVID lockdowns. As the review still has a fairly significant time to run, we expect Lagarde to say little more than that consultations are continuing and that the results will be made public in due course. Several current and previous executive board members had already touted a possible shift to a symmetric inflation target compared with the current ‘below, but close to 2%’, and this remains a possible option for the ECB. But a more explicit make-up policy such as the Fed’s AIT is unlikely to win support across the ECB Council, not least from the Germans.
PEPP Expansion Possible But Not Urgent
We expect no change to policy on Thursday. Interest rate cuts have not been the ECB’s preferred method of loosening policy through the pandemic, and any easing, if it comes, is likely to be through further extension of the Pandemic Emergency Purchase Program (PEPP).
PEPP holdings stand at €512.3bn as of last week versus a total envelope of currently €1350bn. The earlier pace of around €30bn per week eased back through August with the increase last week around half this pace. And, given the purchases are not yet half of the overall program size and there is more than eight months left under the June 2021 timeframe, there is no urgent need to announce any further extension of the program this week. Should inflation dynamics deteriorate further from here and the European recovery look to be under pressure, we do not rule out another upsizing of the package.
Caroline Grady is a Senior Researcher at Macro Hive. Formerly, she was a Senior EM Economist at Deutsche Bank and a Leader Writer at the Financial Times.
(The commentary contained in the above article does not constitute an offer or a solicitation, or a recommendation to implement or liquidate an investment or to carry out any other transaction. It should not be used as a basis for any investment decision or other decision. Any investment decision should be based on appropriate professional advice specific to your needs.)