One Way or Another
May 21, 2014
The euro zone economy is in desperate need of a weaker exchange rate. No surer remedy exists for halting regional disinflation in a timely enough fashion and for ensuring against sliding long-term inflation expectations amid actual inflation that is substantially below target. The euro’s level is not an impediment to engineered depreciation. It’s birth value of $1.17 at the start of 1999 and its lifetime mean of $1.223 are somewhat more than 10% weaker than the current level, and the euro area current account surplus was comfortably large at 2.5% during the year to this past March. The economy’s problems are deficient aggregate demand, excessive un- and underutilized productive resources, a weak banking system that isn’t lending, and the possibility that conditions could evolve into a state of falling prices (deflation) that will make all other problems worse.
After months of saying that Euroland isn’t Japan, ECB officials now have to prove that assertion, and manipulating the euro would be a great place to start. While Japanese government officials and the Bank of Japan fiddled around in the 1990s and 2000s, the yen strengthened. But from a 2012 peak of 76 per dollar, the heralding of Abenomics and its implementation depressed Japan’s currency by around 25% in just a couple of months without aid of any foreign exchange intervention. When market players realized the seriousness of Japan’s desire to depreciate the yen, they were more than happy to comply.
President Draghi of the European Central Bank, as he has done on several occasions, changed the euro’s direction two weeks ago with tantalizing rhetoric but no immediate change in policy settings. From a high of $1.3993 on the day of his press conference to a low today of $1.3664, the euro has dropped 2.6%. Hardly any doubt remains that the other shoe will drop at the June meeting, but there is considerable uncertainty over the menu of actions to be taken then and about possible follow-up steps if inflation in the euro area stays too close to zero. Draghi would be well advised to act really boldly. Announce sharper changes than the market is expecting, and leave no doubt that the euro is still far too overpriced for the regional economy’s present circumstances. The euro has traded without interruption in the 1.30s since June 4, 2013. If a $1.29 handle or lower can be achieved before midyear, the ECB will have made an impressive start in eradicating fear of deflation. Make no mistake, there is never any excuse for a central bank tolerating a currency that is stronger than it wants. Monetary officials just need to find the courage to prioritize that objective above all other goals. The same cannot be said of a central bank faced with a currency that it wants to make a lot stronger where having the will to change the currency field is not enough.
A complication for ECB officials is that other countries also seek a weaker exchange rate. Euroland’s array of economic problems are not unique, but they are more extreme at the moment than the problems faced in other advanced economies, such as Australia, New Zealand, Switzerland, Japan, and China. In some cases, currency strength can be advantageous, enabling monetary authorities to postpone tightening of central bank interest rates longer than would otherwise be the case. The Central Bank of Iceland released a statement today that said more or less as much. With Icelandic economic slack continuing to diminish, monetary conditions there will in time need to be tightened one way or another. If the appreciating Icelandic crown continues, tighter monetary conditions can be achieved through that channel rather than a hike in nominal interest rates. Likewise, if ECB officials hope to limit how much they ease unconventional levers, engineering a swift drop in the euro offers an answer.
Washington has a long tradition of verbal remarks and more concrete misbehavior of omission and commission with the effect of undermining the dollar’s value against other currencies. But lately, currency management hasn’t been a front-burner item. That could change in light of 1Q14 data that showed a negative 0.83 percentage point contribution to U.S. GDP growth last quarter. If foreign demand had instead buoyed aggregate final U.S. demand by 0.5 percentage points, GDP would have advanced at a more respectable 1.4%, instead of 0.1%. That said, U.S. officials tolerated Abenomics and the yen’s resulting slide because the government was finally doing something to end deflation. Likewise, an ECB easing sufficiently credible to drive the euro southward would also probably evoke a response of relief rather than alarm because America needs an economically healthy Europe that will not be intimidated by Russian President Putin.
U.S. hegemony in reserve currency portfolios could pose another impediment to a weakening euro. The common European currency is the natural object of diversification away from the dollar, and the weaker the euro becomes, the more attractive will be the price for building holdings of euro.
Like Iceland, Britain is in a position to welcome a stronger currency. Within the G7, Britain will be a growth leader in 2014. All components of private demand are contributing. Bank of England minutes were upbeat about the economy and revealed that some members are closer in their thinking to entertaining the first interest rate hike from the 0.5% level to which it has been pinned since March 2009. The stronger is sterling, the further into the future can be that first day of rate normalization.
Copyright 2014, Larry Greenberg. All rights reserved. No secondary distribution without express permission.
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