ECB Has Nobody to Blame But Self for Euro’s Buoyancy

July 9, 2014

The European Central Bank cut interest rates and unveiled plans for a targeted LTRO initiative in early June in order to avert deflation and ensure that the prolonged period of sub-target inflation in the euro area doesn’t drag down long-term inflation expectations, which officials insist remain well anchored near target.  In that month’s press conference, ECB President Draghi identified the strength of the euro as the primary cause of incremental disinflation during the past year.  By that observation, depreciating the euro would seem to be a critically important intermediary policy goal, in much the same earlier role that weakening the yen in 2013 had influenced the Bank of Japan’s policy.  The rhetoric of the two central banks was similar.  Institutions with long-held hawkish instincts about achieving predictable, consistent, and most importantly low inflation conceded that inflation had in fact become too low to meet the definition of price stability.

The timing of a shift to more accommodative ECB monetary policy seemed almost perfect, given the scale-back in Fed asset buying and concurrent evidence that the Federal Reserve is making progress in meeting its two mandates of 2% inflation with full employment.  From the standpoint of influencing exchange rates, changes in monetary policy work best if the policies of other central banks are pulling in the opposite way.

The euro has alas continued to trade with considerable resilience.  The current level of $1.3642 is almost spot on the year-to-date mean of $1.3700 and 2.5% firmer than its 2013 average level.  To exert sufficient support on Euroland growth and inflation, the euro really needs to decline through and somewhat past $1.25.  Relative to 2013 averages, the euro is also 6.8% stronger against the yen and up 1.1% in trade-weighted terms.

ECB monetary policy is in fact considerably tighter than the rhetoric implies.  From a mid-2012 peak of EUR 3.102 trillion, the ECB balance sheet has contracted by 33.3%, including a decline of 9.4% since end-2013.  On-year M3 money growth in the second quarter of this year of only 0.9% is down from 2.8% in the prior statement year and 3.4% in the year to 2Q12.  Bank credit to the private sector dropped 2.5% between mid-2013 and mid-2014.  Over the past five years, ECB policymakers have tolerated annualized growth of 1.9% in M3 and 0.3% in private-sector credit. 

The balance sheets of the Fed and Bank of Japan, in contrast, are currently increasing.  Since mid-2012, the Fed’s assets have climbed slightly more than 50%, including a gain so far this year of 8.6%.  Released minutes today from the June FOMC meeting failed to characterize inflation differently despite agreement that U.S. growth will be faster in the next two years than over the past one.  Some committee members are worried that very low European inflation could soften expectations about future U.S. inflation, and the medium-term estimate for inflation was revised marginally lower. Elsewhere, Abenomics in Japan included an ambitious directive of quantitative and qualitative central bank easing to double the monetary base in two years and to length the average maturity of its government bond portfolio to seven years from less than four.  The continuing absence of ECB quantitative easing remains conspicuous.

To depress the euro, ECB officials will need to adopt and boast without apology that it is pursuing radical reflation that recognizes the euro’s excessive strength and the phenomenon of sub-1% inflation as flip sides of the same problem that will be attacked aggressively and without interruption until average inflation of the region meets the target of “below but close to 2%” and none of its members is experiencing sub-0.5% inflation any longer.  Don’t hold your breath.  This is not going to happen, particularly because policy is decided by a committee of 24 people.  Such a cumbersome group deprives the ECB of the ability to lead the market.

Another roadblock on the way to a $1.25 euro will be Euroland’s current account surplus, which will approximate 2.5% of GDP both this year and next.  The U.S. deficit will in the meantime stay above 2% of GDP, and Japan is likely to run a surplus of no more than 0.5% of GDP.

Copyright 2014, Larry Greenberg.  All rights reserved.  No secondary distribution without express permission.

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