Will the Euro Lose Significant Strength?

April 3, 2014

Purchasing power parity theory postulates that in the long run currencies associated with relatively high inflation like the United States during much of the 1970s tend to depreciate.  Put differently, the external and internal values of money move directionally in tandem.  One would correspondingly think that negative inflation, or deflation, might be associated with rising currencies, and so that seemed to be confirmed during much of Japan’s experience with deflation.  The appropriateness of these correlations breaks apart, however, when one realizes that excessive inflation and deflation are both undesirable situations.  In fact, deflation is worse because it is more difficult to end than problem than to stop inflation.  Also, although and economy can growth reasonably well for quite some time while experiencing high and accelerating inflation, deflation stunts deflation quickly.  In the five years between 1Q75 and 1Q80, for example, U.S. real GDP grew 4.0% per annum, and the jobless rate fell three percentage points from 8.6% in March 1975 to 5.6% by May 1979.  If deflation is bad for an economy, one would like to see markets automatically depreciate the currency because that would lift the price of imports and import-competing goods produced domestically.

The possibility of deflation, although still being dismissed by European Central Bank officials, has caught their attention.  Macroeconomic and monetary trends are being monitored very closely, and officials promise to counter-attack the danger “swiftly” if that is what it takes to keep deflation away.  The euro area does not have deflation yet, though some of its component economies do.  These countries may find it just as difficult to shake off deflation as have independent nations with their own currency like Japan.  If deflation in Ezone members that already have such proves enduring, like a cancer it will be only a matter of time before healthy non-deflationary parts of the European Monetary System metastasize. 

It’s clear from today’s ECB statement that measures that can be expected to blunt part of the euro’s strength will be a part of the ECB’s strategy to ensure against a drop in medium-term expected inflation.  The question remains whether a significant loss of euro strength could be engineered by them, and I think that the answer is probably not without violating the Maastricht and other treaties that confine what ECB officials are allowed to do.  Japanese authorities tried numerous tricks to weaken the yen to no avail until voters elected a new government, which appointed new central bank leadership that then engineered a sea-change in the previous conservative institutional philosophy of the BOJ, which like the German Bundesbank never saw a drop in inflation that it didn’t consider good.  The ECB was fashioned in the Bundesbank’s image and constrained to stay in that mindset for posterity through treaty law, lest their come an ECB Governing Council that forgets its core beliefs.

All this is not to say that the euro will keep climbing into the wild blue yonder.  The stronger and more damaging to the local economy the euro’s level becomes, the harder it will be for it to appreciate.  A technical correction even seems overdue, given that the euro has posted quarterend-over-quarterend on-year gains against the dollar, yen and its trade-weighted index in the past four quarters.  Changes below show the movement of the euro at end-1Q14, end-4Q13, end-3Q13, and end-2Q13 from a year earlier.  Note, too, that since the year to 1Q03, the euro has posted March 31-over-year-earlier gains against the dollar twice as many times as the instances in which if fell.  That’s a function of ever-present diversification away from the predominant reserve asset currency.

Change, Y-o-Y EUR/USD EUR/JPY Trade-Wted Euro
End-1Q14 +7.4% +18.0% +5.3%
End-4Q13 +4.3% +26.7% +4.9%
End-3Q13 +1.7% +32.1% +5.1%
End-2Q13 +2.8% +27.6% +4.6%

What all this means is that corrections downward in the euro during this “prolonged period of low inflation” in the euro area are apt to be short-lived, limited or both.  The $1.30 – 1.40 range looks like a more comfortable trading range than levels below $1.30, and it is easier to envisage penetration into the $1.40s for a while than the $1.20s.  It’s also hard to imagine a sharp decline versus the yen, given the likelihood that the Bank of Japan will also be eventually augmenting its monetary stimulus in order to promote its goal of 2% inflation.

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

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