One of the features of current world economic policy is the implicit effort of the European Central Bank to gain a competitive advantage by driving the value of the Euro lower on the foreign exchanges. Yesterday there was another effort via Reuters.
A consensus is forming at the European Central Bank to take the interest rate it charges banks to park money deeper into negative territory in December, four governing council members said, a move that could weaken the euro and push up inflation.
Some argue that a deposit rate cut should even be larger than the 0.1 percent reduction currently expected in financial markets, the policymakers said.
Actually after the recent speeches of Mario Draghi it was already clear that a deposit rate cut of more than 0.1% was being considered. Or perhaps more specifically they want us to think is being considered. Reuters did however touch on what I consider is the real game here.
The euro fell by as much as half a cent in response to the Reuters story
Draghi’s Currency Wars
Back at the last policy meeting for the ECB it had a problem. The Euro effective or trade weighted exchange rate was in the low 94s which is where it was when it implemented a major expansion of asset purchases back in January. To be specific the value of the Euro had fallen sharply initially and had continued lower until it dipped below 89 in mid-April. But from then onwards it had risen back to pretty much where it had begun. If you look at this in terms of bang for your buck then treading water does not seem especially good value in return for 60 billion Euros of QE a month.
Thus we saw Mario Draghi respond with a salvo of Open Mouth Operations which have involved hints and promises about taking the deposit rate which is already at -0.2% lower and either a fast rate of asset purchases or extending the term beyond the current end date of 2016. In response the Euro has fallen again and has done so most markedly against the US Dollar where it is now in the 1.07s but if we look wider we see that it is at 91.55 on the effective index. Accordingly Mario’s jawboning has been a success in financial markets terms as the Euro has dropped, however for the real economy we need to take care as if you think about it investment decisions are based on estimates of where they think an exchange-rate will be over a period of years not weekly or monthly fluctuations.
Mario has not always been a soft currency supporter
Back in July 2013 we were told a rather different story. From Reuters.
Noting that the currency’s recent strengthening on foreign exchange markets was a sign of renewed confidence in the euro, Draghi told a news conference:
So the current weakening is a sign of a lack of confidence in the Euro which Mario is encouraging? Anyway a year later Mario had decided you could have too much of a good thing. From CNBC in July 2014.
The recent rise in the value of the euro could stifle the flickering signs of growth in the euro zone,
Such reminders raise a wry smile but to be fair they also indicate that too much pressure is on central banks these days in terms of economic policy. Thus they have morphed into political style behaviour.
Here is something that rarely gets a mention so perhaps it is another example of the military dictum that it is best to hide something in plain sight. In today’s complex world how do you define a competitive devaluation and indeed exporting deflation. Well I would suggest that acting to drive your currency lower via monetary expansion when you are in the process of announcing a quarterly current account surplus of 53.8 billion Euros is a clear example. Indeed fuel is added to the fire by the fact that the surplus was over 20 billion Euros larger than a year before.
Now we get to something even more awkward if we look at the trade colossus which is Germany. In the first quarter of 2015 it announced a trade surplus of 56.8 billion Euros which means that the lower Euro is benefiting one of the factors which those who look at balance sheet balances think got the world into its current malaise. Also I have argued on here in the past that claimed defeats for Germany on policy such as over Greece might be considered a price to pay for a Euro value much lower than where a Deutschemark would be now. There has been an enormous competitive devaluation here which is being added to.
Just for clarity the German numbers include intra- Euro area trade so are not a like for like comparison with the overall Euro area ones.
What about QE?
Fans of the Matrix series of films will recall the bit when the Frenchman tells us about “cause and effect”. Sadly for his eloquent description we see that in the QE era the effect becomes before the cause. In the UK the UK Pound had its 25% or so fall in 2007/08 before QE began in 2009 and the Euro fell in 2014 ahead of the QE announcement in January 2015. Expectations of monetary easing lead to a currency fall before the easing happens or if you like we see yet another example of markets front-running central banks.
Take your pick as to where you think this began but back in April 2014 we saw the Euro top out in the mid-104s in trade-weighted terms but the acceleration began from 100 on December 16th 2014. Either date presents a much bigger move that what has happened since and makes any regression analysis problematic.
The economic impact
Back in March 2014 Mario Draghi told us what the ECB thinks the impact is.
Now, as a rule of thumb, each 10% permanent effective exchange rate appreciation lowers inflation by around 40 to 50 basis points. So we can say that between 2012 and today about 0.4 or 0.5 percentage points of inflation was taken out of current inflation because of the exchange rate appreciation. Having said that, we have to be cautious, because there was a previous depreciation of the euro.
If we look at where we are and compare to the nice round number of 100 of mid-December 2014 then so far if we assume the Euro remains where it is now for long enough for Mario to consider the move “permanent” then the maximum impact on the inflation rate is 0.4%.
The ECB has been much more reticent about the impact on economic growth but if we used the Bank of England rule of thumb we have seen a move equivalent to to 2% fall in interest-rates. If we make a larger jump and look at the numbers established by the US Federal Reserve yesterday then the Euro area would get a 2.2% rise in exports and a 0.6% rise in economic output or Gross Domestic Product. Now I rush to say that America is not the Euro area and we are ignoring gains from falls in imports as the Euro is not the reserve currency but it does give an impression. Also you could choose different dates to compare.
Also we have to factor in that the Euro area has lost some of the gains from the falling oil price as it fell too. Over the past year it has taken away about a third of the gains that would have otherwise taken place.
I will leave that to the Swedish Riksbank which has rather intriguingly trolled the ECB in its monthly minutes which were published earlier today.
The markets have also interpreted the latest communication from the ECB as a clear signal that further stimulus measures are to be expected in December……. The ECB has indicated that it may make its monetary policy even more expansionary.
Indeed is the next bit trolling or a threat?
Expectations of a more expansionary monetary policy from the ECB have, together with an appreciation of the Swedish krona in September, contributed to the majority of analysts expecting further easing measures from the Riksbank before the end of the year,
So the Riksbank is trolling both the ECB and analysts now? Anyway the Financial Times reported it this way.
Riksbank head ‘would not hesitate’ to intervene in FX (Foreign Exchange).
This is obviously in itself a localised issue in the sense that Sweden is so near to the Euro area and is relatively small. But we are faced if we look at the countries looking to lower their currency as well (Japan springs to mind) with the issue of who is going to import the deflation they export? Meanwhile Paul Krugman searches for David Bowie on Spotify.
Is there life on Mars?
Or for Jeff Wayne.
At midnight on the twelfth of August, a huge mass of luminous gas erupted from Mars and sped towards Earth