The ECB would do well to leave the Euro exchange-rate alone.

Over the past 24 hours we have seen something of a currency wars vibe return. This has other links as we mull whether for example negative interest-rates can boost currencies via the impact of the Carry Trade? In which case economics 101 is like poor old HAL 9000 in the film 2001. As so often is the case the Euro is at the heart of much of it and the Financial Times has taken a break from being the house paper of the Bank of England to take up the role for the ECB.

The euro’s rise is worrying top policymakers at the European Central Bank, who warn that if the currency keeps appreciating it will weigh on exports, drag down prices and intensify pressure for more monetary stimulus. Several members of the ECB’s governing council told the Financial Times that the euro’s rise against the US dollar and many other currencies risks holding back the eurozone’s economic recovery. The council meets next week to discuss monetary policy.

There are a range of issues here. The first is that we are seeing an example of what have become called ECB “sauces” rather then sources leak suggestions to the press to see the impact. Next we are left mulling if the ECB actually has any “top policymakers” as the FT indulges in some flattery. Especially as we then head to a perversion of monetary policy as shown below where lower prices are presented as a bad thing.

drag down prices

So they wish to make workers and consumers worse off ( denying them lower prices) whilst that the economy will be boosted bu some version of a wish fairy. Actually the sentence covers a fair bit of economic theory and modern reality so let us examine it.

The Draghi Rule

Back in 2014 ECB President Draghi gave us his view of the impact of the Euro on inflation.

Now, as a rule of thumb, each 10% permanent effective exchange rate appreciation lowers inflation by around 40 to 50 basis points.

There is a problem with the use of the word “permanent” as exchange-rate moves are usually anything but, However since the nadir in February when the Euro fell to 95.6 it has risen to 101.9 or 6.3 points. Thus we have a disinflationary impact of a bit under 0.3%. That is really fine-tuning things and feels that the ECB has been spooked by this.

In August 2020, a month in which COVID-19 containment measures continued to be lifted, Euro area annual
inflation is expected to be -0.2%, down from 0.4% in July……..

Perhaps nobody has told them they are supposed to be looking a couple of year ahead! This is reinforced by the detail as the inflation fall has been mostly driven by the same energy prices which Mario Draghi argued should be ignored as they are outside the ECB’s control.

Looking at the main components of euro area inflation, food, alcohol & tobacco is expected to have the highest
annual rate in August (1.7%, compared with 2.0% in July), followed by services (0.7%, compared with 0.9% in
July), non-energy industrial goods (-0.1%, compared with 1.6% in July) and energy (-7.8%, compared with -8.4% in

The Carry Trade

This is the next problem for the “top policymakers” who appear to have missed it. Perhaps economics 101 is the only analysis allowed in the Frankfurt Ivory Tower, which misses the reality that interest-rate cuts can strengthen a currency. Newer readers may like to look up my articles on why the Swiss Franc surged as well as the Japanese Yen. But in simple terms investors borrow a currency because it terms of interest-rate (carry) it is cheaper. With an official deposit rate of -0.5% and many negative bond yields Euro borrowing is cheap. So some will borrow in it and cutting interest-rates just makes it cheaper and thereby even more attractive.

As an aside you may have spotted that a potential fix is for others to cut their interest-rates which has happened in many places. But with margins thin these days I suspect investors are playing with smaller numbers. You may note that this is both dangerous and a consequence of the QE era so you can expect some official denials to be floating around.

The Euro as a reserve currency

This is a case of be careful what you wish for! I doubt the current ECB President Christine Lagarde know what she was really saying when she put her name to this back in June.

On the one hand, the euro’s share in outstanding international loans increased significantly.

Carry Trade anyone? In fact you did not need to look a lot deeper to see a confession.

Low interest rates in the euro area continued to support the use of the euro as a funding currency – even after adjusting for the cost of swapping euro proceeds into other currencies, such as the US dollar.

The ECB has wanted the Euro to be more of a reserve currency so it is hard for it then to complain about the consequences of that which will be more demand and a higher price. Perhaps they did not think it through and they are now singing along with John Lennon.

Nobody told me there’d be days like these
Nobody told me there’d be days like these
Nobody told me there’d be days like these
Strange days indeed — strange days indeed

Economic Output

Mario Draghi was more reticent about the impact of a higher Euro on economic output which is revealing about the ECB inflation obsession. But back in 2014 when there were concerns about the Euro CaixaBank noted some 2008 research.

Since January 2013, the euro’s nominal effective exchange rate has appreciated by approximately 5.0%. Based on a study by the ECB,an increase of this size reduces exports by 0.6 p.p. in the first year and by close to 1.0 p.p. cumulative in the long term.

With trade being weaker I would expect the impact right now to be weaker as well. Indeed the Reserve Bank of Australia has pretty much implied that recently with the way it has looked at a higher Aussie Dollar which can’t impact tourism as much as usual for example, because there is less of it right now.


One context of this is that a decade after the “currency wars” speech from the Brazilian Finance Minister we see that we are still there. This is a particular issue for the Euro area because as a net exporter with its trade and balance of payments surplus you could argue it should have a higher currency as a type of correction mechanism. After all it was such sustained imbalances that contributed to the credit crunch and if you apply purchasing power parity to the situation then according to the OECD the exchange rate to the US Dollar should be 1.42 so a fair bit higher. There are always issues with the precision of such calculations but much higher is the answer. Thus reducing the value of the Euro from here would be seeking a competitive advantage and punishing others.

Next comes the way that this illustrates the control freakery of central bankers these days who in spite of intervening on an extraordinary scale want to intervene more. It never seems to occur to them that the problems are increasingly caused by their past actions.

The irony of course is that the elephant in the room which is the US Dollar mat have seen a nadir with the US Federal Reserve averaging inflation announcement. If so we learn two things of which the first is that the ECB may work as an (inadvertent) market indicator. The second is that central banks may do well to leave this topic alone as it is a sea bed with plenty of minefields in it. After all with a trade-weighted value of 101.53 you can argue it is pretty much where it started.





6 thoughts on “The ECB would do well to leave the Euro exchange-rate alone.

  1. So…I really do struggle to comprehend cause and effect here. USD has been printed in excessive scale. Robinhood investors have taken their furlough checks, and since every shop is closed or difficult to enter they have become day traders and only bought TSLA stock. Similarly Fed has hoovered up all of Junk Bond stocks and the USA is burgeoning with printed money.

    Despite there being a massive shortage of dollar in March, when the sky was caving in. Global currency pundits think there is way too $ much sloshing about so instead, GBP and EUR are more valuable.

    I guess each massive stimulus of “magic money tree” money washes around all the oceans into the ports and rocks all the moored-up boats about. Some boats float better than others. As Shaun suggests it just seems that the tide has not evened up all boats yet, temporarily Europe is higher valued.

    Or.. is this the nail in the coffin for the extraordinary benefit of being the world’s reserve currency? I think we will find out during market volatility in mid-October… prior to the US election.

    It seems crazy to me that GBP can buy more dollar when you look at the state of the country..

    • Hi Paul C

      These things are always relative. For a while we saw the £ hit as the impact of the Covid pandemic on the City of London took centre stage. The Euro has a safe haven play in such times with its trade surplus. Then the US Dollar had a weaker phase and as markets stabilised the £ went up and the Euro carried on.

      But as JimW has already pointed out there is usually demand for dollars over the year end so watch this space.

  2. It is one of those weird economics U-shaped curves, where the value of the currency bottoms around 0% rates, but rises either side on rising or increasingly negative rates. Given that governments are the main borrowers, it becomes a self-fulfilling prophecy as rates are driven further down as gives need to borrow more, yet the currency rises.

    As I said just the other day, Erhard talks about falling prices from competition and certainly that philosophy alongside the strong DM never did Germany any harm. In contrast, here we have been devaluing since 1968 and have just got poorer – yet Bailey and his clowns push for more of the same.

    It is a curious thing that military hegemony has only once changed hands without a major war – the UK to the USA in the 30s, but then there were other issues. So, currency wars since 1971 seem (to borrow incorrectly from Clausewitz) to be the extension of policy by other means. The US famously invaded Iraq after Saddam began pricing oil in euros and having captured the Ministry of Oil in Baghdad, promptly reverted it to USD. The position of world reserve currency has enabled the USA to print without impunity and devaluation effects, but eventually any rational person starts to wonder what to do with all this paper when it can only be used to buy things in dollars, but Trumpian policy is increasingly isolationist, so they don’t want the Chinese buying the place up. This may well be what is driving the GBP against the USD as Chinese buyers are buying London property and reversing the old image of the Chinese laundry.

    It is worth noting that a 10% rise in the euro depresses inflation by 0.5%, but a 5% rise in the GBP knocks off 1.5%, so someone is using dodgy figures (my money would be on Bailey and Haldane). The euro is the next best choice as a reserve, especially as the Single Market comes together. Other currencies are just too small, volatile or carry political risk.

    • Hi Dave

      One thing the US Dollar has is that you can buy pretty much anything anywhere with it. The competitors for its crown as in the Euro or the Yuan are quite some distance from that. But the Euro does have a trade surplus which as it is so close to where it began has offset all the other bad news,

      Surely the Euro carries quite a bit of political risk? They need places like Italy init to keep the level down but do not want to pay too much for it.

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