international analysis and commentary

The euro and the dollar

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The euro fell below parity with the dollar on 23 August 2022 for the first time in twenty years. The best explanation is monetary policy and not purchasing power. A euro buys a lot more than a dollar, whether the frame of reference is Big Macs, like The Economist uses, or just about anything else. The interest rates targeted in monetary policy are another matter. The US Federal Reserve (Fed) started raising rates in March of 2022, while the European Central Bank (ECB) started only in July. And while the ECB surprised markets by delivering a rate rise that was twice as high as advertised — 50 basis points, or one half of one%, rather than 25 basis points, taking the cost of main refinancing operations to a positive 0.50% — the target for the Fed funds rate had risen from 0.25% to between 2.25 and 2.50% by that time.

 

THE ECB PLAYS CATCH-UP. The Fed was fighting inflation aggressively; the ECB appeared to be falling behind. Currency markets moved quickly to price in the difference. Since September, the ECB has raised rates in parallel with the Fed, but gap in policy rates remains constant and the euro has only strengthened marginally against the dollar.

This story has three implications for the transatlantic relationship that deserve attention. Those implications derive from the reasons for price inflation, the impact of relative currency movements, the risks that changes in monetary policy will provoke instability in financial markets, and differences between central bank mandates. The short story is that the United States needs to move more quickly and more strongly because the inflation it faces and the inflation the ECB has to deal with are caused by different factors. Market reactions to this stronger tightening by the Fed, however, are adding pressure onto the ECB by fuelling European inflation.

The ECB will find it difficult to match any tightening by the Fed in terms of pace or duration because of the possibility that moves that are too aggressive could cause instability in European banks and securities markets. And the political consequences of this divergence are potentially significant. While US politicians may face the wrath of the voters for their mismanagement of the economy — even if this was not so apparent during the 2022 midterm elections — central bankers are likely to take the blame for high rates of inflation in Europe. Depending upon how European politicians respond to any perceived “failure” on the part of the ECB, the divergence across the Atlantic could increase, raising the risks of financial instability along with it.

INFLATION AND ITS CAUSES. The magnitude of inflation in the United States and Europe is similar. In its autumn 2022 World Economic Outlook, the International Monetary Fund projected that prices would rise over the course of the year by 8.1% in the United States and 8.3% in Europe. Where they start to differ is in 2023, when price inflation should fall in the United States to 3.5% while inflation will continue to run at 5.7% in the euro area.[i] At least part of that difference is due to timing. Price increases accelerated earlier in the United States than in Europe and so if there is a ceiling to how far they will climb, those price rises should also drop out of the index sooner. Part of the difference is also due to the credibility of the monetary response. If the Fed is more credible in its efforts to tackle inflation, that is all the more reason for market participants to expect inflation to slow down, which means they will be less tempted to put up prices or wages to compensate.

This all assumes that the forecasts are accurate. There are many reasons for uncertainty. To begin with, while inflation on both sides of the Atlantic can be traced in large measure to supply shocks related to the Covid-19 pandemic and the war in Ukraine, the impact of those shocks is not symmetrical. Supply chain disruption collided with pent up demand for goods in the United States more strongly than in Europe; by contrast energy and food prices have risen more sharply and consistently in Europe than in the United States, particularly in the aftermath of Russia’s invasion of Ukraine.

The zero-covid policy in China may continue to disrupt supply chains with important implications for manufacturing on both sides of the Atlantic, but US and European firms are learning to adapt to relative scarcity by finding alternative sources. The gap in energy and food prices is likely to be more persistent, which means Europeans will have to reengineer their energy economy while at the same time facing a very personal cost-of-living crisis for households as well as industries. Americans will no doubt complain about the high price of petrol, but the magnitudes of the adaptations required are very different. Those additional European costs will eventually filter into prices and wages.

The role of fiscal policy is also important. The Biden Administration passed major stimulus and infrastructure legislation in March and November of 2021 that fuelled inflation with $2.9 trillion in programmed additional spending. European governments also ran up deficits and debts but at much lower levels once the worst of the pandemic had ended. This explains why inflation accelerated earlier in the United States; it also explains why the Fed has acted more aggressively (and how the ECB justified its greater caution). The question is how much and how long that additional fiscal stimulus will add upward pressure on prices and wages in the United States.

 

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So, despite the International Monetary Fund’s forecasts, it is possible for inflation to prove to be stronger and more consistent on both sides of the Atlantic. Therefore, it is too soon to imagine that either the Fed or the ECB will pivot in their efforts to tackle inflation. Either central bank may slow the pace of increases, but neither is able to commit to the kind of forward guidance they could offer the markets when inflation rates was almost non-existent and interest rates were close to zero or even negative.

EXCHANGE RATES, PRICE RISES, AND THE THREAT OF FINANCIAL DOMINANCE. This consistent tightening of monetary policy may create additional problems for the European Central Bank. Those problems stem from the fact that energy and food commodities tend to be priced in dollars in world markets. As a result, any persistent weakness in the euro relative to the dollar will only put upward pressure on food and energy costs, adding to European price inflation. Yet so long as the Fed is tightening at least as fast as the ECB, it is safe to bet on continuing euro weakness.

The challenge for the ECB’s Governing Council is that it has too much liquidity in the banking system. Hence, raising the policy rates does not tighten monetary conditions as much as it should. Much of that liquidity is the result of special long-term loans made to stabilize the banking system. Those loans were initiated in September 2019 when the Governing Council realized more liquidity might be needed to prevent European prices from falling. They were expanded during the Covid-19 pandemic when the Governing Council sought to encourage banks to help stabilize the supply of credit to households and firms. Now roughly €2 trillion of such loans remain on the ECB’s balance sheets – with the implication that most banks do not need to borrow at the ECB’s main refinancing rate to meet their minimum liquidity requirements. As the rates go up, those banks are largely unaffected.

The Governing Council sought to address this problem at its policy meeting in October 2022.[ii] The plan was to change how it charged interest on these ‘targeted long term refinancing operations’, as the loans are called, starting 23 November. The new rate would make the loans relatively more expensive and so create incentives for banks to pay them back early. As banks paid back these loans, the supply of liquidity in the euro area would shrink and the importance of the policy rates in influencing bank lending would increase. This would effectively tighten European monetary policy even if the pace of interest rate increases slowed in Europe relative to the United States. Moreover, the effects could be strengthened if the ECB started a quantitative tightening, by allowing some of the more than €3.2 trillion in assets held on its balance sheet under its combined asset purchase programmes to run off as they matured in 2023. The decision to do that, has not yet been taken.

The Governing Council of the ECB

 

The reason the Governing Council hesitates in this quantitative tightening is that there is considerable uncertainty about what such actions will mean for financial stability. What they worry about is ‘financial dominance’, which is a situation where central bankers have to choose between the urgent problem of stabilizing the banking system before they can turn to the problem of price stability, no matter how important that problem might be. The turmoil that took place in the United Kingdom in October 2022 is a good illustration of what the ECB’s Governing Council would like to avoid.

The dilemma for the Governing Council is that further aggressive interest rate rises are likely to raise the cost of borrowing for European governments inequitably, lowering the price offered for bonds from heavily indebted countries like Italy and Greece more than for countries with lower debts like the Netherlands and Germany. These relative price movements will affect banks as well as governments. Much of the Italian and Greek debt in circulation is held by Italian and Greek banks, respectively. The usefulness of that debt as collateral for borrowing will decline alongside the price. Therefore, the cost for banks in Italy and Greece to access liquidity will increase. Those are the same banks that will face higher costs for the special long-term loans they took out from the ECB during the crisis. And they are the banks that will be most affected by a further decline in government bond prices due to any attempt to shrink down the ECB’s balance sheets through quantitative tightening.

The Governing Council cannot avoid the pressure on Italian and Greek public finances caused by its monetary tightening, and neither can it eliminate the additional pressure this will bring to bear on Italian and Greek banks. Nevertheless, it needs to move slowly to avoid encouraging market speculation against either governments or banks and the resulting financial market volatility. Such speculation would work against the goal of bringing down price inflation by blocking the transmission of monetary policy across Europe’s monetary union. It would also distract Europe’s monetary policymakers from the actions they need to undertake to ensure price stability.

The Governing Council recognized this threat to the effectiveness of its monetary policy, and so announced the introduction of a new ‘transmission protection instrument’ last July.[iii] That instrument is essentially a threat to punish market speculators by taking the opposite side of their trades – squeezing them out of the markets at significant losses. How this might work remains to be seen, but the threat alone could be sufficient. This is an important addition to the Governing Council’s arsenal, even if it does create incentives for the Governing Council to move cautiously to avoid being tested by the markets. The point to note, however, is that this kind of instrument is not something that the Fed has or needs. So, while the Fed also needs to worry about creating unnecessary market volatility, it can be more aggressive than the Governing Council in its monetary tightening – so again the Governing Council faces the prospect of additional or prolonged euro weakness which threatens to add to the upward pressure on European prices.

POLITICS, INDEPENDENCE, AND ACCOUNTABILITY. The Fed may appear to be acting more decisively in confronting inflation, but the ECB faces different and arguably more complex challenges. Worse, that difference in appearance is only adding to the pressure on the Governing Council. This makes it all-the-more likely that the ECB will continue to lag behind, at least in terms of market perceptions.

 

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The political implications are potentially significant. In the United States, responsibility for inflation seems to be in the hands of the President and his administration. Joe Biden’s popularity is suffering as a consequence. The President can try to shift that blame onto the Fed, as Donald Trump tried to do many times during his administration, but the voters are not often convinced to shift the focus for their attention. The 2022 midterm elections showed some of that laser-like focus. Although Biden continues to win low polling numbers, individual members of Congress were able to take some distance from his responsibility for macroeconomic performance while they focused the voters’ attention on other considerations.

In Europe the situation is different because there is no chief executive or administration to be held accountable. Responsibility for inflation falls squarely with the Governing Council and the ECB. This situation was obvious when prices were falling, and the Governing Council had to experiment with new instruments to try to stimulate economic performance.[iv] It is even becoming even more obvious in the face of rising inflation.[v] Governments that do not like the ECB’s tightening and that worry about being attacked by the bond markets criticize the Governing Council for doing too much. Governments that worry about inflation complain it is taking too little action. This is in many respects a no-win situation.

European policymakers should make note of this distinction. To the extent they pile criticism onto the European Central Bank, they are only likely to strengthen negative market reactions. In this least bad scenario, this will continue to add downward pressure on the euro-dollar exchange rate. In the worst case, it may encourage market participants to test just how committed the Governing Council is to use its transmission protection instrument.

A better strategy would be for governments to rally around the ECB in its efforts to combat inflation and to reassure voters that the Governing Council knows what it is doing. This is a hard message to sell, not least because governments across the euro area are more inclined to criticise monetary policy makers than to praise them. But it is a message that Europeans need to strengthen if they are going to offset the structural differences in monetary policy across the Atlantic.

 

 


Footnotes:

[i] See World Economic Outlook: Countering the Cost-of-Living Crisis, International Monetary Fund, 2022, p. 132.

[ii] “ECB recalibrates targeted lending operations to help restore price stability over the medium term,” European Central Bank, 27 October 2022.

[iii] “The Transmission Protection Instrument,” European Central Bank, 21 July 2022.

[iv] Erik Jones, “Do Central Bankers Dream of Political Union? From epistemic community to common identity,” Comparative European Politics 17:4, 2019, pp. 530-547.

[v] Erik Jones, “The War in Ukraine and the European Central Bank,” Survival 64:4, 2022, pp. 111-119.

 

 


*The Italian version of this article was published in Aspenia 99