Euro surge is ECB's newest complication for pandemic economy

[FRANKFURT] European Central Bank (ECB) president Christine Lagarde has a new challenge to worry about on top of a fading economic recovery and a slump in inflation - a surging currency.

The euro has jumped 12 per cent in just five months since the start of coronavirus lockdowns, climbing above US$1.20 on Tuesday for the first time in more than two years. Investors say more gains may well be ahead, and two top ECB officials have acknowledged it's on their minds.

"The euro-dollar rate does matter," ECB chief economist Philip Lane said Tuesday evening in an online conference, causing the single currency to pare its gains. "If there are forces moving the euro-dollar rate around, that feeds into our global and European forecasts and that in turn does feed into our monetary policy setting."

The euro's rise is just one part of a broader story of US dollar weakness that has pushed the greenback to its weakest against major peers in more than two years. But the 19-nation European currency union is particularly exposed because of its relatively heavy reliance on exports and its long record of feeble inflation.

A stronger currency makes exports less competitive, and depresses price growth by making imports cheaper. Rapid appreciation was often cause for former ECB president Mario Draghi to express concern that it would weaken the economy.

Now his successor will have to decide whether she wants to deploy a similar tactic. That could be at her press conference after the next policy meeting on Sept 10, when she'll also have updated economic forecasts.

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RED LINE

"US$1.20 for the euro is something of a red line," said Katharina Utermoehl, senior economist at Allianz. "At the moment there is really not that much that the ECB could do other than try to talk down the currency by highlighting the persistent economic uncertainty, while keeping the door open to a further increase in asset purchases later in the year."

The severity of the current situation was evident on Tuesday when the latest data showed euro-area inflation turning negative for the first time in four years.

Exporters aren't feeling the exchange-rate pain just yet, though that's because they have the far more pressing problem of a worldwide recession.

"The stronger euro is clearly an additional burden for exporters, but what's much more important is that global demand is generally quite low," said Olaf Wortmann, an economist at Germany's VDMA Mechanical Engineering Industry Association.

ECB Executive Board member Isabel Schnabel, who is responsible for market operations, said this week that officials are monitoring foreign exchange developments - though she took a somewhat benign view of what they might mean.

The US dollar's decline can be seen partly as a sign of global confidence returning, because it reflects a reversal of earlier "safe-haven flows" of funds into the US when investors turned to government debt as a low-risk home for their cash, she said.

UNCLEAR IMPACT

Ms Schnabel also said the impact of the exchange rate on inflation is unclear - a view backed by ECB research which shows that the pass-through of currency movements to prices has declined in recent decades.

Still, the central bank was struggling to hit its inflation goal of just-under 2 per cent well before the pandemic, so even the prospect of yet more downward pressure will unsettle some policy makers.

"When you have a stronger euro and market expectations for it to keep rising, inflation forecasts are likely to eventually be revised down," said Carsten Brzeski, an economist at ING Germany. "That's when the ECB will have to decide - as it did in previous years - whether it needs to do more." Mr Lane's remarks had an impact, with the euro trading around US$1.19 as of 8.58am Frankfurt time on Wednesday.

There may be more upside though - options-pricing models in financial markets suggest the odds that it'll rise above US$1.25 in the next three months are higher than those for a drop below US$1.13, according to Bloomberg calculations.

"Euro strength looks overdone, but we need to respect the momentum and the positive narrative in the market's mind for the time being," said Ross Hutchison, an investment director at Aberdeen Standard Investments. "We can't rule out it going higher."

BLOOMBERG