Where Is the Euro Heading?

The European Central Bank (ECB) has been more content of late, with the euro sitting at multi-year lows and laying the foundations for inflation to kick in and hoist the troubled euro area out of the economic quicksand it has been wallowing in for some time.

As external factors led by low oil prices continue to weigh and the beating down of the single currency continues, some voices of concern are starting to be heard, saying that maybe the euro’s downward slide is too much, too fast.

All was boding well in Europe, as oil prices have basically halved, pushing up consumer confidence, real household income and GDP growth, but at the expense of downward pressure on the already suppressed inflation in the euro area. While this was partly compensated by the falling euro, the common currency’s spiraling trajectory is now becoming cause for concern.

The euro currently stands at a 12-year low against the US dollar and at a 7-year low against sterling. Last week alone, the euro lost as much as 3.2% against the dollar, thanks to the launch of the ECB’s €60 billion a month asset-purchases program. Now markets anticipate parity between the euro area currency and the dollar in the coming months, something we haven’t seen since 2002 and something that neither the ECB nor anyone else was expecting.

Cause for concern?

Although ECB President Mario Draghi has recently been expressing his contentment with how Europe has turned the corner and can now look forward to stronger recovery, he is fully aware that the common currency has taken a heavy beating lately. Punches came from the unpegging of the Swiss franc from the euro, a strengthening US economy, the Greek and Ukraine affairs, and most prominently, the recently expanded €60 billion a month asset-purchases program, or quantitative easing (QE).

All these factors have weighed on the euro, and the ECB is tasked with trying to judge the right amount of QE counter-pressure to ensure things don’t accelerate out of control. Just how well the ECB has managed this, and how hard the consequences of the euro’s slump will hit the pockets of ordinary euro area citizens, remains to be seen.

One of those to voice their concern is ECB Governing Council member from the Bank of Italy, Ignazio Visco, who revealed at the weekend how the single currency “had weakened faster than expected” and that the QE program could even “overshoot its goal, as well as cause an excessive rise in the prices of financial and real estate assets.” Talking about the Governing Council’s deliberations, he said there was no doubt that “the strength of the exchange rate decline is larger than we had expected.”

Head of the International Monetary Fund, Christine Lagarde added her sentiment on Monday, pointing to a potential risk that “the Euro Area and Japan could remain trapped in a twilight zone of low growth and inflation. These ‘low-low conditions’ would raise the risk of recession and deflation, because they’d make it harder for many countries to reduce high unemployment and high debt.”

Risky slide

Considering the ECB’s calculations in its December Bulletin had forecast a mean exchange rate of $1.25 for 2015, the downward slide of both oil prices and the euro since then forced the ECB to expand its QE program to €1.1 trillion in total. Now that the euro is speeding toward parity with the US dollar, the Governing Council is betting on its monetary policy decisions passing through to the real economy, but the lack of structural reforms by individual governments is hindering progress, as Draghi is always keen to point out.

With the euro area already dipping its toes in the chilly waters of deflation in January (-0.6%), negative or very subdued HICP figures are projected for most of this year. While the ECB revised downward its inflation forecast for this year, it raised the projection for 2016 on the back of the expected effects of its QE program.

As the euro slides further, it is the people of Europe who will ultimately foot the bill for the euro area recovery, through higher import prices, more expensive holidays and so on. Some believe that, in terms of the exchange rate, things have finally reached equilibrium.

On Friday March 13, French President Francois Hollande expressed his opinion that the euro had reached the “right level against the dollar”, referring to a rate in the range of $1.06. Goldman Sachs’ head currency strategist Robin Brooks wrote at the end of last week: “After all these years of extraordinary monetary accommodation, which prevented the dollar from trading its true strength, we see the coming normalization of US monetary policy as an important catalyst.”

As more positive stimulus for the US dollar trickles across the pond and volatile oil prices continue to cause uncertainty, the future direction of the euro is still very much in question and also in the minds of the Governing Council, which nobody can deny has its work cut out for it in the months to come.

by John Boyd

courtesy of WBP Online