The combination of a strong currency and an extreme unemployment problem leaves the ECB with a new challenge. Ironically, the problem is no longer the survival of the euro, but the common currency’s strength
Last year, the European Central Bank entered an existential battle for the euro. By promising to do ‘whatever it takes’ to safeguard the euro, the ECB managed to calm sovereign debt markets and engineer a much-needed easing of overall credit conditions in the Eurozone.
Unfortunately, the Eurozone economy remains stuck in a slump. Eurozone growth momentum was only marginally positive in Q3 at 0.1% quarter-on-quarter, and Italy and France continue to struggle with negative GDP dynamics. In year-on-year terms, Eurozone GDP is still negative (-0.4%), and the unemployment rate stands at 12.2% – a record high. There are currently 19.4 million unemployed in the Eurozone – 6.8 million more than in 2008.
Moreover, not all components of Eurozone financial conditions are improving. Over the last twelve months, the ECB’s trade-weighted euro index is up around 6%. All else equal, this could pose a significant drag on GDP in 2014. Using simulation results from the ECB’s Area Wide Model, the impact on Eurozone growth could be in the region of 0.4 percentage points in the first year following such a currency appreciation.
The combination of a strong currency and an extreme unemployment problem leaves the ECB with a new challenge. The challenge is no longer the survival of the euro. Ironically the challenge is now the common currency’s strength. The ECB’s next battle may not be about saving the euro, but about reducing its value.
When compared to the 30 largest major and emerging-market economies in the world, the Eurozone is heading quickly towards problematic territory. On the one hand, the Eurozone has the largest unemployment problem of any major developed market or emerging market economy (relative to its own history). Unemployment is about three percentage points above its historical average.
On the other hand, the Eurozone has an appreciating currency. The level of the Real Effective Exchange Rate is currently in line with its historical average, but further appreciation – in line with the trend of the last year – would push it into ‘strong territory’ relative to its history.
Countries with high unemployment and a strong currency are typically the ones complaining about their currency. In the terminology of the global financial press, countries in this quadrant are the ones likely to enter a currency war.
Based on the ECB’s surprise decision to lower its reference rate to 0.25% at the November meeting, one could argue that the ECB has already entered the battle to push the euro lower. The rate cut followed a significant appreciation of the euro since September, and the euro’s strength is playing into both the ECB’s growth and inflation projections (we will know by how much after the forecast revision in December).
While the ECB follows a single mandate (an asymmetric inflation target), there is accumulating evidence that the ECB may be less tolerant of a strong currency and deflationary risk than the Bundesbank would have been historically.
First, it has been leaked that the German members of the ECB’s Governing Council – as well as other northern European members – voted against the rate cut on 7 November.
Second, the ECB’s behaviour is increasingly deviating from that of the Bundesbank in the past. In the 1980s, the Bundesbank tolerated very low core inflation without resorting to comparable ‘emergency easing’ measures, for example. German core inflation dropped below the current level in the Eurozone (0.8%) on several occasions in the pre-euro period without triggering dramatic monetary policy responses.
Third, ECB officials have recently indicated they are open to further monetary easing. For example, in an interview with The Wall Street Journal on 13 November, ECB Chief Economist Peter Praet mentioned the possibility of a negative deposit rate, and even suggested that asset purchases were an option if needed to fight off deflation risk.
All told, there is accumulating evidence that the ECB is becoming more proactive – including taking steps to avoid excessive currency strength. It is all a part of the euro’s evolution – from a currency built to mirror the key characteristics of the DEM, towards a more pragmatic currency construct, better suited to deliver on the needs of the Eurozone economies overall.
Strong foreign capital inflows into Eurozone equity markets have been a key source of upward pressure on the euro over the last several months. Should this continue, there is likely to be a need for the ECB to become more aggressive on monetary policy (both relative to the US and Japan) to avoid excessive euro appreciation. Failure to react would create an additional headwind for Eurozone growth at a time when the recovery remains very weak and fragile.
There is already some evidence that the ECB is deviating from the old ways of the Bundesbank. However, more will be needed to avoid an excessively strong euro and excessively tight overall financial conditions. The ECB is highly unlikely to intervene directly in the currency market any time soon. It will likely play by the rules of the G7 as long as possible, and hence avoid verbal intervention as well for the time being.
However, as the currency continues to strengthen and moves into ‘strong territory’ relative to its history, the negative growth effects may eventually become intolerable. The basic challenge for the ECB is to ease overall financial conditions to the benefit of Eurozone growth. So far, easier credit conditions have pulled in foreign capital and caused the currency component of financial conditions to tighten. The ECB may need to enter the currency war more actively to secure a more competitive euro in 2014, and thereby support a more robust economic recovery.
Jens Nordvig is a managing director at Nomura global investment bank. A full version of this post first appeared on the Vox site
