Is euro to repeat its past highs with the dollar?

European Central Bank President Mario Draghi, at ECB Youth Dialogue, Lisbon School of Economics. ECB work, some rights reserved.

The strengthening of the euro vis-à-vis the US dollar is taking alarming proportions, puzzling markets and the European Central Bank. The Eurozone single currency has gained 14% from the beginning of the year, with the tempo of appreciation accelerating. It gained around 10% during the summer. For around three years, the ECB has been following an extraordinary monetary policy, pumping €60 billion a month into the financial system, aiming at reviving the economy and the fading inflation. This policy brought the two monies close to parity for two years (around 1.05 from March 2015 until January 2017). In contrast, last week, the euro strengthened to around 120 American cents, because this ECB policy is thought to end in December.

During the first months of this year the rate of the two currencies kept oscillating around 1.06 that is close to parity. The resumption of growth in Europe, albeit mild is a factor strengthening the euro, but the main strengthening factor is that the super relaxed monetary policy of ECB is expected to be reversed during the next few months from accommodation to tightening, have started driving the foreign value of the euro upwards.

How far can it go?

The question is the following: If things evolve as expected and the ECB announces before the end of the year a policy tampering, how much higher the euro can go? Not to forget that its parity with the US money had reached 140 cents in spring 2014 and had come close to 160 cents in September 2007. In short, the parity may continue strengthening but predicting it is a tricky business. To be reminded the major world banks at the beginning of this year were contemplating a full parity (1:1) before December.

In any case, monetary policy and the wider financial developments in both shores of the Atlantic Ocean play a central role in defining the euro/dollar rate. So what the ECB is to decide this Thursday 7 September at its monetary policy setting Governing Council meeting, is of paramount importance. Mario Draghi, its President and the rest of Council members have to find a balance between two adverse tendencies. If they act as markets currently expect them to do, and set a path for tampering their extraordinarily accommodating policy, the euro will continue strengthening.

Targeting inflation

A stronger euro though will undermine ECB’s main task of bringing inflation towards the set target of close to 2%. Institutionally, European Central Bank’s core mandate is to do whatever it can, in order to bring inflation the closest possible to target. Nevertheless, a stronger euro will set in motion adverse forces. It will make imports cheaper and send headline inflation rates to even lower levels, in the opposite than the required direction.

There is more to it. An expensive euro will also undermine the efforts of the southern EU countries and France to export more and regain a sustainable growth path. Those countries will also be hurt by a stricter ECB policy, through higher interest rates. The increased cost of refinancing their debt will push them to recession.

Threat of recession

By the same token, there are strong arguments in favor of a stricter policy (stop the injection of fresh billions in the economy and favor the exit of interest rates from the very low area), despite the its negative effects on growth and inflation. The most important of them is to secure the necessary ammunition in case of a new crisis. It would be very dangerous for ECB to confront a new emergency with even more cash printing, at a moment when its balance sheet is already overloaded with €2tn of generously and zero interest rate circulated cash. Obviously, in order to be prepared to face a new crisis, the ECB must adopt a strict line.

All more so because the likelihood of a new crisis is not small at all. Increased global uncertainty and what the central bankers said last month at their annual Jackson Hole gathering, are quite alarming. Janet Yellen, the Fed Chair clearly stated a new crisis in bound to come sooner or later, because of the “all-too-familiar risks of excessive optimism, leverage, and maturity transformation reemerging”.

In short, if the ECB doesn’t tamper its extraordinarily accommodating policy and continues spreading around for free €60bn a month after December, it will expose Eurozone to great risks. In contrast, the difficulties of a strict policy with a more expensive euro and a bit higher interest rates will be mere nuisances, compared to the helplessness in view of a new crisis. Let alone the dangerous distortions caused to the entire economy by the zero interest rates, the huge free unwarranted incomes of the banking sector and the addiction of the financial system to zero cost money.

A difficult choice

For sure, the ECB and Mario Draghi have to find answers to all those questions next Thursday or rather after a few weeks in October at the latest. The political sides of such crucial choices will certainly play a paramount role. In the past, Draghi has managed to achieve such majorities in the Governing Council, so as to support those countries who mostly need backing. Continuing on the extraordinary policy lines next year serves the Southern member states and France, while a stricter option is solicited by Germany. Obviously, Berlin doesn’t mind coping with a more expensive euro, expecting more gains from higher interest rates, thanks to its colossal reserves and surpluses.

In the end, a compromise is to be sought, with Draghi vying to get the most for the deficitary Eurozone countries, as he has been doing all along his term as head of ECB.  The result will most probably not look like today’s generosity, but will be closer to this direction. In this way, Germany and some others in the minority side of the Governing Council will also be served, through ECB’s free money support to their unhealthy banking systems. If this is the case, the ascent of the euro may be restricted at around the current levels.