The silent euro-dollar parity war rages but realities at home prevail

Mario Draghi, President of the European Central Bank, prepares to read his introductory statement at the Press Conference after the meeting of the Governing Council, in Frankfurt am Main, on 7 September 2017. On the right, Christine Graeff, Director General Communications.  (ECB Audiovisual Services work, some rights reserved).

At last, the European economy is growing faster than the US. According to Eurostat, the EU’s, statistical service, during the second quarter of this year, GDP grew by 2.4% in the club of 28 member states compared to the same period of 2016 and 2,2% in the US. It’s worthwhile nothing that in both the EU and the US GDP growth gains momentum, albeit at a restricted tempo. In the first quarter of the year the rate of GDP growth was 2.1% in Europe and 2.0% in the US.

However, the faster growing GDP in the EU compared to the US, explains just part of the recent appreciation of the euro with the dollar. The rest is a matter of monetary developments. To be noted, the single European money has gained 14% this year in relation to the American greenback. Such a fast appreciation of the euro versus the dollar cannot be explained by very small differences of growth rates, between the two economic Leviathans.

Why does the euro appreciate?

As in the case above, the extraordinary medium term developments in the money market cannot be explained by the tiny difference of inflation rates between the two economic super powers. In the face of it, inflation developments shape monetary policy decisions. Yet, without notable discrepancies in growth or inflation, the two central banks, the American central bank, the Fed, and the European Central Bank follow directly opposing policy lines. The reason is the huge difference of exposure (printed money) between the two central banks, $4.5 trillion for the Fed and less than €2 trillion for the ECB. If we also take into account the growing double American deficits, fiscal and foreign, the American money plethora has reached dangerous levels.

This is the main reason for the euro appreciation. Mind you, what we are discussing here are medium term developments in money markets –  not the minute by minute, hour, day or week oscillations of parities, largely influenced by news like North Korean missiles flying above Japan and plunging in mid Pacific Ocean. Let’s dig a bit, then, on monetary policies.

Contrasting monetary policies

Of course, by monetary policy we primarily mean interest rates and decisions about money printing and cash injections into the economy, as administered by central banks. Now, on interest rates things are pretty straightforward. The ECB is to hold its basic interest rate at 0 (zero), with its President Mario Draghi plainly stating it: “one thing is clear; the bottom line is that interest rates will stay, as it’s written here, at the present levels (zero for the main refinancing operations) for an extended period of time and well past the horizon of our net asset purchases”. That means, interest rates will remain at their present levels well after December 2017, when the current extraordinary monetary measures are thought to expire.

On the other shore of the Atlantic Ocean, the American central bank, the Fed abandoned its zero interest rate policy in November 2016, following the opposite direction than the ECB. So far, the Fed has increased its basic interest rate twice by 0.25% each time (December 2016 and June 2017) and, until recently, analysts were anticipating one or two more rate hikes before the end of the year. This appears rather imperative, because as noted above, the Fed has allotted to the US banks $4.5 trillion at zero cost, and it has to stop.

Money printing

Nevertheless, the new hikes will very probably not come soon in the US. And this, despite the fact that inflation is very close to the target of 2% and growth holds, two clear signs that interest rates have to rise; but in vain. The real reason for the Fed postponing the decision for more expensive money is that, such a move will cause extra costs to borrowers and will primarily hit the banks. Lenders are the more leveraged economic agents of the country and as everybody knows, what is bad for banks is bad for the…nation. As a result, the postponement of Fed’s decision explains a good part of the fall of the dollar during last summer. The rest had to be attributed to the fact that the ECB was expected to generously cut down its monthly money printing of €60 billion a month. Two weeks ago under these conditions, the euro surpassed the benchmark rate of 1.20 with the dollar (more than 120 dollar cents per euro).

However, on the afternoon of 7 September, after the meeting of ECB’s Governing Council, Mario Draghi, said “… a very substantial degree of monetary accommodation is still needed…” As a result, the hike of the euro parity was effectively arrested at levels below 1.2, since the continuation of money printing reduces the foreign value of every monetary unit. On 11 September the European Sting , regarding this, concluded: “Draghi’s 2018 compromise: enough money printing to revive inflation and check euro ascent”. So, predictably, the euro/dollar parity is to remain at its current levels for the next months.

Stabilizing the parity

Coming back, now, to GDP growth, monetary developments are clearly pointing to the prospect that the European economy will continue growing faster than the US. The arrest of the appreciation of the euro versus the dollar will support not only the European exports to the US, but to the entire world. The two mega-economies compete not only in their own markets, but all over the globe. They offer comparable products and services and buyers, when deciding what to choose, take also into account the parity between the two moneys and prefer the cheaper. So, the cries about trade and money parities wars are not totally unfounded.

Draghi, in order to repel the American criticism, about Europe technically keeping the euro cheap, added, “monetary accommodation is still needed for underlying inflation pressures to gradually build up and support headline inflation developments in the medium term”. In short, the President of ECB told the Americans something like ‘we will continue printing euro, not to keep it cheap but to attain our inflation target of close to 2%’. Truly, the recent appreciation of the euro had further undermined the revitalization of inflation in Eurozone, making imports cheaper. The European Sting has analyzed this process.

In any case, the fact remains that the Eurozone economy will most probably continue growing faster that the US, as in the first two quarters of this year. And at the end of the day, the euro is to remain more or less at its present parity levels with the dollar. This scenario wouldn’t damage Europe’s growth prospects. It will also maintain EU’s advantage, in the unfortunate occasion of open trade and money parities wars. The next ECB Governing Council meeting in October will take stock of all that.