In the summer of 2012, European Central Bank governor Mario Draghi pulled off something of a coup.
Using a few carefully chosen words he was able to drive down bond yields and largely remove the threat of contagion from a very unstable eurozone. That speech led to the ECB’s ace in the hole – the outright monetary transaction programme, which has never been, or had reason to be, used. But are Mr Draghi and the ECB’s governing council now trying to pull of a similar feat with the euro?
The single currency has appreciated 7 per cent versus the US dollar over the past year and by a similar amount on a trade-weighted basis. This strength has been a problem for the ECB and its efforts to stave off deflation. The final reading of eurozone inflation for February was 0.7 per cent year-on-year, a touch lower than the first estimate.
So far the stronger euro and low levels of inflation have not catapulted the economy into the feared Japanese-style deflationary spiral. Consumer confidence surged in March to its highest level since December 2007 and points to solid consumer spending. Meanwhile, retail sales have had a sturdy start to the year. However, the ECB has done little to further loosen monetary policy, despite the growing belief among investors that more action is needed given the currently very low rates of inflation and high unemployment across many countries in the single-currency bloc.
The strengthening euro is evidence that the ECB has become a victim of its own success in stabilising the regional economy. The stronger currency undermines trade, putting the brakes on the export-led recovery that has boosted the fragile regional economy, while making imports cheaper and putting downward pressure on prices.
The ECB does not have currency targets and, like many other central banks, focuses on inflation and price stability, but the strength of the euro has become increasingly relevant to the ECB’s assessment of the economy and where it is heading. The lack of tangible action in response to the stronger euro suggests perhaps a tolerance among policymakers for a de facto tightening of monetary policy, and an uncertainty over the legality of more non-standard policy measures, such as outright quantitative easing. This has changed recently, however, with more ECB council members discussing this possibility, most notably Jens Weidmann, president of the German Bundesbank and someone who had been one of the biggest opponents of QE.
Without tangible action, the next choice is intangible action, or verbal easing. In the past few weeks there has been rhetoric by members of the ECB’s governing council that, taken together, suggests the ECB is trying to “do a Draghi” and talk the currency down from the ledge. Some members have suggested the most appropriate response to a stronger euro would be a negative deposit rate (currently 0.25 per cent). Negative deposit rates fall firmly into uncharted waters and the impact they would have on markets and the currency is unknown. But it may be that no one is planning to introduce a negative rate, and policymakers are hoping instead that simply talking about it will be enough.
Trying the same trick twice might not fool investors. Back in 2012, markets reacted sharply to what has become known as Mr Draghi’s “bumblebee speech”, with yields on government debt in the crisis economies falling significantly. But the response in currency markets in the wake of the latest talk of action to bring down the euro has been much more subdued. Markets may be starting to experience “whatever-it-takes” fatigue, and unless the ECB takes some pointed action, doubts could easily start to emerge about the central bank’s willingness to fight off deflation, and the stronger euro could persist for some months.
The ECB’s expectation, however, is that the euro will eventually depreciate. Global central bank policies have begun to diverge with the introduction of tapering in the US. Both the Federal Reserve and Bank of England are likely to raise interest rates sooner than the ECB. Fundamentals mean this should lead to a depreciation in the euro over the coming months as the region’s weaker, albeit improving, economic recovery lags the US and UK, resulting in larger interest rate differentials.
Kerry Craig is global market strategist of JP Morgan Asset Management
