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The Euro’s strengthening exchange rate is driven more by expectations of renewed economic growth than by the prospect of the ECB ending QE.

How the ECB’s QE Program Influences the Euro Exchange RateARTICLE

By Frances Coppola

In 2012, the single-currency Eurozone came close to breaking up, most likely saved by a bold promise from the president of the European Central Bank (ECB). The practical effects of that promise are still influencing the U.S. dollar-euro exchange rate today.

The 2012 crisis began with Greece facing debt default and exit from the Eurozone, while investors feared other highly indebted countries (e.g., Portugal, Spain, and Italy) would follow. If these countries had still had their own currencies, investors’ fear of debt default would have caused their individual exchange rates to fall versus the dollar. But because they were all members of the euro, the euro’s exchange rate fell.1 This was accompanied by sharply spiking yields on government debt of the weakest countries, as investors feared those countries would exit from the euro and their debt would be redenominated in their much weaker individual currencies.

But the President of the ECB, Mario Draghi, promised to do “whatever it takes to preserve the euro”2 – and his promise worked. The euro’s exchange rate rose and bond yields fell. Although there have been two further crises in the Eurozone since that promise was made (Cyprus 2013 and Greece 2015), the euro has never again been in danger of breaking up.

After the 2012 crisis, the Eurozone suffered falling inflation,3 poor economic growth,4 and very high unemployment.5 To counter this, the ECB cut interest rates to unprecedented lows6 and provided large amounts of funding for Europe’s troubled banks.7 This proved insufficient: in January 2015, as oil prices slumped, the Eurozone entered deflation.8 In March 2015, after much debate, the ECB embarked on an Expanded Asset Purchases Program, more usually referred to as “quantitative easing” (QE).9

Effect of ECB’s QE on the Euro Exchange Rate

The ECB’s QE is thought to help the Eurozone economy through four principal channels:

  • By announcing large-scale asset purchases, the central bank signals to market participants its commitment to keep interest rates low in the future.
  • Keeping interest rates low prompts investors to sell euro-denominated assets in favor of assets denominated in other currencies, thus helping the euro’s exchange rate to fall, which in theory boosts exports’ competitiveness.
  • By purchasing a large quantity of low-risk assets held by insurance companies and pension funds, the central bank encourages them to diversify into riskier assets, such as corporate bonds or stocks, which should encourage companies to invest.
  • By purchasing assets from the banks, the central bank provides them with extra money to fund productive lending.

How has QE worked in practice? Well, ECB interest rates have stayed very low.10 Yields on Eurozone government bonds have also fallen and in many cases are now below zero, especially for shorter-dated bonds.11 European stock and bond prices have risen considerably. And the ECB says that bank lending (“credit to the private sector”) has increased.12

The euro’s effective exchange rate rose steadily from the start of QE, which appears to suggest that the exchange rate channel did not work.13 But the ECB had done smaller-scale asset purchases before commencing QE,14 at which point it also signaled its QE plan15 – and the euro’s exchange rate fell significantly at that time.16 It may be that depreciation had already been “priced in” to the euro exchange rate by the time QE officially started.

More importantly, though, the Eurozone has at last started to recover. Although inflation is still some distance below the ECB’s 2 percent target,17 economic growth is picking up18 and unemployment is falling.19 How much of this is attributable directly to QE, and how much to other factors, is unclear. But it raises the prospect of an end to QE and start of interest rate normalization in the not too distant future.

How Ending QE and Raising Interest Rates May Affect the Euro Exchange Rate

The Eurozone’s brighter economic outlook is encouraging inward investment into the bloc, which influences the euro’s exchange rate. Since March 2017, the euro’s effective exchange rate has risen sharply.20

However, several countries in the Eurozone are still mired in recession and have fragile fiscal finances. Furthermore, the ECB’s “single mandate” says that it should conduct monetary policy so as to keep inflation “below but close to” the target of 2 percent per annum.21 Currently, inflation is well below this. Raising interest rates and ending QE would potentially reduce inflation still further, and prematurely ending the asset purchases that are keeping Eurozone government borrowing costs low could have unfortunate consequences for financial stability.22

In April, Draghi squashed suggestions that the ECB should start raising interest rates before ending QE. And in June, when the ECB’s policy committee discussed reducing the scale of asset purchases, stock and bond markets promptly fell, eliciting a comment from the ECB that investors had “misjudged” the message.23 In July, the ECB refused to set an end date to QE, standing by its earlier guidance that QE would continue at least to December 2017 and probably well into 2018.24 Despite growing economic confidence, therefore, the end of QE in the Eurozone still seems some way off.

Even when the ECB does decide to end QE and start reducing the size of its balance sheet, it is likely to proceed very slowly and cautiously. The U.S. Federal Reserve signaled the end of its own QE far in advance so as not to cause market disturbances, and raised interest rates before starting to reduce its balance sheet. It has now indicated that it will start to shrink its balance sheet “relatively soon,” but at an extremely slow pace: the Fed’s balance sheet may not return to its pre-crisis size for decades, if indeed it ever does. This is the model that the ECB will be looking at when it comes to unwind its own QE program. It may proceed even more cautiously than the Fed, because of the wide economic differences between various Eurozone member states and, therefore, the risk of financial crisis.

The Takeaway

The euro’s strengthening exchange rate is driven more by expectations of renewed economic growth than by the prospect of the ECB ending QE and increasing interest rates. If the ECB withdraws stimulus slowly and carefully, there may be little or no effect on exchange rates. The euro’s effective exchange rate may simply appreciate gently as investment returns and growth accelerates.

Frances Coppola - The Author

The Author

Frances Coppola

With 17 years experience in the financial industry, Frances is a highly regarded writer and speaker on banking, finance and economics. She writes regularly for the Financial Times, Forbes and a range of financial industry publications. Her writing has featured in The Economist, the New York Times and the Wall Street Journal. She is a frequent commentator on TV, radio and online news media including the BBC and RT TV.

Sources

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