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How the Euro's Exchange Rate Affects ECB's Policy Decisions

By Frances Coppola

The Eurozone is gradually recovering from the crises and depression of recent years. GDP growth has resumed, although it is still fairly slow at around 0.6 percent per quarter.1 Unemployment is falling, though it is still high in some countries.2 There has been growing speculation that the European Central Bank (ECB) would soon start tapering off its quantitative easing (QE) program, and perhaps raise interest rates.3 But it appears that low inflation and a rising euro exchange rate have interfered.

Early in 2017, the ECB committed to maintaining asset purchases under its QE program until December 2017. Many analysts thought that if QE were to be tapered off in early 2018, the ECB would announce this in September 2017. Interest rate rises might be signaled then, too.4 Over the summer of 2017, the euro's exchange rate rose not only because of improving Eurozone economic prospects, but also in anticipation of ECB monetary policy tightening.5

 

Low Inflation and a Strong Euro Exchange Rate Drive a 'Softly-Softly' Approach to QE Tapering

 

However, other analysts warned that persistently low inflation and rising euro exchange rates could force the ECB to keep monetary conditions very loose for some time to come.6 And it appears that they have been proved right.

 

On September 7, the ECB announced that QE would continue "until the end of December 2017, or beyond, if necessary, and in any case until the Governing Council sees a sustained adjustment in the path of inflation consistent with its inflation aim." And it warned that if economic conditions deteriorated or inflation started to fall, it would increase the size of its asset purchase program. It also said that key interest rates would remain very low for "an extended period of time."7

 

The ECB's decision to maintain very low interest rates and QE for the foreseeable future is consistent with its single mandate, which prioritizes achieving an inflation rate that is "below, but close to" its 2 percent target. Currently, inflation in the Eurozone is at 1.3 percent:8 the ECB forecasts that it will fall to 1.2 percent in 2018, before recovering to 1.5 percent in 2019.9 In a press conference, the ECB's governor, Mario Draghi, confirmed that the ECB's priority was to raise inflation closer to 2 percent.10

 

Strengthening Euro Exchange Rate Reflects Improved Eurozone Outlook

 

A key factor in the subdued outlook for inflation is the euro's exchange rate. The ECB's September macroeconomic forecast notes that the euro's "nominal effective exchange rate" (NEER) has risen by 4.4 percent since June.11 The NEER is the euro's exchange rate against a trade-weighted basket of the currencies of all the Eurozone's trade partners, unadjusted for inflation. Normally, a rising NEER would put downwards pressure on inflation, since imports priced in foreign currency would become cheaper in euros. Oil, for example, becomes cheaper in euro terms when the euro's exchange rate increases versus the U.S. dollar.

 

However, the ECB says that the principal driver of the rising NEER is increasing demand in the Eurozone arising from the improving growth outlook. It therefore expects inflation to rise gradually towards its target despite the strong euro.12

 

Although interest increases and QE tapering appear to be off the menu for the moment, the euro's exchange rate rose in response to the ECB's upbeat assessment of the Eurozone economy. Analysts forecast that the euro will rise further against the British pound and the U.S. dollar, in particular.13

 

The

Takeaway:

The ECB's announcement may provide a degree of certainty for companies doing business in the Eurozone. Although experts expect the euro's exchange rate to continue rising, interest rates may remain low for some time to come and corporate borrowing will continue to be supported by the ECB's asset purchases. This may encourage international businesses to invest in the zone.

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

1. “Euro area statistics summary,” Eurostat, https://www.ecb.europa.eu/stats/html/index.en.html
2. “Unemployment statistics,” Eurostat; http://ec.europa.eu/eurostat/statistics-explained/index.php/Unemployment_statistics
3. “Pressure builds on ECB chief Mario Draghi over QE programme,” Sky News; http://news.sky.com/story/pressure-builds-on-ecb-chief-mario-draghi-over-qe-programme-11023092
4. “ECB to hold steady this week as traders eye a September ‘taper’ of its bond-buying program,” CNBC; https://www.cnbc.com/2017/07/19/ecb-to-hold-steady-this-week-as-traders-eye-a-september-taper-of-its-bond-buying-program.html
5. “ECB sends a dovish message but markets don’t buy it,” CNBC; https://www.cnbc.com/2017/07/20/ecb-holds-interest-rates-steady-as-traders-eye-draghi-qe-tapering.html
6. “Here’s how the ECB got stuck in the “euro trap” on its way to winding down QE,” Marketwatch; http://www.marketwatch.com/story/heres-how-the-ecb-got-stuck-in-the-euro-trapon-its-way-to-winding-down-qe-2017-09-05?mod=mw_share_twitter
7. “Monetary policy decisions,” European Central Bank; https://www.ecb.europa.eu/press/pr/date/2017/html/ecb.mp170907.en.html
8. “Euro area inflation,” Eurostat; http://ec.europa.eu/eurostat/statistics-explained/index.php/Inflation_in_the_euro_area
9. “September 2017 ECB staff macroeconomic projections for the euro area,” European Central Bank; https://www.ecb.europa.eu/pub/pdf/other/ecb.ecbstaffprojections201709.en.pdf?a13047040af5611b7e0cda69c6a88bf2
10. “Press Conference: Mario Draghi, President of the ECB, Vítor Constâncio, Vice-President of the ECB, Frankfurt am Main, 7 September 2017,” European Central Bank; https://www.ecb.europa.eu/press/pressconf/2017/html/ecb.is170907.en.html
11. “September 2017 ECB staff macroeconomic projections for the euro area,” European Central Bank; https://www.ecb.europa.eu/pub/pdf/other/ecb.ecbstaffprojections201709.en.pdf?a13047040af5611b7e0cda69c6a88bf2
12. Ibid.
13. “Euro Forecast to Maintain Longer-Term Uptrend as ECB Maintains Relaxed Approach to Appreciation,” Pound Sterling Live; https://www.poundsterlinglive.com/eur/7497-pound-to-euro-exchange-rate-draghi-comments-eyed

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