- A lower EUR will help Germany and the ECB meet monetary policy objectives
- ECB policy is targeting an expansion of the monetary base, similar to BoJ action
- Mario Draghi insists the exchange rate is not a policy target
By Max McKegg
Growing dissent between the European Central Bank and Germany over the appropriate use of monetary policy is leading to a stand-off. But if the stars line up, both parties can come out looking like winners. The ECB would see inflation expectations redirected towards its target of 2% and the Germans would see off quantitative easing. This win-win outcome will occur if the exchange rate can be manoeuvred lower.
Last week, we had speeches from both the ECB's president Mario Draghi and vice-president Vitor Constancio. Draghi’s comments attracted the most attention, but the vice-president’s contained more insight into the the current thinking at the ECB.
A lower exchange rate could help the ECB meet its inflation target but the ECB's president
Mario Draghi says such action isn't in its sights. Photo: Thinkstock
Constancio's speech was titled: “A new phase in the ECB’s monetary policy”. It explained how the Targeted Long-Term Refinancing Operation and the plan to buy asset-backed securities and covered bonds are intended to further ease the stance of monetary policy in a situation where policy rates are already zero bound. The intent is to signal to the markets the unflinching commitment of the Governing Council to meet the price stability mandate. This is how Constancio put it:
"Central banks simply cannot run the risk of observing inflation expectations starting to become unanchored … The risk related to inflation expectations considerably influenced our decision in September to add a new set of measures."
The ECB October Monthly Bulletin illustrates just how “unanchored” inflation expectations have become in recent months, breaking decisively under the 2% target line.
Source: ThomsonReuters and ECB calculations
ECB to follow Bank of Japan and target monetary base
Policy is now being targeted at increasing the monetary base, via building up the ECB’s balance sheet. The Bank of Japan is showing the way in this regard, while the US Federal Reserve says monetary base expansion is only a side-effect of its credit easing policy. In both cases it was achieved mainly by government bond purchases.
For the ECB, buying private sector assets directly from banks and the wider market is a quicker way of boosting the monetary base than waiting to see how much demand there will be for TLTROs. Furthermore, ongoing repayment of earlier loan programs is decreasing the monetary base, so there would have to be a substantial take-up of the new loan program to make much impact. The ECB has decided it can’t take that risk. Hence the plan to buy asset-backed securities and covered bonds – if the Germans let them.
This chart shows that while the Europeans have been dithering about what to do, the other members of the G3 have been getting on with the job.
Source: ThomsonReuters Datastream
The exchange rate to the rescue
The markets have already decided the asset-buying plan is half-hearted, so bond yields and the exchange rate have hardly moved. Mario Draghi and his colleagues at the ECB are adamant that the exchange rate is not a policy target. However, given the current strained relations between the ECB and Germany over the asset-buying plan, a decline in the EUR now would get everybody off the hook.
There would be no need to swallow bitter pills like socialisation of risk, quantitative easing, or subsidising peripheral bond markets.
The ECB estimates that a 10% permanent depreciation of the effective exchange rate would raise inflation by 40 to 50 basis points. But engineering a decline in the exchange rate of that magnitude or more is not an easy task, mainly because there are so many balls in the air.
The markets tend to focus on movements in the EURUSD rate, but on its own this does not tell the whole story. What’s needed is a fall in the nominal effective exchange rate, the overall measure of the EUR.
The ECB calculates the effective exchange rate based on the Eurozone’s top 20 trading partners (EER-20). The table below shows the EER-20 has declined only 3.1% over the past year, despite EURUSD falling more than double that.
EURUSD and EURGBP both fell 7%, and EURCNY 6.7% (given the renminbi’s link to the US dollar). But against that, the euro rose against the Japanese yen, the Czech koruna, the Swedish krona and the Hungarian forint.
The net result of the various cross-rate moves is that the EER-20 is still far above its 2012 low as shown in this chart.
Returning the EER-20 to its 2012 level would require most, if not all, of the component crosses to decline. There are hopes for EURUSD, based more on a stronger dollar than pro-active actions by the ECB.
The biggest weighting in the index is EURCNY, but it seems unlikely that would decline independently of the dollar.
It would be very useful to all concerned if EURJPY could reverse the recent rally and head in the opposite direction. And, as it turns out, that is exactly what might be about to happen.
– Edited by Gayle Bryant
Max McKegg is managing director of Technical Research Limited