European Central Bank Executive Board member Benoit Coeure warned that the rising euro could depress inflation unless it’s offset by a strengthening economy, bolstering the case for keeping monetary policy loose for an extended period.
“Exogenous shocks to the exchange rate, if persistent, can lead to an unwarranted tightening of financial conditions with undesirable consequences for the inflation outlook,” Coeure said in Frankfurt on Monday. “Against this background, the recent volatility in the exchange rate represents a source of uncertainty which requires monitoring.”
The euro’s surge has become an additional headache for the ECB as policy makers try to determine the future of their bond-buying program, which is currently scheduled to expire by the end of this year. President Mario Draghi warned last week that officials were watching the currency after it gained 14 percent against the dollar this year and forced the central bank to cut its inflation projection.
Coeure said that while there is no immediate cause for concern, as the 19-nation bloc’s improving economy allows companies to raise prices to offset the dampening effect of the exchange rate, there is reason for watchfulness.
“Should the contributions of the different shocks driving the exchange rate change over time, then also our assessment of the impact on inflation will have to change — expansion or not,” he said. “The emerging disconnect between the euro’s exchange rate vis-à-vis the U.S. dollar and the long term interest-rate differential between the U.S. and Germany may suggest that we are entering such a situation.”
With the impact of the currency on prices partly determined by the strength of the recovery, ECB stimulus will play a significant role in dampening the pass-through because “policy will remain more accommodative for longer,” he said.
Coeure also noted the criticism that non-standard monetary stimulus such as bond purchases, negative interest rates and forward guidance haven’t yet returned inflation to target. In the ECB’s defense, he said that monetary policy can ease financial conditions to boost economic activity, but there are limits to what it can control.
“Monetary policy is far from being ineffective in stimulating aggregate demand, also when approaching the effective lower bound,” he said. “The fact that inflation remains subdued rather reflects constraints operating at the third stage of transmission — from activity to prices — that are often outside the control of monetary policy.”