Why Europe’s Central Bank Shouldn’t Worry About the Euro

The European Central Bank has spent much of this decade convincing markets that the euro is irreversible. It is therefore mildly ironic that policy makers in Frankfurt may be in trouble because of the sudden return of confidence in the single currency.

Investors flocking to the euro have pushed it above $1.20, a 14 percent appreciation since the start of the year. The risk is that, by making imports cheaper, a stronger single currency will make it harder for the ECB to hit its inflation target, undermining the central bank’s plans for a smooth exit from its program of quantitative easing.

Mario Draghi, ECB president, acknowledged this risk during his press conference on Thursday when he said that the “volatility” of the exchange rate “represents a source of uncertainty.” He was right, however, not to go further. The central bank targets inflation, not the exchange rate. Obsessing about the level of the euro means failing to understand that the strength of the currency can have different causes — some of which are way less worrisome than others.

The recent appreciation of the euro is the result of two positive developments. The first is a sharp reduction in the risk that the single currency may disintegrate, following the defeat of euroskeptic candidates in the Dutch and French elections at the start of this year. The second is an unexpected improvement of the growth prospects of the euro zone. The ECB yesterday raised its growth forecasts to 2.2 per cent this year. Both these factors make investors more willing to hold assets denominated in euros, contributing to the strength of the currency.

It would be very short-sighted for the ECB to react to this appreciation by ditching its plans for a gradual exit from QE. The exchange rate is only one element in the composition of inflation, which is what policy makers must ultimately care about. To the extent that a stronger euro signals robust domestic demand, policy makers must watch out for a return of inflationary pressure.

The ECB must also be careful about its role in the international economy. The last thing policy makers should do is to keep the euro artificially low while the economy is expanding. The recent appreciation of the euro against the dollar is telling us that investors are becoming more confident of the prospect for the euro zone economy vis-à-vis the U.S. It is only right that the U.S. enjoys the benefits from a cheaper currency — including more competitive exports.

The ECB must therefore only concentrate on inflation. Of course, there may be reasons to worry about it. The central bank trimmed its inflation forecasts Thursday, showing price pressures are still far from its objective just below 2 percent. This calls for prudence in the unwinding of the monetary stimulus.

However, if there is anything that should worry Draghi and his colleagues, it is not the euro but their ability to react to weakening price pressures. The central bank is operating under a self-imposed set of constraints on how many sovereign bonds of each euro zone countries it can purchase. Some of these limits — for example the ceiling on how many German bunds the ECB can buy — will start to bite sometime next year. Ensuring there is sufficient flexibility in the conduct of monetary policy is more important than worrying about a flexible exchange rate.
Source: Bloomberg

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