ECB Insight: Parity or Not, ECB Insiders’ Comments over Last Months Suggest Euro Per Se Unlikely to Drive Policy

14 July 2022

By David Barwick – FRANKFURT (Econostream) – Striking though the euro’s latest descent on foreign exchange markets may be, with the common currency now having reached parity with the dollar, a review of European Central Bank insider comments in recent months leaves us sceptical that the latest developments will induce the ECB to take any steps it cannot clearly justify on the basis of inflation.

It is a pity of course that parity has been reached for the first time in decades just as ECB Governing Council members enter the blackout period prohibiting sensitive comments before a monetary policy meeting.

That leaves observers with little more to go on in terms of recent public statements than those yesterday from Banque de France Governor François Villeroy de Galhau, who said that it was ‘not so much the euro that’s weak, but the dollar that’s strong’ on account of the latter’s safe haven status.

The low exchange rate of the common currency versus the dollar is ‘good news for activity as it supports exporters, but unfortunately it raises inflation a bit’, he said, repeating the mantra that the ECB watches the euro exchange rate because of the relevance to inflation, but does not target it.

Beyond confirming that the euro’s weakness is, unsurprisingly, very much on monetary authorities’ radar, Villeroy didn’t offer much reason to expect them to do something about it.

Indeed, he sounded more upset over less back on May 16, when, speaking of the pace of normalisation, he said, ‘And let me stress this: we will carefully monitor developments in the effective exchange rate, as a significant driver of imported inflation. A euro that is too weak would go against our price stability objective.’

Comments of this sort are heard at occasional intervals; for example, from Austrian National Bank Governor Robert Holzmann on June 1: ‘A 50 basis-point rise would send the necessary clear signal that the ECB is serious about fighting inflation. A clear interest-rate signal would also help to support the euro’s exchange rate. The weak euro is not helpful on the inflation front.’

Isolated verbal interventions like this, reiterations of the ECB’s no-exchange-rate-target mantra and saying nothing on the subject are the three choices Council members have when commenting publicly, but offer little in the way of guidance as to how euro-dollar parity is likely to be regarded.

Econostream reviewed relevant comments made by various ECB insiders who spoke to us in recent months and has to conclude that when all is said and done, if the ECB wishes to be consistent, then Italian politics and the possibility of an energy embargo should be garnering more attention than the exchange rate at the moment.

That is not at all to say that the euro’s forex softness doesn’t matter. With the magnitude of September’s rate hike hinging on whether the medium-term outlook improves or not, a weaker common currency, as one person points out, can make a difference, reinforcing the idea that 50 basis points are a done deal. But importantly, this is via inflation, precisely the channel the ECB generally claims is the one that matters for its policymaking.

Person 1 (three months ago):

‘I think [the exchange rate] was more important during the time of the very low inflation, because that was one of the important factors that you could actually indirectly try to drive at least a bit, and that’s why it got a bit more inflation in the system. During the times of high inflation I would say it’s of less importance, because we have much more important aspects that we need to take into account.’

Person 2 (three months ago):

‘It was interesting that usually when the euro depreciates … usually nobody cares. But if there is an appreciation there is always comment on that from some countries which are exporting in US dollars. So, this time it is mainly because of the inflation outlook. It was – and it is quite natural, because we are expecting different cycles in the US and in Europe – even the nature of the inflation is different in the US, if you look at the inflation figures, the breakdown, a lot of it is coming from, you know, stimulus-induced price increases in the US. So, that is more of a fiscal nature, or at least some of it, and therefore it’s quite understandable that they will move quicker, faster and to a higher level, and that will, you know, depreciate more the euro, and it will create inflation also from that perspective. But when we look at, at least in models, how big is that impact, because a lot of what we export is more about quality, not about price pressures, we are not dealing so much with commodities or base metals or whatever there is a huge price sensitivity. So, these multipliers are relatively low in the euro area. But it can make a difference. It can make a difference, especially in a situation when we are talking about 2024 that if the depreciation will be higher, it can add a few tenths of a percent, and there is a difference whether we end our forecast [horizon] at 2% or 2.5%. … We should look at of course not setting some targets for it, because you know, at least we do not have at least here a very good experience with interventions. But we will have to take it into account when deciding about the rates.’

Person 3 (two months ago):

‘The pass-through of FX moves on inflation is not that great or that quick. Certainly, the FX rate matters for inflation, but the Governing Council should always look at it from an inflation point of view and not think about the FX rate as such. … Well, anyway we are not going to do FX interventions, but even to do monetary policy tightening and justify it clearly from an FX point of view, I don’t see it. … I understand that zero is extremely important for rates, even though rates can be negative. But the parity for euro-dollar is just one figure like the others … it shouldn’t have psychological effects like zero for rates.’

Person 4 (1.5 months ago):

‘We won’t do anything about it in the sense that we won’t, because of the exchange rate, explicitly take a specific action. Implicitly yes. But not explicitly saying, “In order to increase the exchange rate, now we [do this] for the euro to increase.” I don’t think this will happen.’

Person 5 (1.5 months ago):

‘[T]he discussion is whether inflation expectations are anchored. Obviously, the exchange rate matters for inflation expectations, and therefore, but … I don’t think the discussion should say, look, the euro is getting weaker and weaker, we should do something to react. Because there is a target, which is inflation expectations, that is enough work already, and then everything will evolve around that. Obviously, to some extent, is there a point in focusing on the exchange rate? This is a war that is already lost. The normalisation cycle in the US has to be far steeper and more aggressive and bigger than in the euro area, because we don’t have the same problems they have. So in that regard, there is no point in fighting something that is going to happen anyway. But obviously it will condition the path, the same when the US hikes, there is a transmission through all the financial channels to the rates in Europe, and that is also conditioning our inflation expectations, but there is no, I would be surprised if in internal discussions anyone said this is a factor for doing this or that. That would be strange, even inappropriate. … We just need to focus on our work and the euro will behave accordingly. … It’s a lost war. We need to focus on the things that we can control.’

Person 6 (one month ago, speaking of the June 9 Governing Council meeting):
‘We are dealing with interest rates, not the exchange rate. That’s important. … We were discussing inflation perspectives, not the exchange rate, not employment.’