Why Some ECB Officials Are Suddenly Concerned About Euro Weakness | Instantaneous

In recent days, ECB officials have made their concerns about the weakness of the euro more clear. French central bank governor Villeroy de Galhau stressed that a weaker euro would undermine the ECB’s price stability objective. ECB executive board member Isabel Schnabel was quoted as saying the ECB was closely monitoring the impact of the weaker euro on inflation. This contrasts sharply with the minutes of the ECB meeting in April where the exchange rate was only mentioned four times. There was also speculation in the market that the major central banks could opt for some sort of Plaza deal, using coordinated action and even currency intervention to prevent the US dollar from further strengthening and the euro to weaken further.

To what extent should the recent weakening of the euro really concern the ECB? Since the last ECB staff projections in March, the euro has lost some 5% against the US dollar. The trade-weighted euro exchange rate lost almost 2%. However, compared to a year ago, the euro has depreciated more than 13% against the US dollar and around 6% in trade-weighted terms. In normal times, this weakening of the currency would have been a welcome relief for eurozone exports, but right now it is an additional inflation problem. According to the usual estimates, the depreciation of the euro since March could add another 10 basis points to inflation this year and 20 basis points next year. However, at a time when the main inflationary drivers are energy and commodity prices, which are priced in US dollars, the impact of the weak euro on inflation could be even stronger.

With headline inflation rates above 7%, it’s hard to understand why some ECB officials are worried about a few extra basis points. The weak euro may not be the reason for high inflation, but it at least reinforces it. The main reason why ECB officials have become more vocal on the exchange rate may be the fact that while higher policy rates won’t lower energy prices or fill containers in Asia, higher policy rates could strengthen the euro. The so-called exchange rate channel may currently be the most effective, and probably the only, means of mitigating inflationary pressures relatively quickly. That’s why ECB hawks might be inclined to use the currency as an argument to support a 50 basis point rate hike in July and strong forward indications that more rate hikes are to come. Expect more than the four exchange rate references at the April meeting in the coming weeks ahead of the June 9 ECB meeting.

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