Will a Strong Euro Tie the ECB's Hands?
Exchange rates are on the radar screen for policymakers in the euro zone—the 12 countries that use the euro as their common currency—as the euro's continued rise vs. the U.S. dollar has placed it near the $1.40 mark. Action Economics doesn't expect current foreign exchange levels to curtail the euro zone's economic recovery or prevent the next rate hike by the European Central Bank (ECB), which we currently expect in September.
Verbal intervention, when policymakers attempt to guide currency levels by making comments about their relative strength, will become louder if the euro breaches the $1.40 mark, and ongoing strength in the common currency will make additional rate hikes less certain and more dependent on upcoming data reports.
The euro appreciated 6.3% against the dollar in June, year-over-year, and is trading above its last cyclical high of $1.3637 from Dec. 30, 2004. In light of lingering concerns about the U.S. subprime sector, it seems only a matter of time until the euro breaches the $1.40 mark. The euro is also strong against the Japanese yen, with carry trades and the prospect of further ECB rate hikes as factors supporting further strength.
On a real (adjusted for inflation), trade-weighted basis, the appreciation looks somewhat less dramatic. The trade-weighted index (TWI) for the euro rose just 2.8% year-over-year in June, compared with the 6.8% year-over-year appreciation in the euro vs. the greenback that month. Nevertheless, the TWI is also at the highest level since the start of the European Monetary Union in 1998. Despite this, euro zone officials do not seem overly concerned so far, with the exception of French President Nicolas Sarkozy, and we agree that the euro zone should be able to cope with its currency's recent appreciation.
World Growth Factor
A stronger euro does undermine the competitiveness of euro zone goods on international markets and could potentially cut foreign demand, which has been a supporting factor for the EMU's growth. However, low wage growth and larger productivity gains mean that real exchange-rate increases are less significant. Furthermore, world growth remains very strong, which ultimately is more important for export growth than the exchange rate.
The European Commission has shown that export demand is relatively insensitive to changes in exchange rates, and that a 10% appreciation of the real effective exchange rate would cut overall exports by only around 2%. One reason is that exporters typically hedge their short-term currency exposure, and longer-term shifts depend on whether exchange-rate moves are deemed transitory or permanent. If swings are deemed temporary, exporters adjust profit margins when exchange rates rise by cutting prices if domestic products are expensive on foreign markets and vice versa. Some firms have sufficient margins for more permanent adjustments.
More important for export demand is overall world growth. According to the EU commission, a 10% drop in world demand would cut euro zone exports by 8%. And so far world growth remains very robust. The International Monetary Fund predicts world growth of 4.9% this year and next, which is just marginally lower than the 5.3% in 2006. The positive impact from strong world growth would far outweigh the impact of a 10% euro appreciation.
This explains why the EU commission survey shows that the industrial sector remains very optimistic with regard to the growth outlook. The reading for export order books continued its ascent in the second quarter this year. The reading dropped slightly in June, to 5, from 6 in May. However, the May number was the highest in at least 12 years, which suggests that export orders inflow remains exceptionally strong. This is a very different situation from 2004, when the euro reached its last peak against the dollar.
Furthermore, a stronger euro also means lower import prices, which ultimately will have a positive effect on consumer price inflation. The EU commission says estimates show that the exchange rate pass-through for the euro zone is rapid and large to import prices. The pass-through to consumer prices is more muted and takes longer, but ultimately it will have an impact, which in turn is improving purchasing power and may strengthen domestic demand.
To the extent that the stronger euro has a positive impact on the medium-term inflation outlook, it also affects ECB policy. According to the EU commission's calculations, a 6% appreciation of the real trade-weighted index has an equal effect as a 100-basis-point interest rate hike. With the trade-weighted index up 4% year-over-year in the first half of 2007, this is an additional tightening of monetary conditions, on top of the ECB's interest rate hikes.
Overall, we agree with officials that the euro zone economy is still sufficiently strong to cope with the recent euro appreciation. Very robust domestic demand, coupled with still strong world growth, will remain supportive of the recovery. However, a further rapid euro appreciation could bring some problems for the growth outlook and ECB policy. Officials will be very wary of sudden exchange rate swings, which could have a destabilizing effect. A stronger currency may provide some welcome tightening of monetary conditions. But the ECB is likely to prefer tightening via interest rates rather than through the exchange rate channel.
ECB officials, as well as EU Monetary Affairs Commissioner Joaquin Almunia, have once again started to repeat the familiar line that "excess volatility" in exchange markets is undesirable, and that exchange rates should reflect fundamentals. Hermann Remsperger, a member of the executive board of Germany's central bank, has called on China to speed up measures to increase the flexibility of its currency. The risk is of more verbal intervention by officials with the euro approaching $1.40. But, despite public pressure from Sarkozy, the risk of unilateral intervention from the ECB seems pretty slim. Officials stress the need to tackle exchange rate issues on a global level.
In our view, it is likely that the euro will breach $1.40 at one point, but we would not expect a marked and lasting appreciation beyond that level. For the interest rate outlook, that means that with euro zone growth above potential, and the output gap closing, the ECB is likely to bring rates to a level where it judges monetary conditions to be neutral rather than accommodative. That means current euro strength is unlikely to prevent the next rate hike, which we currently expect in September.
However, ongoing euro strength will support the policy doves at the ECB council and provide some argument against further hikes beyond September. That means that additional moves will be data dependent, and ECB decisions will be less clear-cut and predictable.
Under our central scenario of ongoing robust growth, another hike in December still remains the most likely option, but much will depend on confidence numbers in the second half. If there are signs of a slowdown in growth, the ECB may pause after the next rate hike to assess the situation, and await the impact of previous rate hikes on the economy.