Thursday, 3 July 2014

Ahead of Today's ECB Press Conference

Ahead of the ECB press conference this afternoon, it’s worth reviewing the challenges the ECB faces in its efforts to boost inflation.

The main strategy the ECB is pursuing is to weaken the currency, in an attempt to increase the euro-denominated price of imports into the Eurozone and to lower the prices of Eurozone goods and services denominated in other currencies. The main tactic it’s employing in pursuit of this strategy is to lower its policy rates, widening the interest rate differences between the euro and other currencies.

The first challenge with this approach is that is relies heavily on the notion that exchange rates can be managed by managing interest rate differentials. It’s true that the literature on the uncovered interest rate parity puzzle finds a general tendency for high-yielding currencies to appreciate. But the proposed mechanisms that bring about this correlation are not well understood at a conceptual level, and this literature doesn’t suggest that a central bank can expect to manage the exchange rate via interest rate policy. At a minimum, the experience of the euro over the past month suggests the ECB faces a real challenge in weakening the currency via rate policy.

The second challenge is that the Eurozone isn’t a mid-sized, open economy, like the UK, which experienced an increase in its inflation rate after a depreciation of sterling. As a result, the currency depreciation required to increase the Eurozone inflation rate by, say, 50 bp, is presumably much larger than the depreciation required for a similar increase in the UK inflation rate. To put these moves in perspective, sterling depreciated roughly 30% relative to the dollar in 2008. A similar move in the euro would bring the currency to just below parity against the dollar. With this in mind, it seems highly improbable that a difference in the policy rates of 35 bp will lead to a depreciation of the euro sufficient to produce a noticeable increase in the Eurozone inflation rate.

In the bigger picture, the main potential internal catalysts for growth in the Eurozone are probably fiscal stimulus and labor market reforms. The latter are increasingly unlikely given favorable pricing of peripheral debt currently, while the former are under discussion within the EU but face serious constraints, given the negotiating stance taken by the northern EMU member states.

The potential external catalyst for growth in the Eurozone is an increase in export demand, consistent with the ECB strategy. But I believe an increase in export demand will only take place in an environment of more robust global growth. In particular, I don’t believe the ECB will be able to increase export demand noticeably unless it can engineer a significant currency depreciation. And I don’t believe the ECB will be successful in engineering a significant currency devaluation simply by increasing the policy rate difference with the US by 10 bp.

No doubt Draghi will be asked about his exchange rate strategy at today’s press conference, particularly as the euro has richened back to its level at the time of the June press conference. And no doubt he’ll reiterate that the ECB is prepared to use unconventional instruments, including large-scale asset purchases. And in this regard it’s worth noting Draghi’s comments during the last press conference on the timing of policy changes with respect to persistent low inflation, “…the longer it lasts, the higher the risks. And that's what we are reacting to. We are reacting to a risk of a too-prolonged period of low inflation.”

During the height of the euro sovereign debt crisis, peripheral spreads and the euro were negatively correlated, as the euro weakened in response to higher peripheral spreads. At the moment, I expect this negative correlation will continue, as peripheral spreads narrow in response to any currency strength. In particular, unless the euro weakens or unless global growth increases, the ECB will feel an increasing need to conduct large-scale asset purchases. My expectations for the next few months are that the euro is unlikely to weaken by an amount that would boost inflation noticeably and that global growth is likely to remain modest so that peripheral spreads will continue to narrow as the prospects for large-scale asset purchases increase. But today's press conference will provide another opportunity for assessing the views of the Governing Council on the issue.

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