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Column-Might the ECB be tempted to prop up the euro?: McGeever -Breaking

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© Reuters. Vienna, Austria, September 17th, 2018: New banknotes in 100 and 200 euros. REUTERS/Heinz-Peter Bader

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By Jamie McGeever

ORLANDO (Reuters) – The record-breaking euro price of oil and gasoline has prompted investors to worry about the possibility of an unlikely intervention by the ECB to support the euro against the US dollar.

It seems odd that the European Central Bank would choose euro purchasing over raising interest rates to limit inflation. Both tighten monetary policies, but the ECB is reluctant to announce any rate rises until the second quarter of this year. They will also be cautious about the impact on the economy and the potential inflation spur.

The euro fell against the dollar last week but is still stable in comparison to a basket of currencies that has a trade weight of at least 5%.

It has been over 20 years since any direct intervention by the euro-targeted authorities on the market. There are no signs of disorderly movement.

However, in times of crisis and war, there is no way to predict the future.

A surge in commodity prices after the Russian tanks invaded Ukraine has reached such an extent that any further euro appreciation could cause an inflationary spiral already out of control.

George Saravelos (head of global currency strategies at Atlantis) has warned us that this is the truth. Deutsche Bank (DE:), in a headline titled: “The ECB must intervene in.” It is important to be clear that he does not believe this will happen and that there are other options for the ECB, including interest rate rises or verbal intervention.

However, he claims that the biggest danger to the economy of the euro area is the surging oil prices. These could trigger a “vicious spiral” in financial conditions.

It is now the most expensive oil in euros. It reached 108 euro per barrel on Thursday, an increase of almost 25% and half a percent respectively in the past week. Prices for natural gas have increased more than twice since February and are now up 800% over the last 12 months.

Saravelos says that “if financial conditions become disorderly”, there are precedents for coordinated FX interventions from the G7. He points to G7 action taken in 2011 to strengthen the Japanese yen in the wake of the Japanese tsunami and earthquakes, as well as the Fukushima nuclear accident in March 2011.

This was the final time that the ECB entered the FX markets. You have to look back at 2000, when the ECB conducted seven rounds of euro-buying interventions worth nearly 10 billion euros. The fledgling currency had lost 30% of its initial value.

FX intervention isn’t something that the ECB should take lightly. Although the euro has seen a 2% drop in dollar value since Russia invaded Ukraine on March 1, its trade-weighted currency remains strong and steady.

FORGET IT

A weaker euro could be a problem for the ECB. The annual inflation rate is currently at a record 5.8%. This number will likely rise, but it seems that this may still be a long way away. Vitor Constancio (ex-ECB Vice President) points out that the currency rate isn’t generally an objective for monetary policies because it is difficult to accurately identify its drivers.

Constancio notes, however that unilateral intervention rarely proves effective. It is hard to see the U.S. Federal Reserve joining a policy of weakening the dollar at a time when they will be increasing interest rates.

“Right now the euro is hovering at $1.11 and there’s no need for or possibility of organizing multilateral interventions. “It is therefore better to forget about the issue,” he stated.

The consensus is building that the euro may be heading lower. Robin Brooks is chief economist of the Washington-based Institute of International Finance. He predicts that parity with US dollars – which would require a 10% decline from current levels – could be achieved within three months.

Since 1999, the ECB has maintained a consistent position that it will intervene on the currency market if there are unwarranted movements or volatility.

Its infrequent actions suggest that market conditions will need to change significantly to allow it to act again. The implied euro/dollar volatility has risen to 10% from a low level. This is well below levels that did not trigger intervention in the past.

However, even if the euro trades soon at parity against the dollar as Brooks from the IIF predicts, market volatility might not be important to ECB policymakers if there is a looming recession.

The situation in the Euro zone is changing rapidly and second-round inflation effects seem implausible. The ECB intervening to support the euro is not logical. Brooks stated that an effective tightening policy would not make sense.

(The author is a columnist at Reuters.

(By Jamie McGeever, Editing by Andrea Ricci

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