By Saikat Chatterjee and Dhara Ranasinghe

LONDON (Reuters – The euro fell as much as 4% against both the dollar and Swiss franc within two weeks, raising questions about what – if any – the European Central Bank can do to stop it.

In normal circumstances, weakness of the Euro would be welcome by an export-dependent country that long has had difficulty meeting a 2% inflation goal. The policymakers must not ignore it in times of rising inflation to 5% plus, record energy costs, and Russia-linked economic growth.

The decline in currency strength is due primarily to the decreasing likelihood of an ECB interest-rate rise. Investors will be curious to know how much policymakers are prepared to take it.

After Monday’s pledge by the Swiss National Bank to reduce franc strength, the ECB is now focusing on what the ECB has to say. While the SNB often intervenes to purchase euros or dollars, the SNB hasn’t interacted verbally since 2016.

According to analysts, Thursday’s ECB announcement may include a reference to monitoring exchange rates. This line has been missing in recent months. The statement could signal that rates hikes are still possible. Many suggest that there may be direct currency intervention, which is a rare possibility.

A note entitled “The ECB must intervene in,” contains the following: Deutsche Bank (DE) George Saravelos was the global currency strategist at George Saravelos. He claimed that depreciation of euro is already causing economic damage through the import price channels.

Saravelos stated that the single best way to reduce inflationary pressures within the Euro zone is through a stronger currency. He also added, “the more oil we push higher, and the euro drops further, pushing commodities in euros higher. This creates a vicious inflationary cycle.”

This year has seen a flurry of price increases in commodity markets, hitting 14-year-highs at $140 a barrel and a record high of approximately 128 euro per barrel.

Graphic: oilpriceeuros: https://fingfx.thomsonreuters.com/gfx/mkt/zjpqkodlkpx/oilpriceeuros.JPG

European gas prices are up 15% this year. Some project that they will go up by a third to 300 euro per megawatt hour.

The annual euro area inflation reached a record 5.8% during February. Meanwhile, energy inflation stood at 31%. Citi predicts Brent’s most recent spike will bring 0.3 percent to the Harmoned Index of Consumer Prices (HICP), in March and April, while gasoline prices will rise 0.4 percentage points over the following year.

Saravelos believes FX intervention is unlikely, but he doesn’t rule out coordinated action involving G7 central banking if “things go disorderly”.

He suggested that interest rates be raised to 0%, from the current rate of -0.5%, and that bond-buying increases are the best options.

Graphic: eurotradeweighted: https://fingfx.thomsonreuters.com/gfx/mkt/dwvkrlqmgpm/eurotradeweighted.JPG

INTERVENTIONS

Many central banks are concerned about currency market turmoils. At least a few, including South Korea and Poland, have intervened to stabilize exchange rates.

The ECB has repeatedly stated that it doesn’t target the forex rate. It hasn’t intervened since 2011 when it was part of a coordinated G7 effort, to lower the yen after the Fukushima earthquake and disaster.

The last time it intervened alone was in 2000, when seven rounds of euro-buying totaling 10 billion euros were conducted to support the currency shortly after its launch.

The possibility that the exchange rate pass-through to inflation (ERPT), may have decreased may explain why there has been some reluctance. A paper by the ECB published in September estimated the ERPT related to import prices outside of the bloc at 0.3%. This is compared with 0.8% in 1999.

According to the paper, while an average 1% Euro depreciation increases import prices by 0.3% per year, headline HICP rises around 0.04%.

Aaron Hurd (senior portfolio manager for currency), stated that the current economic environment must worsen and that currency needs to plummet faster in order to allow them to intervene. State Street (NYSE:) Global Advisors.

For the ECB’s intervention, he believes the euro must fall to parity with the dollar – a further 8% decline.

A significant intervention is required to change the currency. According to a Bank of England study, daily turnover in euro dollars was approximately $770 billion by October 2021 in London.

Analysts at ING Bank also don’t consider the euro to be “screamingly overvalued”. They attribute its decline to differing rate-hike expectations from the Fed and large outflows of equity markets.

The ECB might talk about monitoring the exchange rate, but it may not go further. It may “introduce the idea that the ECB could consider supporting the currency if it falls further,” it stated.

According to the bank, a second shock in energy prices could lead to the currency falling towards 2020’s lows of around $1.0640.

(1 euro = $1.0964)

Graphic: chfueurointervention: https://fingfx.thomsonreuters.com/gfx/mkt/klpykbjoxpg/chfueurointervention.JPG