The world's big four central banks are all in an unenviable position of fighting the highest inflation in decades without crashing their economies. From an exchange-rate perspective, the European Central Bank's is the most unenviable of all.
Think the Fed has it rough with inflation? The ECB has a weak euro to boot
The challenge facing the European Central Bank is compounded by the strength of the U.S. dollar.
By Jamie McGeever
July 9, 2022 at 12:00PM
The euro sank last Wednesday to a 20-year low against the dollar of $1.0165, less than 2 cents from the psychologically significant barrier of parity.
The euro has fallen more than 10% against the dollar this year. While the real effective exchange rate has weakened much less, its fall of just under 3% in April-June was its biggest quarterly loss in over seven years.
Exchange-rate weakness boosts inflation in the euro zone more than it does in many other major economies. World Bank figures show that euro zone imports as a share of GDP last year were a record 45.5%, compared with 28% in Britain. Comparable figures for Japan and the United States in 2020 were 15.8 and 13.3%, respectively.
Of course, this is offset by the weaker euro's boost to exports. But for a region that imported about 40% of its energy needs from Russia just before the war in Ukraine broke out, the terms of trade are deteriorating.
According to HSBC, a 10% fall in the trade-weighted euro adds around 1 percentage point to euro zone inflation after a year, while a similar rise in trade-weighted sterling adds 0.5 percentage point to U.K. inflation over the same period.
These rules of thumb tend to be better guides in more benign economic times, and relying on traditional economic models in the post-pandemic world is fraught with risk.
On the other hand, a flickering light may be better than no guiding light at all in such fog. The euro's rapid slide will be uncomfortable for the ECB.
"The euro is in a tricky position," notes Daragh Maher, head of Research Americas at HSBC.
No central bank wants a rapidly weakening exchange rate, but many are getting one, at least against the 20-year-high dollar.
The Bank of England faces acute 'stagflation' risk while the Bank of Japan has seen the yen plunge to a 24-year low against the dollar.
Even the dollar itself faces potential downward pressure in the coming months as U.S. recession fears eat away at Treasury yields and erode market expectations for higher interest rates.
McGeever is a columnist for Reuters.
about the writer
Jamie McGeever
Economists here came up with the concept of "rational expectations" that appear to have helped the U.S. cut inflation without a surge in unemployment.
