monetary policy

Draghi's Dilemma

  • Why it matters

    Why it matters

    The euro’s surge is complicating the process of unwinding the ECB’s ultra-loose monetary policy.

  • Facts

    Facts

    • The euro surged 13 percent against the dollar in the last five months and climbed on Tuesday abover $1.20, its highest level in over two years.
    • The ECB’s bond-buying program, purchasing €60 billion of state and corporate bonds per month, is due to wind down at the end of this year.
    • The strength of the euro has begun to affect European stock markets, with Germany’s DAX index down 8 percent since July.
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Mario Draghi
Magic Mario: Mr. Draghi kept his counsel on European monetary policy. Source: AP

On the German markets, Mario Draghi is sometimes called Mario the Magician. The name alludes to a Thomas Mann story, but above all to the European Central Bank (ECB) president’s ability to move markets with just a few words.

Or even by saying nothing at all. At the annual meeting of international central bankers at Jackson Hole, Mr. Draghi made no reference to the current strength of the euro. Investors took this as a sign the ECB was relaxed about the currency’s recent surge.

As a result, the European currency jumped some more, reaching a level of almost $1.20 on Monday and surpassing that symbolic mark on Tuesday, hitting its highest level in two and a half years. The euro has risen 13 percent since March, when it was worth just $1.05.

Analysts expect the trend to continue. A report from private bank Metzler predicts the euro will soon break the $1.21 barrier. BNP Paribas said it expected the euro to hit $1.30 in the next two years. It’s a far cry from even earlier this year, when many were predicting the euro could reach parity with the dollar.

“We believe it’s just a matter of time before the ECB reacts to developments on the markets and puts the brakes on the high-flying currency.”

Metzler Bank

The ECB’s reaction is seen as crucial, and perhaps overdue. “We believe it’s just a matter of time before the ECB reacts to developments on the markets and puts the brakes on the high-flying currency,” Mr. Metzler said. The ECB’s next meeting on September 7 will give a clearer picture of the bank’s position.

Mr. Draghi faces a dilemma. In the medium term, an overly strong currency will become a serious burden on euro zone exports. European goods and services will be more expensive on the world market and imports cheaper, pushing down inflation in the euro zone. To some extent this is exactly what Mr. Draghi wants. But only to a point — if it happens too suddenly, it could become a problem.

Most economists remain relaxed about the euro’s abrupt rise in the value. They see it as the result of economic and political fundamentals, rather than a wave of speculation. Emmanuel Macron’s victory in the French elections and Angela Merkel’s commanding lead in the German polls are seen as stabilizing after recent upheavals. But continued appreciation of the euro could risk lasting damage to the real-world economy.

Mr. Draghi must tackle this alongside the problem of ending the ECB’s ultra-loose monetary policy. Since early 2015, the bank has bought around €60 billion, currently $72 billion, of government and corporate bonds each month, in an effort to stimulate the European economy and counter the stubborn risk of deflation.

The so-called “expanded asset purchase program” was due to expire at the end of the year, but is expected to be extended from January 2018, albeit at a lower rate.

So far, the central bank’s stimulus program has helped drive growth. Collectively, euro zone countries are managing growth above 2 percent — their best performance in years. But inflation has remained obstinately low, and is expected to remain so for at least another year. That’s fueling calls for the current policy to be prolonged.

A further problem for Mr. Draghi is that tightening monetary policy is likely to lead to a rise in euro-zone interest rates. That in turn would push up the euro higher. In recent months, currency markets have become extraordinarily sensitive to Mr. Draghi’s words. In late June, he hinted that ECB bond-buying could be halted, and the euro surged on the markets.

Conversely, in August 2014, when Mr. Draghi first signaled plans for massive intervention in the bond markets, the euro slumped dramatically. By the time the bank actually bought its first bonds, the currency had already fallen 20 percent against the dollar. From there, it remained relatively stable. Experts felt the markets had already priced in the program’s effects.

Now, the situation is trickier because others factors are reinforcing the euro’s strength. Skepticism about President Donald Trump’s ability to drive US growth is pushing the dollar down on international markets. Yet another headache for Mr. Draghi.

The strong euro has also begun to impact Europe’s stock exchanges, as investors factor in downward pressure on corporate profits. The DAX, Germany’s leading stock market index, has fallen 8 percent since July, with Spain’s Ibex down 4 percent. Italy has fared better so far, its blue chip stock down less than 2 percent since the euro began its surge.

Mr. Draghi said little about the euro or monetary policy at Jackson Hole. But he was vocal on other matters, sending a clear message to the Trump administration on protectionism and isolationism.

Expansive monetary policy meant it was was essential to keep the financial industry on a tight regulatory leash, Mr. Draghi said. “There is never a good time for lax regulation…but when monetary policy is accommodating, lax regulation runs the risk of stoking financial imbalances.”

Ingo Narat is an editor with Handelsblatt’s finance section. Jan Mallien covers monetary policy for Handelsblatt in Frankfurt. Brían Hanrahan adapted the story for Handelsblatt Global. To contact the authors: mallien@handelsblatt.com, narat@handelsblatt.com

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