Now that the U.S. Federal Reserve seems ready to embark on rate liftoff, the conventional wisdom is that the expected increase in the U.S. dollar makes the argument for a new European Central Bank monetary stimulus less compelling.
But the opposite is closer to the truth.
As the dollar increases, so does the real burden of dollar-denominated emerging market debt — it costs more local currency to make dollar-denominated interest payments – while capital flight makes it harder for emerging economies to refinance the debt.
The ECB didn’t start the currency war, but it’s good to see it is fighting back.
The recent rise of the dollar already is turning emerging economies into submerging ones, deteriorating the global market for euro-zone exports and making a robust additional monetary stimulus that much more attractive for fighting euro-zone sluggish inflation.
A new ECB monetary stimulus can be thought of as a kind of insurance policy against the expected feedback on Europe of a slowdown of emerging markets caused by a rising dollar.
A new insurance policy might not be needed if the ECB leadership felt secure that the credibility of its inflation mandate was undoubted.
But euro-zone inflation has been so far below target for so long, it probably is wise for the ECB to reassure markets it intends to stay the course – especially when the Federal Reserve’s monetary policy is turning more restrictive.
That’s what motivates the expected extension of QE asset purchases past the current September 2016 cutoff date — to give markets ‘forward guidance’ that the ECB intends to continue its low interest-rate policy for some time to come.
It’s a way for the ECB to signal the de-coupling of its monetary policy from that of the Federal Reserve.
But signaling longer-term policy intentions may not be enough to maintain ECB credibility at a time when the euro is too high and euro zone inflation too low for too long.
There is a new uneasiness in Frankfurt that despite reasonable recent economic data from the euro zone, a blow to ECB credibility (a sharp fall in inflation expectations perhaps) could be in the offing unless something is done very soon to quicken the pace of euro-zone inflation.
The Germans on the ECB’s governing council (ECB Executive Board member Sabine Lautenschlager and Bundesbank President Jens Weidmann) may want to wait before a new stimulus is administered.
But ECB President Mario Draghi is not going to take unnecessary risks with the family jewels — and who can blame him.
Time no longer is on the ECB’s side.
The most likely candidate to speed inflation is a cut in the ECB’s deposit rate, sending it further into negative territory.
A deposit rate cut can be thought of as the equivalent of an increase of a tax on member banks’ idle funds held overnight at the central bank. The implicit tax gives member banks an incentive to put idle funds to work and some of that money will go abroad, putting downward pressure on the euro.
The reason I believe the ECB will cut the deposit rate next month is that there is a growing consensus in the governing council that getting the euro down is the only channel that works to speed inflation and recovery — and cutting the deposit rate is essentially a politically-convenient, disguised intervention in the exchange markets to lower the euro.
The deposit rate already is a favored means of currency intervention in several European countries.
The central banks of Sweden, Switzerland and Denmark all have deposit rates deep in negative territory to prevent appreciation of the currencies against the euro.
Old wine in new bottles! Across Europe, the deposit rate is fast becoming the modern manifestation of the old beggar thy neighbor policy gambit of currency devaluation.
The ECB didn’t start the currency war, but it’s good to see it’s fighting back.
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