The euro and the European Central Bank’s relationship status: It’s complicated.
The currency leapt last week after ECB president Mario Draghi used his post-rates-decision press conference to express only measured alarm at the potentially inflation-denting rally in the euro – a green light to some for further gains.
Clearly, though, the central bank is not indifferent to the exchange rate.
In a detailed speech today that referred to the exchange rate no fewer than 48 times, board member Benoît Cœuré said “simple eyeballing” of the level of the euro, set against inflation, would suggest “a pass-through of around 40%”. The relationship, however, is not so simple, he said, suggesting that on this occasion, the economy can likely take the strain:
There are occasions when euro area core inflation rises, rather than falls, following an exchange rate appreciation – which is entirely at odds with our traditional thinking on the pass-through. Perhaps unsurprisingly, this is typically the case when the exchange rate appreciates in response to a favourable demand shock. The logic is as follows: as the economy operates above capacity, inflationary pressures emerge that are sufficient to fully offset the disinflationary effects coming from the exchange rate channel.
These examples demonstrate that it is by and large the state of the economy that will determine the strength of the pass-through. Monetary policy, for its part, is likely to influence the pass-through predominantly through its impact on the economy itself.
The end result:
With policy being effective in boosting growth, any disinflationary effect of a stronger currency arising from expectations of a tighter future monetary policy stance might be mitigated, or offset, by the ensuing improvement in the economic outlook. However, exogenous shocks to the exchange rate, if persistent, can lead to an unwarranted tightening of financial conditions with undesirable consequences for the inflation outlook.
Frederik Ducrozet at Pictet Asset Management said the comments suggested the central bank sees the potential damage from the rising euro as “manageable“.