The European Central Bank seems to be increasingly concerned about the exchange rate of the euro, which has been rapidly appreciating against the US dollar over the summer. Rightly so, considering past experience, in particular the tightening cycle of monetary policy from 2005 to 2008).
When the ECB started raising rates in December 2005, for the first time after more than two years of constant rates, the exchange rate with the dollar was slightly below 1.20, much the same level as today. The US Federal Reserve had started tightening 18 months earlier (in June 2004) with a series of gradual rate increases (from 1.00 per cent to 4.25 per cent), but this did not substantially affect the exchange rate.
The euro started rising after the first ECB moves, reaching in the following two years a level close to 1.50. It approached 1.60 in the spring of 2008, as the Fed inverted its policy while the ECB continued to raise its interest rates. Overall, during this tightening cycle the euro appreciated by around 30 per cent.
History seems to be repeating itself. As the Fed started tapering and then raising rates, for the first time at the end of 2015, the euro-dollar oscillated around 1.10, but as soon as the ECB signalled the possible slowdown of its asset purchase programme, the exchange rate jumped to 1.20 in less than three months.
It is not difficult to imagine the direction the euro will move when more concrete steps are taken to stop the purchases and then to start raising interest rates again.
In fact, there may be reasons to think that the euro might appreciate even faster than in the previous cycle. First, while in 2004-2006 the Fed raised rates 17 times — from 1.00 per cent to 5.25 per cent — at a regular and gradual pace, this time rates have been raised only three times — possibly four if the expected increase in December materialises — in nearly two years. Markets are forecasting only one further rise by the end of 2018. The US pace of tightening thus seems to be much slower than in the previous cycle, although this is partly dictated by the low-inflation environment.
Second, the eurozone current account is in surplus, by about 3 per cent of gross domestic product, while in the mid-2000s it was in overall balance. Most forecasts do not show a major change for the next few years. This produces an additional demand for the currency in the order of €350bn a year, which exerts further upward pressure.
Third, the ability of the eurozone to address, at least in part, the weaknesses of the institutional framework of the monetary union and the defeat of populist parties in recent elections, has strengthened the safe-haven characteristics of the single currency, as experienced during the North Korean crisis with the euro strengthening against the dollar.
An excessively sharp and rapid acceleration of the euro would cause the ECB concern for several reasons.
It would put direct downward pressure on inflation, making it more difficult for the central bank to achieve its objective, defined as a rate of inflation below but close to 2 per cent over the medium term.
It would have a negative effect on economic activity, which is gradually strengthening but barely back to the pre-crisis level and lagging behind the US recovery. This would put further downward pressure on eurozone price developments.
It would also lead the ECB to prolong its extraordinarily accommodative policy measures, characterised by negative interest rates and government bonds purchase, which both have technical implementation problems and collateral effects, in particular on the financial system.
A final problem is the inherent dynamics of the foreign exchange markets. As shown in the past, exchange rate movements tend to be unrelated to underlying fundamentals for quite a long time, as central banks are not fully equipped to counter self-fulfilling short-term markets developments.
The latter partly depends on co-operation between the monetary authorities of the major economic areas, which is complicated by the different institutional set-up across the Atlantic. While in the eurozone responsibility for the external value of the currency is shared between the ECB and the eurogroup president, in the US the Treasury is ultimately in charge of the exchange rate of the dollar.
The ECB has good reason to be concerned.
The writer is a former member of the executive board of the European Central Bank and currently visiting scholar at Harvard’s Weatherhead Center for International Affairs and at the Istituto Affari Internazionali in Rome