The current weak euro exchange rate threatens the European Central Bank’s efforts to steer inflation back to its long-term 2% target, said François Villeroy de Galhau, a member of the ECB’s Governing Council and the Governor of the French Central Bank.
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At the end of last week, the single European currency was the lowest against the dollar since 2017. The weak euro makes dollar-denominated imported goods and commodities more expensive – such as oil – boosting price pressures that have already driven euro area inflation to a record 7.5 percent. thus well above the ECB’s long-term target.
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“I would like to emphasize that we will closely monitor the development of the effective exchange rate, which is a significant driver of imported inflation. Too weak a euro would run counter to our goal of price stability, “Villeroy de Galhau told a French central bank conference on Monday.
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Villeroy de Galhau added that a “decisive” meeting of the ECB’s Governing Council could be expected in June, followed by an “active summer” in the field of monetary policy. According to him, it should at least move towards neutral tuning, which will not further stimulate the economy, but also slow it down.
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The ECB’s deposit rate is currently -0.5 percent, which means that banks are charged a fee for depositing available funds with the central bank. The main interest rate then remains at a record low of zero percent.
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According to economists, the European Central Bank is on thin ice. It must tighten monetary policy so as to curb record inflation, but at the same time not cause economic damage that could affect the most indebted Member States in the region, such as Italy.
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Raising since summer
The ECB should start raising rates and fighting inflation this summer, as its member Villeroy de Galhau said last week. The head of the European Central Bank, Christine Lagarde, and other central bankers also expressed a similar opinion. According to Bloomberg, market bets indicate an increase in the ECB’s key interest rate by one percentage point this year.
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At the same time, several bankers indicated that they were in favor of raising interest rates at the July meeting, mainly due to the rapid rise in inflation. It remains well above the ECB’s 2% target, which was also above inflation in April, excluding the impact of high energy and food prices.
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For the time being, the central bank has left its monetary policy unchanged last month. Its boss, Christine Lagarde, said last week that the ECB was likely to end its bond-buying program in early Q3 and could start raising interest rates a few weeks later. It strengthened market expectations that the ECB would raise interest rates for the first time in more than a decade in July.
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Most other major central banks have already increased their borrowing costs, including the Czech National Bank, which raised the key interest rate to 5.75 percent in early May, the highest level in more than 20 years.
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Parity after 20 years?
As already mentioned, the European Central Bank is not playing a weak card with the euro, which reached a five-year low against the dollar at the end of last week. The US currency benefits, among other things, from its position as a safe haven in times of geopolitical uncertainty. The dollar is also fueled by the US Federal Reserve’s rate hike.
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On the contrary, the value of the European currency is undermined by the uncertainty surrounding Russian gas supplies. At the same time, the outlook for the European economy is deteriorating. The ongoing dispute with Moscow over the supply of natural gas to the continent may slow down economic growth, as predicted by the International Monetary Fund.
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The current situation thus leads some banks to predict that both currencies will reach parity this year. That is, one euro will cost one dollar. Large funds also expect a further decline in the euro towards parity. In the last month alone, their bets on a further weakening of the euro have risen to seven billion dollars.
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EUR / USD is approaching parity.
“The euro itself is not currently an attractive currency,” Francesco Pesole, ING Bank’s monetary strategist, told Bloomberg. Although the Dutch bank keeps its official forecast for the euro at the level of 1.05 EUR / USD for the next six months, Pesole admits that, given the strength of the dollar and market volatility, parity is likely to be reached.
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However, not all views on the further development of the euro are negative. Roberto Mialich, UniCredit’s monetary strategist, expects the euro to climb back above 1.10 EUR / USD next year as the Fed’s rate hike cycle comes to a halt.
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“I see a scenario of a permanent fall below parity only as a side risk, which is likely only if economic growth in the euro area falls much more than expected,” says Mialich.
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However, as long as risky assets are under pressure due to current geopolitical conditions, traditional refuges, such as the US dollar, will be preferred among investors, experts estimate. The war in Ukraine thus remains the main “headwind” for the euro, especially given the prospect of further gas supply disruptions.
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