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After nearly three years of asset purchases and negative interest rates, the European Central Bank has nursed the region back to health and raised inflation from anemic levels.
With the economy on the upswing, all signs point to reduced stimulus in 2018, but there’s one obstacle standing in the way: the U.S. dollar.
Driven by geopolitical risks and gridlock in Washington, the greenback has declined more than 13 percent against the Euro this year. This can be problematic for the ECB for a couple of reasons.
For one, when the Euro rises against the dollar, European exports become more expensive. Typically, this means that European companies will sell fewer goods overseas, which can hurt growth and exacerbate the need for accommodative policy. A rising Euro can also undercut the ECB’s inflation target. A strong currency makes imported goods cheaper for Eurozone residents, which hampers the central bank’s ability to hit its 2% inflation target.
Indeed, the ECB marginally reduced its expectations for inflation in 2018 and 2019 to 1.2 percent and 1.5 percent respectively. The central bank’s GDP forecast for 2017 was revised higher to 2.2 percent from 1.9 percent in June, while the projections for 2018 (1.8 percent) and 2019 (1.7 percent) remained unchanged.
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In his news conference last Thursday, Mario Draghi, the President of the ECB, noted that the bulk of the decisions regarding the asset purchase program would likely take place in October. The ECB has said it will continue its quantitative easing program by spending 60 billion Euros ($71 billion) a month in Eurozone bond markets at least through December, but has not commented on its plans for 2018. Draghi also reiterated that interest rates will be kept low for an extended period of time.
Despite its caution, the ECB is incrementally moving towards a less accommodative policy stance, with guidance on the timing and pace of withdrawal expected in the coming months. The tone of this guidance will be important as too strong a statement could cause markets to roil and interest rates to move higher.
We expect Draghi and the ECB to take a very measured approach, especially in the face of a strengthening currency.
Source: BCA, Bloomberg, NYT