Sunday, October 24, 2010

ECB: Q&A on the impact of a strong euro on the ECB strategy

ECB: Q&A on the impact of a strong euro on the ECB strategy

  • The ECB has sounded relatively relaxed about currency appreciation, and will likely continue its liquidity normalization process by discontinuing the full-allotment at 3M LTROs in December.
  • What matters for eurozone growth prospects is the tradeweighted euro, and not the bi-lateral EUR-USD exchange rate. However, we think that a 1.50 EUR-USD exchange rate could be seen as the line in the sand for ECB verbal intervention.
  • In general, recent developments have shown that the ECB and the Fed have completely divergent views on the role of monetary policy in the aftermath of the crisis. This supports our view that the ECB this time will be able to “decouple” and start raising rates before the Fed.

Too early for the ECB to talk down the euro

Q: The ECB has sounded relatively relaxed about currency appreciation. Is this posture justified?
A: Yes, at least for the time being. Some back-of-the-envelope calculations suggest that recent euro strength should not jeopardize the central bank’s moderate recovery story, although it is likely to suffice to force the ECB to lower moderately its 2011 GDP forecast at the December meeting. Back in September, the central bank projected 1.4% GDP growth next year with slight downside risks, implicitly assuming that the euro nominal trade-weighted index (TWI) would remain constant throughout the forecast horizon at the level
of 103.05 – the average of the ten trading days ending on the cut-off date of August 13. On October 6, the day before Trichet’s press conference, the euro TWI was 2.7% higher than that. Based on our own estimates, this implies a mechanical drag of about 0.2pp on 2011 GDP growth. This relatively small impact explains why the ECB is not willing to talk down the currency at this stage, and why in the introductory statement a “disorderly correction of global imbalances” remained in the last position of the list of possible downside risks to growth.

However, it is clear that the ECB sees recent euro strength as unwelcome, both because the upward leg has been too fast and because it has occurred at a juncture when exports remain the eurozone’s main growth engine.

Given that euro appreciation is largely the result of the Fed’s move towards QE2, which the ECB judges as unwarranted, it is unlikely that in Frankfurt recent euro strength is seen as reflecting fundamentals. At the time of writing, the euro TWI trades at 106.75.

Q: Can a strong euro delay the ECB’s liquidity normalization process?
A: Probably not, and Trichet seemed to confirm this view at the last press conference. The rationale is that the current framework for liquidity provision is engineered mainly to address the pockets of weakness of the financial sector, and not to give an extra lift to GDP growth, although it’s clear that eurozone banks would benefit from a stronger growth environment.

Accordingly, what will dictate the timing of the exit from non-standard tools is the liquidity need of the eurozone financial sector as a whole – which continues to gradually decline – and the reliance on ECB funding of financial institutions in peripheral countries. Here, we recently had some positive news, with Spain, Greece and Portugal reporting a decline in central bank funding in September, and only Ireland recording a further increase (EUR 119bn vs. EUR 95.1bn). On balance, with shrinking excess liquidity in the system and interbank rates slowly drifting upwards in response to lower refinancing needs, we keep thinking that the ECB can afford to discontinue the full-allotment at 3M LTROs at the December meeting, and resume a pre-crisis framework for refinancing operations around mid-2011.

Q: Can a strong euro delay the timing of the first ECB rate hike?
A: Yes. Excessive currency strength (i.e. strength that doesn’t reflect fundamentals) impacts directly the growth/inflation outlook, and therefore the ECB’s reaction function. Our call for a first rate hike at end-2011 remains on track, but we monitor FX developments very closely. This is because further significant euro appreciation, besides lowering appreciably the eurozone GDP path for next year, risks increasing growth
divergence within the area, given that core countries perform better than peripheral countries in terms of non-cost competitiveness, and higher profitability leaves firms in core countries with more room to absorb adverse FX moves.

Large intra-area growth dispersion at a time of generalized GDP slowdown is obviously not good news for the ECB, because it may eventually lead to renewed tensions on sovereign spreads in the most vulnerable countries.

Full report: ECB: Q&A on the impact of a strong euro on the ECB strategy

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