Why Europe’s Central Bank Shouldn’t Worry About the Euro

Confidence comes with a catch. Photographer: Horacio Villalobos/Corbis via Getty Images

The European Central Bank has spent much of this decade convincing markets that the euro is irreversible. It is therefore mildly ironic that policy makers in Frankfurt may be in trouble because of the sudden return of confidence in the single currency.

Investors flocking to the euro have pushed it above $1.20, a 14 percent appreciation since the start of the year. The risk is that, by making imports cheaper, a stronger single currency will make it harder for the ECB to hit its inflation target, undermining the central bank’s plans for a smooth exit from its program of quantitative easing.

Mario Draghi, ECB president, acknowledged this risk during his press conference on Thursday when he said that the “volatility” of the exchange rate “represents a source of uncertainty.” He was right, however, not to go further. The central bank targets inflation, not the exchange rate. Obsessing about the level of the euro means failing to understand that the strength of the currency can have different causes — some of which are way less worrisome than others.

The recent appreciation of the euro is the result of two positive developments. The first is a sharp reduction in the risk that the single currency may disintegrate, following the defeat of euroskeptic candidates in the Dutch and French elections at the start of this year. The second is an unexpected improvement of the growth prospects of the euro zone. The ECB yesterday raised its growth forecasts to 2.2 per cent this year. Both these factors make investors more willing to hold assets denominated in euros, contributing to the strength of the currency.

It would be very short-sighted for the ECB to react to this appreciation by ditching its plans for a gradual exit from QE. The exchange rate is only one element in the composition of inflation, which is what policy makers must ultimately care about. To the extent that a stronger euro signals robust domestic demand, policy makers must watch out for a return of inflationary pressure.

The ECB must also be careful about its role in the international economy. The last thing policy makers should do is to keep the euro artificially low while the economy is expanding. The recent appreciation of the euro against the dollar is telling us that investors are becoming more confident of the prospect for the euro zone economy vis-à-vis the U.S. It is only right that the U.S. enjoys the benefits from a cheaper currency — including more competitive exports.

The ECB must therefore only concentrate on inflation. Of course, there may be reasons to worry about it. The central bank trimmed its inflation forecasts Thursday, showing price pressures are still far from its objective just below 2 percent. This calls for prudence in the unwinding of the monetary stimulus.

However, if there is anything that should worry Draghi and his colleagues, it is not the euro but their ability to react to weakening price pressures. The central bank is operating under a self-imposed set of constraints on how many sovereign bonds of each euro zone countries it can purchase. Some of these limits — for example the ceiling on how many German bunds the ECB can buy — will start to bite sometime next year. Ensuring there is sufficient flexibility in the conduct of monetary policy is more important than worrying about a flexible exchange rate.


Europe Has No Bubbles to Fear

Talk to critics of the European Central Bank’s ultra-loose monetary policy and a common theme emerges: concern about financial stability. Quantitative easing is seen as creating dangerous asset bubbles. Negative interest rates are said to hurt bank profitability, making the financial system more vulnerable to shocks.

These concerns are widely misplaced. In fact, the real worry should be the risks that arise from ending monetary stimulus too soon. A premature tightening could cause euro zone government bond yields to spike, raising doubts over debt sustainability in the weakest member states.

There is little evidence so far that the measures the ECB has implemented to lift inflation and revive growth have had any dangerous side effects for financial stability. The Bundesbank has warned that the ECB’s unorthodox monetary policy has pushed up property values in Germany, adding that house prices in some German cities are now overvalued by up to 30 percent. However, while property prices may be climbing fast in some parts of the euro area, the increases are well in line with long-term valuations. When they are not — for example in the case of prime commercial real estate — the increase does not seem sufficiently widespread to threaten a financial crisis.

A second fear relates to negative interest rates. Instead of paying banks interest on their extra reserves, the ECB now charges banks a rate of 0.4 percent for storing their money. Some central bankers, such as François Villeroy de Galhau, governor of the Bank of France, are now warning against this policy, which they fear is eating too deeply into the profitability of the banks.

Still, the evidence that negative rates are hurting the banks is flimsy. True, between June 2014 and September 2016, the ECB’s monetary policy reduced the margin between deposit and lending rates for the median bank by 1 percentage point. However, only a quarter of this effect can be attributed to negative rates, according to the central bank’s own calculations. Meanwhile, the ECB’s easing package has delivered other benefits, for example improving the quality of credit by reducing the risk of default. The overall impact on the profitability of banks appears negligible. A much bigger challenge for banks — in Germany and elsewhere — is to adapt to the digital revolution, cutting costs and finding new revenue streams.

For now, the continuation of the ECB’s stimulus does not pose particular risks to financial stability. Its premature removal, however, would. As the latest issue of the ECB’s Financial Stability Review has shown, stress in the euro zone sovereign bond market has increased around the turn of the year. On aggregate, government debt for the currency area stands at around 90 percent of gross domestic product, which is high by historical standards. An increase in sovereign risk could have an impact on debt sustainability for the most vulnerable countries, such as Italy or Portugal, where debt is around 130 percent of GDP. And since many banks still hold large quantities of domestic government bonds, these tensions could easily spread to the financial system.

These risks suggest that the ECB should err on the side of caution when it withdraws its stimulus. Luckily, the central bank can afford to be patient: the inflation rate in the euro area — once stripped of its more volatile components — is still well below the central bank’s target of just below 2 percent. Unemployment remains high; the recovery has further to go before putting pressure on wages.

But there are risks that are beyond the control of the ECB. The most important one is the divergence between countries in the euro area. Mario Draghi, ECB president, has made it clear he will not withdraw the monetary stimulus unless the pickup in inflation is broadly spread across the currency union. However, it is possible that the recovery will be faster in some countries than in others. When the ECB chooses to wind down QE and raise rates, the most vulnerable member states could face an exceedingly tight monetary policy. This could spook investors, raising fears over debt sustainability.

With a one-size-fits-all monetary policy, the ECB is poorly equipped to deal with possible financial turmoil in one or a handful of countries. Governments must do their bit, keeping debt levels in check and seeking higher rates of growth. While the ECB can do a lot to preserve financial stability, it cannot act alone.

Bloomberg View