The ECB should be very cautious in tightening the monetary policy
During 2017, the euro has gained ground against several currencies. In the last 3 months, it has risen roughly 5 per cent against a basket of currencies. Notably, it has reached a two and a half year high against the dollar.
The appreciation of the single currency is due to three main reasons. The first one is the improved European context. The recovery of the euro zone has been stronger than expected, which makes investors think that the monetary stimulus might be reduced. Moreover, after the recent elections, the political risk seems to be diminished, thus reducing the fear of a disintegration of the single currency.
Secondly, the stimulus plan promised by Donald Trump during his campaign has yet to be put in place, and indeed is not even near passing Congress. After his victory last November, the markets expected more (nominal) economic growth due to the proposed tax cuts and infrastructure spending, therefore bringing the Fed to push up interest rates and causing an appreciation of the dollar. As such a plan is struggling to be put in place, the reverse mechanism is provoking an appreciation of the euro against the dollar.
The third reason can be found in the statements of the ECB. When Mr. Draghi talked about "reflationary forces" in a June speech, the euro rose as the markets saw in his words a possible reduction of the QE. In this regard, the ECB itself has subsequently specified it is in no rush to rein in QE, thus showing its worry about over-reactions of the markets to its statements.
This trend is sparking concerns among the ECB, since a strong euro risks to undermine the euro zone recovery and depress prices: it could dampen European exports and convert internal demand into more imports. All this happens at a very sensible time as the ECB might be tempted to diminish the QE, that is still the main support to the European growth: it could run out of eligible assets and inflation increased in the last period.
Nonetheless, the QE should not be reduced yet. In fact, the inflation target is "below but close to 2%", but too often it seems that the word "below" is more weighted than "close", as if a breach above to 2% were worse than one well below to 2% (below and not close to 2%). But this is not the case. After so many years of inflation excessively below to 2%, it is odd fearing a period slightly above to 2%, especially because it would benefit the economic growth.
Moreover, the ECB faces an asymmetric risk: if the tightening proves to be premature causing a recession and depressing prices, it has very little room to stimulate the economy again; instead, if it keeps unchanged the stimulus and inflation hits the 2%, it has infinite margin to slow it down.
The ECB should thus make it clear that the eligible assets will be exploited as much as possible and keep the doors open to a possible relax of its self-imposed rules on what it can buy, otherwise the usual statement that the QE will continue "beyond December if necessary" risks to be not credible. Finally, it should stress the fact that, besides the QE, the monetary policy is extraordinarily loose (just think about negative interest rates); on these other measures the ECB has no constraints and therefore, apart from QE itself, monetary policy is going to remain extremely accommodative for the medium term.
2017.08.20