# Analysis-Euro’s 20-year low leaves ECB facing costly choices
Author:  Pal Sinha, Barnali 
Author URL: https://financedigest.com/author/pal-sinha-barnali
Published: 2022-07-07
Category: NEWS
Category URL: https://financedigest.com/category/news
Meta Title: Euro's Tumble Impact on ECB & Economy
Meta Description: The ECB faces tough choices as the euro nears parity with the dollar, with fears of inflation rising and possible recession looming.
URL: https://financedigest.com/analysis-euros-20-year-low-leaves-ecb-facing-costly-choiceshtml

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By Balazs Koranyi and Francesco Canepa

FRANKFURT (Reuters) – The euro’s tumble towards parity against the dollar has pushed the European Central Bank back against a wall, leaving its policymakers with only painful and economically costly choices.

Letting the currency fall would push up already record high inflation, raising the risk of price growth becoming entrenched at a rate well above the ECB’s target of 2%.

But [fighting back](https://www.financedigest.com/2016-the-fight-back-of-the-established-brand.html "2016 – THE FIGHT BACK OF THE ESTABLISHED BRAND") against 20-year lows for the euro would require more rapid interest rate hikes, which could add to the misery for an economy already facing a possible recession, looming gas shortages and sky-high energy costs that are depleting purchasing power.

The bank has so far played down the issue, arguing that it has no [exchange rate](https://www.financedigest.com/currency-exchange-how-to-find-the-best-rates.html "Currency Exchange: How to Find the Best Rates") target, even if the currency does matter. Even the accounts of its June [policy meeting](https://www.financedigest.com/opec-abandons-oil-policy-meeting-after-saudi-uae-clash.html "OPEC+ abandons oil policy meeting after Saudi-UAE clash") published on Thursday indicated no particular concern. But the [market moves](https://www.financedigest.com/these-days-tik-tokers-can-move-markets-more-than-investment-analysts.html "These days Tik-Tokers can move markets more than investment analysts…") are now too big to play down.

The [euro’s weakness reinforces the notion that the ECB](https://www.financedigest.com/stocks-euro-gain-amid-divergent-fed-ecb-rate-hike-outlooks.html "Stocks, euro gain amid divergent Fed, ECB rate hike outlooks") is behind the curve,” Dirk Schumacher, head of European macro research at Natixis CIB, said. Given how high inflation is, a stronger [euro would be quite helpful because it lowers inflation.”](https://www.financedigest.com/euro-zone-inflation-seen-just-above-ecbs-target-in-2025-poll-shows.html "Euro zone inflation seen just above ECB’s target in 2025, poll shows")

The [euro is now down 10% against the dollar](https://www.financedigest.com/euro-rises-after-spanish-cpi-dollar-slips-towards-8-mth-low.html "Euro rises after Spanish CPI, dollar slips towards 8-mth low") this year, even if the trade-weighted currency has only dropped 3.3% so far.

This raises the [cost of imports](https://www.financedigest.com/german-gas-import-costs-surge-153-in-first-half-as-imports-drop-24.html "German gas import costs surge 153% in first half as imports drop 24%"), especially for energy and other dollar-denominated commodities, making everything more expensive. Studies frequently cited by the [ECB suggest that a 1% depreciation of the exchange rate](https://www.financedigest.com/fed-rates-up-boe-up-ecb-up-stocks-up.html "Fed rates up, BoE up, ECB up, stocks up") raises inflation by 0.1% over one year and by up to 0.25% over three years.

MORE WEAKNESS?

The [problem is that economic fundamentals point to even more euro](https://www.financedigest.com/uk-has-bigger-inflation-problem-than-us-or-euro-zone-boes-mann.html "UK has bigger inflation problem than US or euro zone – BoE’s Mann") weakness.

Firstly, the ECB and the U.S. Federal Reserve are moving at vastly different speeds.

While Fed Chair Jerome Powell has made clear he was willing to risk a recession with oversized [rate hikes to bring down inflation](https://www.financedigest.com/german-inflation-rate-to-ease-over-course-of-2023-econ-minister.html "German inflation rate to ease over course of 2023 – econ minister"), the ECB continues to take baby steps in unwinding the exceptionally easy policy of the past decade, when inflation was too low.

It will raise rates for the first time this month but expects to [lift](https://www.financedigest.com/shares-steady-dollar-dips-as-us-holiday-lifts-rates-gloom.html "Shares steady, dollar dips as US holiday lifts rates gloom") the deposit rate out of negative territory only in September, with any further move clouded by recession risks.

The euro zone’s outlook has soured so much since mid-June that one rate hike has been [priced out and markets now see just 135 basis points of tightening from the ECB](https://www.financedigest.com/explainer-oil-price-surge-changes-ecb-narrative-only-at-the-margins.html "Explainer-Oil price surge changes ECB narrative only at the margins").

The Fed, which has already [raised rates](https://www.financedigest.com/boe-raises-rates-again-as-investors-look-towards-end-of-hikes.html "BoE raises rates again as investors look towards end of hikes") several times, including by 75 basis points last month, is expected to increase them by another 180 basis points.

That gives investors [higher profits](https://www.financedigest.com/polish-e-commerce-firm-allegro-eyes-higher-q1-profit.html "Polish e-commerce firm Allegro eyes higher Q1 profit") on the other side of the Atlantic, so they are moving cash out of Europe and weakening the euro in the process.

Secondly, the [euro zone’s](https://www.financedigest.com/euro-zone-recovery-gathers-pace-allays-fears-of-recession-pmi.html "Euro zone recovery gathers pace, allays fears of recession-PMI") huge energy dependence, primarily on Russian gas, also makes the economy more vulnerable to the fallout of the war in Ukraine, a natural drag on the currency.

Faced with the looming risk of recession – and the euro being a pro-cyclical currency – the [ECB”s hands may be tied in its ability to threaten more aggressive rate hikes](https://www.financedigest.com/big-ecb-hike-adds-fuel-to-the-banking-sector-fire.html "Big ECB hike adds fuel to the banking sector fire") in defence of the euro,” ING said in a note to clients.

Finally, the bloc’s [energy bill has pushed](https://www.financedigest.com/energy-bill-support-pushes-uk-budget-deficit-to-february-record.html "Energy bill support pushes UK budget deficit to February record") up import costs, leaving it with a rare current account deficit. Such outflows also weaken the [currency over time](https://www.financedigest.com/how-to-use-algorithms-to-save-time-and-make-money-when-trading-currency-crypto-shares-etc.html "How to use algorithms to save time and make money when trading (currency, crypto, shares etc)").

Since each of 19 [euro zone](https://www.financedigest.com/big-fall-in-euro-zone-inflation-offers-little-help-for-ecb.html "Big fall in euro zone inflation offers little help for ECB") countries are impacted differently, consensus on any push back is also likely to be difficult to achieve.

To prop up the euro, the [ECB could signal](https://www.financedigest.com/dutch-governor-knot-signals-ecb-will-keep-raising-rates-in-months-ahead-ft.html "Dutch governor Knot signals ECB will keep raising rates in months ahead- FT") more aggressive policy tightening, including a 50 basis-point hike in September, and further moves in October and December.

But since markets already expect these steps, the [ECB must also at least in part match the Fed’s message that getting inflation](https://www.financedigest.com/no-messing-around-with-red-hot-inflation-five-questions-for-the-ecb.html "No messing around with red-hot inflation: Five questions for the ECB") down trumps all other priorities, even if that means reinforcing a recession.

Such a message, even if euro-positive, would likely fuel a selloff on the currency bloc’s periphery, setting off [debt sustainability concerns](https://www.financedigest.com/european-shares-weighed-by-us-debt-ceiling-concerns-slide-in-financials.html "European shares weighed by US debt ceiling concerns, slide in financials").

So the ECB must also roll out its already flagged bond-buying scheme aimed at limiting the [rise in borrowing costs](https://www.financedigest.com/suedzucker-quarterly-profits-surge-73-5-despite-cost-rise.html "Suedzucker quarterly profits surge 73.5% despite cost rise") for Italy, Spain, Portugal and Greece.

Spoiler: yes, parity is in play,” [Deutsche Bank’s](https://www.financedigest.com/deutsche-banks-rollercoaster-ride-towards-more-stability.html "Deutsche Bank’s rollercoaster ride towards more stability") Jim Reid said.

(Reporting by Balazs Koranyi and Francesco Canepa; Editing by Hugh Lawson)


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