Why the ECB’s jumbo rate hike isn’t helping the losing euro

The European Central Bank went ahead on Thursday, marking a historically outsized 75 basis point interest rate hike in its bid to control record inflation. However, the euro, after a brief recovery, soon fell, falling below par to settle at less than $1 against the US currency.

What gives?

Blame it on the energy crisis that is fueling rising eurozone inflation and looks set to send the eurozone economy into recession.

“Concerns about the prospect of a recession due to Europe’s natural gas supply constraints should continue to outweigh the euro (euro) benefit from monetary tightening, and while growth prospects remain superior for the US in the second half of 2022,” Thierry Wizman, global head of FX and rates strategy at Macquarie, said in a note.

The euro EURUSD,
fell 0.7% to $0.9949, not far from a near 20-year low below $0.99 earlier this week.

A weak euro worsens the inflation picture, making imported goods more expensive for eurozone shoppers. “The depreciation of the euro has also added to the build-up of inflationary pressures,” ECB President Christine Lagarde noted at a press conference.

Lagarde stressed that the ECB does not — and will not — aim for a specific euro exchange rate, but said the effect of the weakened currency on the economy has been noted by policymakers.

“What is interesting is that the ECB is starting to focus on the euro as a source of imported inflation, when previously it was implicitly focusing on a competitive devaluation,” Sebastien Galy, senior macro strategist at Nordea, said in a note.

Lifting the euro would be a difficult task for the ECB, he said, in a context where the spread between US and eurozone interest rates is too narrow to shake a market that has already “bullied” into long dollar bets, he said. Galy. .

Indeed, the US dollar is on a roll against its major rivals, trading this week at its strongest since 1998 against the Japanese yen USDJPY,
and a 35-year high against the British pound GBPUSD,

“What the ECB needs is to convince the market that it wants a strong euro without offering too many rate hikes. As the euro level is inherently volatile due to large dollar positions, we could over a period of months see a spike in volatility, although range trading is more likely in the coming weeks,” Galy wrote.

In a statement, the ECB’s Governing Council said more rate hikes were likely in response to inflation remaining “very high” and “likely to remain above target for a long time.”

Analysts had debated whether the ECB would raise interest rates by 50 basis points or 75 basis points. The decision means that the ECB’s deposit facility rate will rise from 0% to 0.75%, while the main refinancing rate will rise to 1.25% and the marginal lending facility rate to 1.5%. The move is the largest since the 75 basis point move in 1999, which was aimed at stabilizing the newly launched single currency.

Thursday’s move follows a 50-basis-point hike in July and echoes excessive moves by other major central banks, including the Federal Reserve, which is expected to make a third 75-basis-point move later this month.

“With today’s decision, it is clear that the ECB has abandoned inflation targeting and forecasting and joined the group of central banks focusing on reducing real inflation,” Carsten Brzeski, head of macroeconomic services at ING, said in a note.

The decision reflects a lack of alternatives, the economist said.

It remains unclear how “monetary policy can reduce inflation that is mainly driven by (external) supply-side factors. Even the impact of policy rate hikes on inflation expectations is far from certain,” he wrote. “At the same time, the size of today’s interest rate hike will not determine whether the eurozone economy will slide into recession, nor will it make the recession more or less severe. Any downturn in the eurozone this winter will be fueled by energy prices, not interest rates.”

Eurozone inflation hit 9.1% in August and is expected to rise further as Russia cuts energy supplies in response to sweeping sanctions imposed by Western powers after its invasion of Ukraine.

In its statement, the ECB said recent data showed a significant slowdown in euro area economic growth, with the economy expected to stagnate later in the year and in the first quarter of 2023.

“Very high energy prices are reducing the purchasing power of people’s incomes and, although supply bottlenecks are easing, they are still constraining economic activity. In addition, the adverse geopolitical situation, especially Russia’s unwarranted aggression towards Ukraine, is weighing on business and consumer confidence,” the ECB said.

ECB staff sharply revised downwards forecasts for economic growth, with gross domestic product in 2022 now at 3.1%, 0.9% in 2023 and 1.9% in 2024.

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