ECB to monitor rise of euro after keeping rates on hold

ECB to monitor rise of euro after keeping rates on hold

The European Central Bank has discussed “extensively” how the rising euro could weigh on inflation and will carefully monitor the exchange rate, its president Christine Lagarde said on Thursday as she left interest rates unchanged.

The eurozone central bank’s governing council kept its main deposit rate at minus 0.5 per cent and said its multibillion-euro bond purchases would continue “as long as necessary to reinforce the accommodative impact of its policy rates”.

Ms Lagarde said it would “carefully assess incoming information, including developments in the exchange rate, with regard to its implications for the medium-term inflation outlook”.

The euro is up 10 per cent against the US dollar since March, a shift that could weigh on inflation by lowering the price of imports and drag on the eurozone’s economic recovery from the coronavirus pandemic by raising the cost of its exports to other parts of the world.

Data published last week showed that the eurozone had slid into deflation for the first time in four years; headline consumer price inflation was minus 0.2 per cent in August, down from an increase of 0.4 per cent the previous month.

However Ms Lagarde said the exchange rate was “not a policy target” and surprised analysts by announcing that the ECB had raised its forecast for inflation next year as well as its growth forecast for this year.

Eurozone inflation will rise from an average of 0.3 per cent over the course of this year to 1 per cent next year, the ECB said — up from its earlier forecast for of 0.8 per cent price growth in 2021. Ms Lagarde said this partly reflected government plans to boost spending.

The bloc’s economy is expected to contract by 8 per cent over the course of this year, according to the new forecasts — a slight improvement from June’s forecast of a 8.7 per cent decline. But the ECB trimmed its growth expectations for next year to 5 per cent and for 2022 to 3.2 per cent.

Most analysts had expected a lower inflation forecast as a signal that further policy easing was becoming more likely.

“This was a hawkish surprise,” said Frederik Ducrozet, strategist at Pictet Wealth Management. “The ECB had a strong case to act [on Thursday], so this is potentially a mistake. The hawks are dragging their feet and resisting a move that they know will have to come.”

Most economists expect the ECB to expand its €1.35tn emergency bond-buying programme as early as December if inflation shows little sign of bouncing back towards its target of just below 2 per cent.

Ms Lagarde said it was “very likely” the ECB would use the full €1.35tn it has earmarked — countering some policymakers, who have said it may not need to spend the full amount.

Some analysts believe the ECB may also have to cut rates further into negative territory — an option that Ms Lagarde indicated was possible, saying that the ECB was “determined to use all policy tools it has available”.

The euro strengthened after the ECB’s announcement; the single currency rose by 0.8 per cent against the dollar to $1.19.

“Having signalled that the strength of the euro does not justify further intervention, the ECB has opened the door to a further rise in the euro towards $1.20,” said Lena Komileva, chief economist at G+ Economics. “This increases the pressure on them to do something sooner than would otherwise be the case.”

Ms Lagarde hit an upbeat note on the eurozone’s recovery from its record quarter-on-quarter postwar contraction of 11.8 per cent in the three months to June.

The ECB had detected signs of “a strong rebound in activity broadly in line with previous expectations”, she said.

However economists fear that rising numbers of coronavirus infections, as well as the stronger euro, could weigh on the recovery.

“Their inflation forecast for next year is too low and in any case [the ECB] will still need to do more later this year to defend its credibility,” said Katharina Utermöhl, economist at Allianz.

The US Federal Reserve’s announcement last month that it would shift to a more dovish policy stance with a new average inflation target prompted the dollar to fall further against the euro and led analysts to question how the ECB would respond. 

The ECB kicked off a review of its strategy in January, but the pandemic put that on pause and it is not due to be completed until next year.

Ms Lagarde said the review would examine areas including inflation measurements, its price stability target, financial stability, climate change, digitisation, communication and non-bank financing. She added that it could provide interim updates “as we go along”.

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