Each month, somewhere in the world, a different currency seems to be falling sharply, and the unlucky winner for July is the euro. The euro-zone currency, shared by Germany, France, Italy and 16 others, is flirting with parity with the US dollar for the first time since 2002.
This is a dramatic change from the start of the year when one euro was around $1.14. The parity signals a depreciation of 12%. This may not seem like a big deal unless you are a forex trader. However, large exchange rate fluctuations create uncertainty and can lead to economic and financial instability.
Several factors are contributing to the euro’s crash. Europe was hit just as badly as the US by the pandemic and its inflationary consequences. Europe could be worse off because its economies tended to grow more slowly before the arrival of Covid, and tighter regulations and higher taxes are making Europe less resilient.
Vladimir Putin’s invasion of Ukraine has created geopolitical uncertainty and pushed up energy prices. The closure of the Nord Stream 1 natural gas pipeline to Germany on Monday, ostensibly for maintenance, added to recent pressure on the euro.
But the most important cause is monetary policy. In the face of the highest inflation in 40 years, the US Federal Reserve is normalizing monetary policy, albeit belatedly and slowly. Chairman Jerome Powell has raised the short-term interest rate target by 1.5 percentage points to a range of 1.5% to 1.75%, with a further 0.75 point hike expected this month. The Fed finally stopped buying new assets in March and has started deducting assets from its balance sheet as they mature.
The European Central Bank is even less aggressive in its fight against inflation. Just last month, it stopped net asset purchases and says it won’t reduce its balance sheet until 2024. The short-term policy rate remains at minus 0.5%, with a quarter-point hike expected this month. Officials are suggesting that maybe – maybe – a second hike in September will result in a zero nominal interest rate. The widening gap in yields between the US and the euro zone explains much of the exchange rate fluctuation.
Rather than fight inflation, the ECB is focused on extending monetary easing for as long as possible, at least for some eurozone members. Officials are busy devising a mechanism to prevent “fragmentation,” by which they mean divergence between some countries’ government bond yields and the German bund. The practical effect, if the system works, would be a sustained reduction in interest rates, particularly for Italy.
The risk is that if the lack of coordination between the major central banks persists, Italy’s dysfunctional Fisc could become the least of the problems. The dollar-euro exchange rate is the most important in the world, as noted by the late Robert Mundell, Nobel laureate in economics. As rates begin to shift, companies have to spend increasing amounts of money to hedge against exchange rate risks, may be discouraged from investing to create jobs, and risk currency mismatches when borrowing. All of this is weighing on financial stability and the Main Street economy.
Note that the conventional wisdom that a weak euro will boost European exports is already proving wrong. The euro’s weakness earlier this year has boosted corporate earnings in export powerhouse Germany, largely as companies have been able to book higher euro-denominated earnings on products manufactured and sold abroad. But the good times seem to be ending as Germany reported its first monthly trade deficit since 1991. Energy imports are the main reason for this. Energy markets mostly set prices in dollars, so the weaker euro increases euro costs for German manufacturers.
Europeans have company in currency devaluation. The Japanese yen has fallen this year, breaking Tokyo’s red line of 125 yen against the dollar and now hovering near 137. After thinking a weaker yen could help the economy, Bank of Japan CEO Haruhiko Kuroda and other officials are trying to weigh in to speak the yen into the stability. They have mixed success.
The dice can fall. Monetary authorities have decided they will do it their own way as they struggle to find a way out of their unprecedented policies of the past 15 years. But this year’s fluctuations in exchange rates are a warning that this seeming independence comes at a price – and that price is often paid in depreciating currencies.
Copyright ©2022 Dow Jones & Company, Inc. All rights reserved. 87990cbe856818d5eddac44c7b1cdeb8
https://www.wsj.com/articles/the-incredible-falling-euro-dollar-parity-european-central-bank-11657651084 The Incredible Falling Euro Nears Dollar Parity