The pace of the euro’s plunge against the dollar has taken most eurozone economists by surprise, including those at the region’s central bank.
European Central Bank economists last week unveiled their latest quarterly projections for what will happen to growth and inflation in the region.
The projections assumed that the exchange rate would stay where it was in the middle of February, about $1.13, until 2017. On Thursday, the single currency traded at $1.06.
According to the ECB’s own estimates, a euro that weak would leave policy makers facing a headache about whether to scale down bond buying just months after unleashing their €1.1tn quantitative easing package.
The ECB has welcomed the euro’s depreciation, which should provide a much-needed boost to the eurozone’s exporters. But a sustained weakening could lead hawks on the governing council to ask some awkward questions about whether policy makers were right to keep on buying €60bn-worth of public and private sector bonds a month.
The projections show why the euro’s fall is so important for monetary policy.
The latest estimates, unveiled by ECB president Mario Draghi, suggest that inflation will drift back towards the ECB target of just below 2 per cent over “the medium term”. As the effects of monetary policy take time to filter through economies, the medium term, or what is likely to happen two years from now, is key.
With inflation forecast to reach 1.8 per cent by 2017 the ECB is heralding QE a success less than a week into its launch. However, under an alternative scenario outlined in the projections, a much weaker exchange rate would probably lead the ECB to miss its target, with inflation likely to rise above 2 per cent by the end of the forecast horizon.
The trouble is that the alternative scenario is already in danger of being realised.
Under it, the euro is projected to dip to $1.04 by 2017. If the single currency continues to plunge at the pace it has done over the past five days then it would reach that level early next week.
“If you were a policy maker and you were broadly comfortable with the forecasts a week ago, you should be a little less comfortable now,” said Richard Barwell, economist at Royal Bank of Scotland.
“I’d rather the ECB was prepared to accept the risk of inflation of slightly above 2 per cent than below it. But the impact on the currency is a big part of how QE will be transmitted to the economy. You can’t just ignore it if the euro falls faster than you expected.”
For now, even the most high profile objectors to sovereign bond buying are unwilling to start a debate about tapering asset purchases. They would prefer to wait before judging the impact of QE.
The ECB staff projections also do not necessarily reflect the views of policy makers — some on the council believe that the projections are too optimistic.
“It would be much better if the governing council members published their own forecasts,“ Mr Barwell said.
The next round of projections are released in June. The standard rule of thumb is for a gradual 10 per cent depreciation to add 0.6 percentage points to inflation.
But if the euro’s gyrations remain as volatile as in recent weeks, ECB economists may have to use alternative methods of measuring whether a weaker currency leaves the eurozone susceptible to higher than targeted inflation.
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