Europe’s central bank has its hands tied as the euro soars ever higher

The European Central Bank has dashed hopes of fresh stimulus, sending the single currency rocketing. The relentless rise of the euro is pushing large parts of the eurozone into a Japanese deflation trap, threatening a fresh banking crisis and playing havoc with debt dynamics in a string of vulnerable countries already reeling from the shock of COVID-19.

Christine Lagarde, the ECB's president, said there is "no need to overreact to euro gains", distancing herself from warnings by senior officials that the rising exchange rate is tightening monetary policy pro-cyclically and compounding woes.

ECB chief Christine Lagarde said there is “no need to overreact to euro gains”, a view at odds with some officials.Credit:Bloomberg

The euro jumped instantly to $US1.19 against the dollar and hit a one-year high of £0.92 against the pound. The ECB's trade-weighted index has risen 7 per cent this year and 22 per cent since 2015.

Mrs Lagarde's hawkish tone came despite a fall in headline inflation to minus 0.2 per cent in August, touching minus 2.9 per cent in Cyprus, minus 2.1 per cent in Greece, minus 0.6 per cent in Spain and minus 0.5 per cent in Italy. Core inflation was an all-time low of 0.4 per cent.

The ECB governing council offered no crumbs to the markets, sticking to its scheduled €1.35 trillion ($2.2 trillion) plan of pandemic QE and remaining silent on the prospect of future rate cuts. It vowed only to "monitor" the currency.

The ECB leadership appears as divided as ever, with German-led hawks adamant that there is no need for further stimulus after this year's explosive surge in the M1 and M3 money supply – usually a harbinger of future inflation, though the current circumstances are unique.

Doves centred around the chief economist, Philip Lane, are much more concerned about euro appreciation. They fear a truncated recovery once the low-hanging fruit is picked and the initial "V-shaped" rebound from COVID-19 fades, leaving a shrunken economy with mass unemployment and thousands of crippled companies.

The great unknown is how much structural damage has been done by the 12.1 per cent contraction in the second quarter. There are risks of an "echo crisis" this winter as the long-tail effects of a business capex freeze and lost jobs do their worst.

Oxford Economics sees consumption sliding as rising cases of COVID-19 threaten a second wave.

The EU's €750 billion recovery fund does not kick in until the middle of 2021 and is then spread thinly until 2026. It is too small to move the macro-economic needle.

There is little that the ECB can legally do to drive down the currency even if it tries. Interest rates are already minus 0.5 per cent and arguably at the "reversal rate" where further cuts do more harm than good, eroding the net interest margin for banks and making it harder for insurers to match their liabilities.

There is little the ECB can do to control the euro. Credit:Bloomberg

The ECB has sought to limit the fallout for lenders by a technical device known as "tiering" but small German savings banks that provide 90 per cent of total credit to Mittelstand family firms say their business model is being destroyed.

Diminishing returns set in long ago for QE. Bond yields are already steeply negative on long maturities across the eurozone core. There is almost nothing left to squeeze out of the yield curve. "Beyond verbal intervention, we think the ECB has limited options to weaken the euro," said Bank of America.

Mr Lane attempted to talk down the currency last week with veiled intervention, briefly lowering the exchange rate 2 per cent with a comment that the "euro-dollar does matter".

But his words came close to currency manipulation and appear to violate a solemn accord by G7 central banks to remain silent on exchange rates. Such a demarche risks a hot retort from Washington if repeated.

"Lane committed a cardinal sin and it is dangerous," said Dr Ulrich Leuchtmann, Commerzbank's currency chief in Frankfurt.

The worry in Germany is that Donald Trump will vent his fury by retaliating with punitive tariffs against the car industry, pushing the sector into an even deeper crisis.

It is understood that Berlin made it crystal clear to Mrs Lagarde that she must rein in her officials, hence her awkward attempt to talk up the recovery and sound hawkish. The ECB has other problems. It suddenly faces a systemic policy broadside from the US Federal Reserve, which has shaken up the world of central banking with a new regime of flexible inflation targeting – academic jargon for looser money and a greater willingness to "run the economy hot" in order to boost jobs.

Krishna Guha, from Evercore, says no major central bank can run a tighter policy than the Fed without seeing its currency ratchet up. The problem is doubly serious because the eurozone is "much further along the path of Japanification than the US" and therefore even more vulnerable.

The ECB governing council offered no crumbs to the markets, sticking to its scheduled €1.35 trillion plan of pandemic QE and remaining silent on the prospect of future rate cuts. It vowed only to “monitor” the currency.Credit:Bloomberg

The ECB is now paying the price for errors made long ago. It went through an entire global cycle after 2008-2009 without ever doing enough to meet its inflation target, finishing the 11-year expansion with rates still below zero.

It therefore had no safety buffers left to protect against deflation when the next shock came.

The shock has now hit.

Telegraph, London

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