Euro seeks Draghi’s attention at first ECB meeting of 2018

Bloomberg

There’s one question European Central Bank President Mario Draghi won’t be able to ignore at his first policy meeting of the year: whether the euro is too strong for the currency bloc’s health.
In the six weeks since the previous decision, the single currency for 19 European nations has surged to the highest level against the dollar in more than three years and at one point posted its biggest single-day gain since late 2014. That’s alarmed officials such as Vice President Vitor Constancio, concerned that the exchange rate will put undue downward pressure on already-weak inflation.
The euro’s jump raises the prospect that the Governing Council will reinstate language in its statement warning that volatility is a source of uncertainty that requires monitoring. That wording was last used in September after a 14 percent gain since the start of the year — and prompted the euro to weaken over the next two months.
“Constancio clearly stated the link with dampening inflation and it has to be there in the statement,” said Gilles Moec, chief European economist at Bank of America Merrill Lynch in London. “They have to create the sense that they are of course not targeting the currency, but if it were to have an impact on the inflation outlook then it would have to be taken into account.”
Policy makers start their meeting in Frankfurt and will announce their decision at 1:45 pm on Thursday, with Draghi holding a press conference 45 minutes later. Economists surveyed by Bloomberg predict the ECB’s bond-buying program will be kept at 30 billion euros ($37 billion) a month until at least September, and interest rates will stay at record lows. The single currency extended gains on Wednesday, rising 0.4 percent to $1.2343 as of 10:02 a.m. Frankfurt time. The president addressed the euro in a letter to a European Parliament legislator dated Jan. 23, saying that asset purchases “have not led to statistically significant euro exchange-rate movement.”

BULLISH BETS
Yet as the euro area enjoys its best economic growth in a decade, it’s the calls from some officials to take more decisive steps towards ending that stimulus program that are prompting investors to push the currency higher.
Frederik Ducrozet, senior economist at Pictet Wealth Management in Geneva also predicts that the phrase about the euro causing uncertainty will reappear in the Governing Council statement this week, albeit coupled with an even more positive assessment of the economic situation in the euro area.
Survey data published on Wednesday showed euro-area manufacturing activity slowed in January, even as services picked up, suggesting that the euro’s gains may be weighing on exports. Portuguese Economy Minister Manuel Caldeira Cabral said his economy has remained competitive despite the euro’s gains, noting a 20 percent increase in exports to the US, but also issued a warning.
“We are having a very interesting boom in our exports to those areas so we have some margin
of competitiveness,” Cabral said in a Bloomberg TV interview with Francine Lacqua in Davos, Switzerland. “But we should be aware that the strong euro is always bad for exports.”
Still, a much faster appreciation is needed for the impact to hurt, according to Piet PH Christiansen, an economist at Danske Bank A/S in Copenhagen. He estimates that the last time Draghi mentioned the exchange rate, the euro had appreciated some 5-6 percent on the trade-weighted basis. Since then, it has hovered just above that level “with an uptick” in the recent month, he said.
EURO IMPACT
The main challenge for policy makers is that the currency’s gains have the potential to weigh on inflation, which the ECB forecasts won’t reach its goal before at least the end of 2020. In an analysis of consumer prices’ sensitivity to the exchange rate published last month, central bank officials said that a gradual appreciation to $1.36 over three years could damp the inflation rate by as much as 0.6 percentage point. Inflation was 1.4 percent in December, well below the goal of just under 2 percent.

INFLATION LINK
ABN Amro economists estimate that the recent euro strength will reduce the ECB’s projections for core inflation by around 0.1-0.2 percentage point. According to KBC, a range of analysis suggests a 1 percent move in the exchange rate moves consumer prices in the opposite direction by about 0.1 percent within a year and about twice that in three years.
Viraj Patel, a currency strategist at ING Bank NV in London, estimates that the ECB’s pain threshold, or the point at which appreciation begins to weigh on the real economy, would be a sharp move above $1.25 before the summer.
“It’s not a strict line in the sand, but more the lower bound for when the ECB would start to use stronger rhetoric,” he said. “The currency has to be taken in the context of overall financial conditions – and right now, this is not flagging any warning signs just yet.”