The dollar is once again softer this week, keeping the Euro relatively elevated. At just below the 1.1900 handle, it’s still just a little below the 1.2000 level that caused alarm at the ECB just two weeks ago. While the dollar has weakened amid US President Donald Trump’s push to lower rates and disrupt global trade with tariffs, the Euro has gained. ECB President Christine Lagarde has championed the euro as a replacement for the U.S. dollar as a global reserve currency.
But, there can be too much of a good thing, particularly in the currency markets. A strong Euro poses challenges to fiscal policy in various European capitals and monetary policy in Strasbourg. For several months, inflation and interest rates have been in a delicate balance, allowing the ECB to remain hands-off in the economy. But that might be about to change.
Why a Too Strong Euro is a Problem
A strong currency has its merits when used as a reserve currency, but it also hurts the economy’s competitiveness and growth. On the one hand, exports become more expensive and harder to sell overseas. Imports become cheaper, making them more attractive to consumers. With businesses at best facing lower profits and likely losing sales, the economy would slow down. For the EU, with its economy barely in the green, this can pose a major policy challenge.
For the central bank, it creates another headache. The lower cost of imports means that consumer prices drop. The slower economy implies demand destruction, which lowers pricing pressures. Domestic companies have to cut prices to compete with cheaper imports. This means that inflation can fall below the central bank’s target.
Supporting the Economy
Central banks try to keep inflation modest to both maintain currency stability and encourage economic growth. If money loses a small amount of value, it incentivises people to spend it rather than keep it in savings accounts. This is why most central banks try to keep inflation around 2%. If it falls below that level, the economy could slow, prompting policymakers and economists to blame the central bank for the poor economic conditions.
The ECB has a history of spending decades battling too-low inflation, as structural conditions in Europe have not allowed the economy to take off. If the Euro appreciates too much or too fast, this could cause inflation in the Eurozone to fall below target. Strasbourg is likely to be particularly sensitive to this scenario, since it took a global pandemic to jolt the European economy out of deflationary doldrums. For this reason, the ECB could pre-emptively cut rates to weaken the currency if it believes it is becoming too strong.
When Will Easing Happen?
At the moment, the ECB is still “intensely monitoring” the situation but has been issuing warnings that it is concerned. This is the first level of verbal intervention, as the central bank suggests there is an upper limit to the currency, and traders will be reluctant to push the currency pair above it. For now, it seems to be around the 1.2000 level.
As long as the EURUSD remains below that level, the ECB could stay on the sidelines. But a rapid upward move above 1.2000 could prompt more explicit verbal intervention to push the currency pair back down. Traders would be advised to be careful about going long in such a scenario.
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