The dollar this week is generally weaker amid relative calm in the Middle East and lower odds of Fed rate hike. That alone should have supported the EURUSD. However, the trend has been to the downside. Notably, the pair did not pop higher after softer than anticipated US jobs data last week, unlike other currencies.
This doesn’t mean that the Euro is decoupling, but rather that there are underlying reasons for the shared currency to also be softer along with the greenback. The outlook for the ECB remains fairly the same, unlike for the Fed, which means our attention needs to return to the economy and inflation.
The (Not) Inflation Problem
US July CPI came in largely as expected in July, ticking down by one decimal both on the top and bottom line. Crucially, the drop in core inflation suggests that there is little pass-through from higher energy prices, meaning the Fed has less pressure to raise rates. In fact, after the data, the odds of September hike fell to 40%, although the market still sees one rate hike by the end of the year.
This contrasts with the Eurozone, where consumer prices actually rose by one decimal, also within expectations. Markets cited higher energy prices as the driving factor. But, higher energy prices are also a thing in the US, as the America is Europe’s largest supplier of petroleum, and European countries are paying a premium for reliable supplies. So, why is Europe experiencing inflation when the US is not?
Inflation Is Not Permanent
One of the factors to take into account is that inflation is a ratio, not an absolute value. When the price of a product increases, the difference from the previous price is counted as inflation. When the price stays up, but does not increase even more, then inflation goes back to zero. Momentary shocks, like higher energy prices, cause a bump up in inflation because the price goes up. But, even if the price stays up, unless it goes up again, then the inflation rate will go back down.
Energy prices spiked at the start of the war in Iran, but fell back, only to go on a rollercoaster ride as tensions eased and flared up again. Each peak was lower than the last, and in general, crude prices have not exceeded the prior peak despite the Strait being closed. They have, in fact, gone down. Which means that the inflationary pressure should be easing (like in the US data), not rising (like in the Eurozone data).
How this Weighs on the Euro
A series of regulations in the Eurozone delayed the onset of price increases from higher energy. Petrol stations were not allowed to raise prices immediately as crude rose, like they did in the US. This means there is a delay in the inflationary pressure in Europe compared to America. Therefore, the ECB is reacting to a different scenario that the Fed. In the US, higher energy prices were transferred to consumers quicker, but so are lower prices. This reduces pressure on the Fed quicker than on the ECB.
Why the Euro gets weaker despite the potential for higher interest rates is that the shared economy is underperforming. That means, when the ECB hikes, investors in everything else besides bonds get a lower return on their investment, making the Euro generally less attractive. Unless there is a clear indication that the Eurozone economy will rebound, then continued inflation pressure could leave the Euro weaker against the dollar ahead of the ECB and Fed meetings next month.
