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Saturday, 28 January 2023
FOREX-Euro hits two-year low vs dollar as ECB seen in no rush to hike rates

FOREX-Euro hits two-year low vs dollar as ECB seen in no rush to hike rates

2022-10-31

 The European Central Bank (ECB) has been signalling that it is less likely to raise interest rates than market expectations, but after its retreat from a strong view of itself just a year ago, it may be that the bank’s assessment has changed.

The ECB has probably been right to lower its growth forecasts, but it is also less willing to judge its own actions than it used to be. If not now, when?

That is the question posed by the latest tumble in the value of the euro, which has hit two-year lows against the dollar.

If the ECB is not willing to hike interest rates as fast as markets expect, what is the point of its having already slashed them to historic lows?

We are yet to see the full extent of the damage to the euro that was supposed to be contained by the ECB’s massive stimulus programme in 2009 and 2010. But even if the ECB does not manage to lower inflation to its 2020 target, the implications for its credibility are profound. It may be that the bank’s move to cut rates in 2015 was a miscalculation on its part.

The ECB’s credibility has been damaged
The ECB’s credibility has been badly hit by the crisis, and it is still struggling to get its house in order.

The ECB’s recent actions have been seen as very expansionary by markets, but the bank’s own assessment of its strengths is that it has been very successful in keeping inflation under control.

In its latest Monitor report, the ECB said it “faces little immediate risk of a Greece-style debt crisis”, but that “a significant policy change in the euro area” could “pose additional risks” if the situation in Italy, Spain and Portugal is not soon addressed.

The euro is at risk
The euro has been sliding against the dollar for the past two months after enjoying a strong start to the year.

If the Eurozone crisis deepens and Italy and Spain start to struggle, the dollar could gain ground.

The ECB’s recent actions have been seen as very expansionary by markets, but the bank’s own assessment of its strengths is that it has been very successful in keeping inflation under control.

If the situation in Europe worsens and inflation in the euro area starts to accelerate, the ECB’s credibility could well be dented.

But can the ECB actually end up delivering on its inflation goals?
As we have seen, the ECB can and has ended up delivering on its inflation goals in the past.

In its latest Monitor report, the ECB said it expects “actual inflation to lie closer to” its 2% target “than the ECB’s price forecast”, but added that it “is still comfortable with the targeting given the medium-term inflation path and the near-term inflation outlook”.

What is less certain is whether the ECB will be able to sustain its current level of inflation, and whether it will be able to deliver on its inflation target of 2%.

Current market estimates suggest that the ECB might be able to maintain its current rate of inflation at around 1.5% over the medium term, but this is based on optimistic views of the Group of 30 (G-20) and World Economic Forum (WEF) growth rates.

One thing that is certain is that the ECB’s actions have had a big effect on world markets, and it is unclear how much longer the intervention will continue to be around.

The ECB is likely to keep cutting rates
Since the start of the year, the ECB has cut interest rates by a collective 25 basis points, effectively reducing its interest burden by around a quarter.

Although this may sound like a small figure, it has a big effect when applied to the record levels of mortgage debt that are flooding into the financial system.

At the same time, the ECB is likely to remain extremely reluctant to hike rates in the short-term, even if inflation speeds up.

If it does, it will be forced to do so by the European Central Bank’s stress tests and the European Stability Mechanism (ESM), which will see the bank’s assets fall by around 25%.

In all likelihood, it will take until at least 2021 for the ECB to start to get its monetary balance back on track.

When is the ECB likely to raise rates?
In all likelihood, it will wait until the European Central Bank’s stress tests are completed in 2021 and 2022, when it will be able to see how much money it needs to keep its “virtual” balance sheet intact.

At that point, it will have to decide whether to lift the rate it has set for itself for a period of time.

The ECB is expected to lift its interest rate a few months before it has to begin to pay back its loans, so at least there is a sense of urgency to the rate hike question.

ECB sees no rush to raise rates
The ECB has been far more reluctant than most central banks to start hiking rates, but it has now admitted that it does not see a rush to raise rates as inflation slows further.

This is likely to stay the case, and it is certainly likely to keep rates at a very low level for a very long time.

In fact, the ECB may be content to leave rates at the low level for as long as possible, in order to avoid further loss of market share to the likes of Amazon and Netflix.

What will be next for the ECB?
The ECB has clearly had a profoundly negative impact on the global financial system, and it is now under considerable pressure to do something about it.

The ECB’s stress tests have been widely criticised as a blunt instrument, and it is now under pressure to do something about this.

It could raise rates, but doing so would risk having an impact on the financial system, and it is unlikely to do that for a number of years.

The ECB could also consider buying more physical gold to try to shore up its credibility and reduce the impact of future rate hikes on the market price of gold.

But for all these things to happen, the ECB would first have to start to pay back the money it has borrowed from the European Central Bank.

If it fails to do so, the ECB could lose its independence and become a full-blown central bank, like the Bank of England or the Federal Reserve.

Bottom line
The European Central Bank has done much damage to the global financial system, and it is now in a position to be judicious about its actions. It has also created a new weapon in the fight against inflation by purchasing more gold.

But it is unlikely to use its new found wealth to support the dollar, and it will likely keep rates very low for a long time.

Ultimately, the ECB’s decision to sit on the sidelines and watch as the global financial system spasms and dies will have a significant long-term impact on the global economy.

 

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