Every month seems to find a different currency somewhere in the world in sharp decline, and the unlucky winner for July is the euro. The eurozone currency, shared by Germany, France, Italy and 16 others, is flirting with parity to the U.S. dollar for the first time since 2002.
This is a dramatic shift since the start of the year, when one euro bought about $1.14. Parity signals a 12% depreciation. This may seem like no big deal unless you’re a currency trader. But sharp movements in exchange rates create uncertainty and can lead to economic and financial instability.
Several factors are contributing to the euro plunge. Europe has been hit as badly as the U.S. by the pandemic and its inflationary aftermath. Europe may be worse off because its economies tended to grow more slowly before Covid arrived, and stricter regulations and higher taxes make Europe less resilient.
invasion of Ukraine has created geopolitical uncertainty and is driving up energy prices. Monday’s shutdown of the Nord Stream 1 natural-gas pipeline into Germany, ostensibly for maintenance, contributed to the latest pressure on the euro.
But the most important cause is monetary policy. Confronted with the highest inflation in 40 years, the U.S. Federal Reserve is normalizing policy, although belatedly and slowly. Chairman
has raised the target short-term rate by 1.5 percentage points to a range of 1.5%-1.75%, with another 0.75-point increase expected this month. The Fed in March finally stopped new asset purchases and has begun allowing assets to run off its balance sheet as they mature.
The European Central Bank is even less aggressive in fighting inflation. It stopped net asset purchases only last month and says it won’t start reducing its balance sheet until 2024. The short-term policy rate remains minus-0.5% with a quarter-point increase expected this month. Officials hint that maybe—maybe—a second increase in September will deliver a zero nominal rate. The growing chasm in yields between the U.S. and eurozone explains much of the exchange-rate swing.
Instead of fighting inflation, the ECB is focused on extending the monetary ease as long as possible at least for some eurozone members. Officials are busy trying to design a mechanism to avert “fragmentation,” by which they mean divergence between government bond yields of some countries and the German bund. The practical effect, if the scheme works, would be ongoing suppression of rates especially for Italy.
The risk is that if the lack of coordination among major central banks continues, Italy’s dysfunctional fisc could become the least of anyone’s problems. The dollar-euro exchange rate is the most important in the world, as the late Nobel economist
observed. When the rate starts to shift, companies must spend ever greater sums hedging against exchange risks, can be deterred from job-creating investments, and risk currency mismatches when they borrow. All of this weighs on financial stability, and on the Main Street economy.
Note how the conventional wisdom that a weak euro boosts European exports is already proving false. Euro weakness earlier this year boosted corporate profits in export-powerhouse Germany, mainly by allowing companies to book higher euro-denominated earnings on products made and sold abroad. But the good times appear to be ending as Germany reported its first monthly trade deficit since 1991. Energy imports are the main explanation. Energy markets mostly set prices in dollars, so the weaker euro is raising euro-denominated costs for German manufacturers.
Europeans have company in currency depreciation. The Japanese yen has tumbled this year, breaking through Tokyo’s red line of 125 yen to the dollar and now hovering near 137. After thinking a weaker yen might help the economy,
and other officials are trying to talk the yen into stability. They’re having mixed success.
The die may be cast. Monetary authorities have decided that as they struggle to navigate an exit from their unprecedented policies of the last 15 years, they will each do it in their own ways. But this year’s exchange gyrations are a warning there is a price for this seeming independence—and that price is often paid in depreciating currencies.
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