EUROPEAN UNION: ECB in a bind over euro policy

Analysis

After the New Year, expressions of anxiety about the strengthening of the euro became common-place among European central bankers and in ECB publications. Although no-one has criticised the euro as 'too strong' per se, there is consensus that the rapid decline of the dollar is at least potentially destabilising.

Ambiguous policy framework.A key problem for ECB policymakers is how to consider the role of exchange rates within the context of their price stability mandate. Article 5 of the Treaty Establishing the European Community (TEC) lists the conduct of exchange rate operations as a "basic duty" of the ECB. However, such actions are meant to be consistent with guidelines that may be adopted by the Council of Ministers under Article 111. To date, the council has adopted no guidelines for exchange rates.

Furthermore, neither the Council of Economic and Finance Ministers (ECOFIN) nor the Eurogroup of economic and finance ministers from those countries using the euro has displayed any willingness to promote an official policy on exchange rates. Were they to do so, such guidelines could not 'prejudice' the ECB's ultimate goal of price stability, but they could at least provide some structure to how the ECB regards exchange rates.

Without such guidance, European central bankers must explain any interest in exchange rates as a function of price stability within the euro-area. When the euro was weak, the explanation was straightforward. Exchange rate depreciation raises the costs of imports and so tends to push up aggregate prices. Wim Duisenberg was reluctant to make this argument during his tenure as ECB president, but did so whenever he considered the fall of the euro against the dollar to be excessive. Duisenberg complained about the impact of exchange rates on prices throughout 2000 and particularly around the ECB's ill-fated currency interventions.

Aggregation and asymmetry.Current ECB President Jean-Claude Trichet has a more difficult argument to make. A strengthening euro actually lowers the cost of imports and so puts downward pressure on aggregate prices. From a price-stability perspective, exchange rate appreciation is a one-way bet. However, clearly a stronger euro does have negative effects on economic performance. By raising the cost of exports and lowering the cost of imports, it threatens to undermine the price competitiveness of European manufacturing. Worse, these effects do not play out symmetrically across the euro-area. Those countries most dependent upon exports to the United States (and to the 'dollar zone' more broadly) are most affected, as are those sectors where price competitiveness is more important than other factors such as quality, reputation or intellectual property.

Appropriate response.If the ECB does choose to respond to 'excessive volatility' in the euro/dollar exchange rate, it will have to do so under its qualified authority from Article 105 of the TEC to "support the general economic policies of the Community ... without prejudice to the goal of price stability". In practical terms, the ECB may choose to intervene directly in foreign exchange markets, presumably by selling euros to buy dollars. Or it may choose to lower interest rates in order to induce capital flows to shift away from Europe to the United States. Neither option is likely to have an impact on exchange rates if undertaken at a level that would not pose a threat to price stability.

1. Intervention.The problem with intervention is two-fold:
   • International currency markets are enormous, and so any intervention would have to be substantial to have a lasting impact on exchange rates. Theoretically, the ECB has limitless resources -- it is, after all, selling the same money that it prints. In reality, monetary policymakers would have to be concerned about generating too much liquidity in international markets that could quickly return to have an impact on domestic prices.
   • The ECB does not have much credibility when acting alone and it is unlikely to garner support from US Treasury Secretary John Snow. The ECB tried four times to intervene in support of the euro during the autumn of 2000. The first intervention took place in September and was enacted jointly with the United States. However, then Treasury Secretary Lawrence Summers almost immediately reasserted his commitment to the strong dollar and so the markets soon shrugged off any gains made by the euro. The ECB intervened again three times in November. On these occasions it acted alone. Yet, while it was able to surprise the markets, it remained unable to achieve any lasting result.

2. Interest rates.The other option is to lower interest rates. Here again, the ECB faces two problems:

   • It has to determine the impact of lower interest rates on expected inflation. Currently, the euro-area has a large liquidity surplus as a result of consistently high monetary growth rates. Hence even though inflation rates are declining in the present, there is the danger that this liquidity could generate accelerated inflation in the future. Lower interest rates are likely to increase that risk.
   • The implications of relative interest rates for exchange rates are unclear. If the assumption is that capital is flowing to the highest fixed rate of return, then it would be true that lower interest rates will encourage capital outflows. However, if the assumption is that capital is flowing in response to relative growth rates, then lower interest rates could actually strengthen the euro against the dollar. Much of the recent depreciation of the dollar has taken place against stable relative rates of return both in fixed-income assets and in equities. Signs of recovery in Europe suggest that European equities are becoming relatively more attractive. To the extent that monetary loosening raises their attractiveness, it induces further inflows.

Talking up the dollar.The third policy option is declaratory. By expressing concern about the volatility of the euro/dollar exchange rate, European policymakers are attempting to intimidate market actors into adopting more conservative positions:

• The advantage of this type of rhetoric is that it has virtually no impact on the real economy.
• The disadvantage is that markets soon begin to discount the willingness of policymakers to engage in any more meaningful action through currency intervention or interest rate decisions. Indeed, this discounting is the source of much of the psychological importance attributed to particular exchange rate thresholds. Once those thresholds are breached, policymakers must either respond or be found wanting. When policymakers do not respond or when the response is ineffective, the result is further exchange rate volatility. That was the lesson of the interventions in autumn 2000, and so long as this dynamic is at work, the pressure on the ECB should only be expected to increase.

Burden sharing. All of this explains the Europeans' concern with 'burden sharing' in facilitating a correction in the US current account deficit. East Asian policymakers have been unwilling to shoulder a heaver burden on domestic demand via exchange rate appreciation, which would allow for a more even distribution of dollar weakness. Under the current global exchange rate policy paradigm, the euro and other 'laissez faire' currencies bear most of the brunt of a weakening dollar, while Asians continue to enjoy export surpluses. For this reason, markets will be carefully watching for any signs of coordinated US-EU rhetorical pressure on Asian policymakers to 'flexibilise' their currencies -- as first evidenced in the September 2003 Dubai statement from the G7 (see INTERNATIONAL: G7 statement augurs currency shift - September 23, 2003).