Another week, another high for the euro against the dollar and sterling. This week the single currency went above $1.20 for the first time since January 2015, and hit levels against the pound last seen when the global financial crisis was raging.
In the eyes of some — possibly including its own officials — the move creates a dilemma for the European Central Bank, which is considering how to wind down the quantitative easing programme it began in 2015. In the past, a rising euro has also generally triggered a wider chorus of concern from politicians and industry about the plight of European exporters.
In reality, the ECB has plenty of flexibility to respond, and there is not much evidence the rise in the euro so far will choke off the recovery. If it threatens to do so, the means to keep momentum going lie in the finance ministries of the eurozone as well as in its central bank.
As is often the case with currency markets, the general direction of the move upwards in the euro this year is understandable while the predictability of the timing is less so.
The eurozone economy has been in a solid recovery since 2014. And although it is the Federal Reserve, not the ECB, that has been tightening monetary policy, benchmark eurozone bond yields relative to those in the US have been steadily heading upwards throughout 2017.
However, the role that exchange rates can play in managing growth in the medium term is often overstated. When the ECB pre-announced its QE programme in the autumn of 2014, the euro dived, sparking accusations in many quarters that the bank was simply engineering a disguised competitive devaluation.
But the eurozone recovery since then has, happily, been driven much more by private domestic demand than by net exports. And although the euro has risen from around $1.05 at the beginning of this year to this week’s highs, it still remains well short of the levels above $1.30 it was trading at before QE was announced.
The question now becomes how the eurozone authorities should respond. On the monetary policy side, the ECB has plenty of space to delay its withdrawal from QE if it sees fit. There is no need to barrel ahead with a preordained programme of tightening regardless of events. But better than fussing about the level of the currency would be for the eurozone’s governments to do their part in ensuring that the domestic demand-led recovery continues by using their available fiscal space.
One of the reasons the euro has been so weak for most of the period since 2014 is the policy mix of relatively tight fiscal and super-loose monetary policy. A boost to domestic demand through public spending will allow the eurozone recovery to continue even if the euro continues to strengthen.
Those countries with fiscal space to spare, like Germany and the Netherlands, should be encouraged to use it. The ECB will be better off if it can count on broad-based economic momentum without being forced into a cat-and-mouse game with the value of the currency. Although its policymakers often seem to believe otherwise, the eurozone as a whole is a largely closed economy: exports and imports are relatively small compared with overall gross domestic product.
The recent rise in the euro is neither inexplicable nor disastrous. The best response would be for eurozone governments as well as the ECB to focus on domestic demand and recognise that trying to manage the economy by worrying about the level of the currency is a fool’s game.