Having strengthened steadily since last July, the euro has taken a breather in response to Draghi’s remarks following last week’s ECB Governing Council meeting. Most notably, by highlighting the downside risks to inflation from the euro’s appreciation, Draghi actively revived the possibility of an interest rate cut in the near future, implying too that the single currency should not be seen as a one-way bet.

Like his famous “whatever it takes” speech last summer ahead of the announcement of the OMT programme, Draghi’s latest comments mark a significant departure for the ECB. This was the first time that the Governing Council has explicitly singled out the strength of the euro as a downside risk to its ability to meet its price stability mandate. On several past occasions, the euro has matched its recent appreciation without alerting the doves in the ECB’s Governing Council (see chart below). Indeed, such an appreciation would often previously have been welcomed as a benign influence helping to keep inflation in check.

But should Draghi’s latest verbal intervention really be interpreted as a credible threat by the ECB to cut rates? To answer this question, we have looked at how the euro’s recent rally is likely to alter the ECB’s inflation forecast and, hence, potentially also the outlook for monetary policy.

Judging from its most recent forecasts, events in the foreign exchange markets caught the ECB by surprise. In December, it expected inflation this year to be in the range of 1.1–2.1%Y/Y, assuming a depreciation of the euro’s trade-weighted or nominal effective exchange rate (NEER) of 0.9% in 2013. Since then, however, the euro’s NEER has appreciated by nearly 4%. And the euro is likely to remain supported in the near term as banks continue to repay some of the funds borrowed under the central bank’s LTROs as well as expectations of further quantitative easing in other major economies.

Previous ECB forecasts, however, suggest that the Governing Council is unlikely to get carried away by short-term trends in foreign exchange markets. In June 2009, for example, after the euro’s NEER had appreciated by more than 8% over the preceding six months, the ECB subsequently raised its forecast of the depreciation that it expected to see over the remainder of the year. And we believe the ECB will expect the euro to reverse some of its recent gains throughout the remainder of this year too, partly reflecting the continued underlying weakness of the euro area economy. Indeed, our own forecasts see the euro ending the year at $1.30, implying a depreciation of the euro’s NEER between now and then of around 1%. This, however, would still leave the euro about 3% stronger over the year as a whole, a marked contrast to the depreciation currently expected by the ECB.

If the ECB adopted our own exchange rate forecast, what would that imply for its inflation outlook? Perhaps surprisingly, very little in the short term. According to a recent study by the ECB, other things being equal, an upward revision of the euro’s NEER of around 4% would lower the ECB’s mid-point inflation forecast by just 0.1ppt this year to about 1.5%. But exchange rate movements eventually reveal their full impact after one or two years. Indeed, the same study suggests that the recent appreciation, if sustained, might push down CPI inflation by 0.3ppts to just 1.1% in 2014.

Moreover, a strong euro is likely to hinder the periphery’s recovery, which, due to weak domestic demand, will rely on exports to outside the euro area. Indeed, the euro’s recent appreciation will likely have already forced exporters to cut their prices in euro terms, and the squeeze on profit margins will continue as firms strive to offset the exchange rate-induced loss in competitiveness.

In the case of Spain and Portugal, this could offset as much as 40% of the boost to competitiveness painfully earned in the past few years by reducing unit labour costs. Exporters might well respond by trying to push wages down even further and/or reducing staff, both of which are likely to increase the downward pressure on prices.

All of this suggests that the ECB will revise down its inflation outlook when it presents its updated macroeconomic projections on 7 March. But despite all the evidence that inflation next year will undershoot its previous forecast by a considerable margin, possibly bringing inflation close to or even below 1%, we think the ECB’s revisions will be relatively modest, not least due to the large uncertainties surrounding both the future evolution of the exchange rate and model-based estimates of the exchange rate pass-through to consumer prices.

And while for some observers, the larger-than-expected contraction in GDP in the final quarter of last year might ring alarm bells, the Governing Council might continue to be reassured by recent signs of recovery in Germany and stability in certain other member states at the start of 2013.

So, assuming we are right that its inflation forecast will remain broadly consistent with its mandate, we believe the ECB will also want to continue to leave policy unchanged, keeping its remaining conventional powder dry for if and when financial market tensions re-emerge and/or growth surprises on the downside. If, however, the euro was to resume its rally and push beyond $1.40 in the near term, the impact on the inflation outlook would make the pre-emptive interest rate cut, hinted at by Draghi last week, likely.

The Euro's nominal effective exchange rate: Six-month rate of change*

*Daily data. Percentage change compared to six months earlier. Source: Datastream and Daiwa Capital Markets Europe Ltd.

Tobias S. Blattner
Euro area Economist