Why the ECB Wants Higher Inflation: Euro Exchange Rate Themes for 2016

The European Central Bank will continue to fight for higher inflation in 2016 - the more agressive it gets the more the downside risks to the euro exchange rate complex become.

Mario Draghi warns that the ECB will act

The euro has hardly reacted to the release of the minutes from the European Central Bank's November policy meeting. Commentators such as ourselves saw the event as an added source of volatility for the currency and many out there will be wondering why markets are relatively sanguine following the release.

The message from the minutes is clear - the Bank stands ready to act on the weak inflation besetting the Eurozone.

The minutes noted:  

"It was therefore seen as necessary to step up communication and underscore the Governing Council’s determination and readiness to act as soon as warranted by new information and a new assessment, with the December Euro-system staff projections allowing for an in-depth reflection on the monetary policy stance.”

What is clear is that the ECB is no longer content to sit back and watch inflation threaten the Eurozone’s recovery. But what does the proactive stance mean for the exchange rate?  

The ECB’s mandate is to deliver price stability for the euro area, which is defined by the ECB as an inflation rate of “below but close to 2 percent” over the medium-term.

With Eurozone inflation rates having been in negative territory in 2015, and failing to offer a convincing recovery since, a sense of unease has grown amongst policy makers as it is argued that deflation can be just as damaging to the economy as high inflation.

Why is Deflation Bad?

Some of the negative impacts of deflation include the hit on company finances; revenues fall but the wages they pay their employees are typically more “sticky”, so the real wages they have to pay rise.

Most readers would however suggest their pay packets staying 'sticky' is a good thing, but consider that while your pay may not go down it certainly won't be going up very quickly either in a deflationary environment.

The clincher though is that a firm facing lower revenues and higher costs could lay off staff and contribute to a rise in unemployment.

In addition, the ECB, and other central banks for that matter, will be concerned that monetary policy can also become less effective at supporting the economy, as lower inflation leads to higher real interest rates.

These in turn cannot be offset by conventional policy when interest rates reach zero.

"And in a situation of high indebtedness, too low inflation increases the burden of servicing that debt," ECB President Mario Draghi noted at a speech given earlier in November.

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Will the Euro Fall Further or Rise?

The minutes to the November ECB meeting actually contain little new information. In a speech in Frankfurt, held on the 3rd of November, Draghi made it clear the ECB would act again:

"Even though domestic demand remains resilient, concerns over growth prospects in emerging markets and other external factors are creating downside risks to the outlook for growth and inflation.

"In this context, the degree of monetary policy accommodation will need to be re-examined at the Governing Council’s December meeting."

It was this speech that arguably sunk the euro exchange rate complex: on the 3rd of November the EUR to USD conversion was seen at above 1.10, it has since fallen into the 1.060's.

The pound sterling has meanwhile risen from the 1.399 region to test the 1.43’s.

Will the euro fall further? It seems to us that the damage posed by further interest rate cuts being announced in December has been done.

While the euro may fall further we will have to wait for the event itself for any significant volatility. The risks are certainly to the upside we believe - markets are so heavily positioned against the euro that any lacklustre announcement could snowball into a run above the 1.10 region against the US dollar.

Symmetrically, a fall back towards the 1.40 region against the pound could occur.

The stakes are high, as noted by Handelsbanken, "not delivering anything to the market will result in harsh price action after the large decrease in the EUR since the October meeting."

At the very least Handelsbanken believe the ECB could include the extension of the current programme beyond the end of September 2016 and/or the widening of the programme to take in other asset classes.

Even this would result in a stronger euro we believe – markets have priced the exchange rate at levels that require a cut to interest rates.

Handelsbanken say a strong measure would include an increase in the size of the asset programme and/or a deposit rate cut.
We have a sense that the market may already be expecting the latter owing to the aggressive nature of the November sell-off.

At present the base-case held by analysts is that the ECB will deliver that cut and ensure the trend lower in the euro continues, likely at a slower pace.

Handelsbanken themselves are forecasting the euro to dollar exchange rate to fall to 1.03 by the first quarter of 2016.

As can be seen in our collated forecasts there are some major thinkers out there who are more aggressive and the prospect for parity over coming months remains alive.

EURUSD forecasts

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