ECB mulls monetary stimulus, but faster growth comes with risks
With the ECB mulling a radical rethink in favour of monetary stimulus, a declining euro will spur Europe's growth, but there are risks
A revolution is under way at the European Central Bank. A new order is sweeping aside monetary conservatism in favour of faster growth - and that puts the euro at risk.
This week's monetary policy meeting should see the ECB enter a dramatic new phase of monetary accommodation. For many months there have been rumblings from the ECB about the need for "alternative measures" to bolster recovery and growth. ECB president Mario Draghi has repeatedly stressed his readiness to act against the risk of deflation.
Germany's Bundesbank, the custodian of tough monetary rigour in Europe, has steadfastly stood in the way. The Bundesbank has always insisted the ECB should follow its hawkish lead on inflation, but this is about to change.
Economic necessity is finally prevailing in ECB policymaking. A flagging euro-zone recovery and the crisis in Ukraine pose significant new risks to growth. Unemployment at 12 per cent is dragging on domestic demand and the strong euro is hurting exports, which means the euro zone could easily be pushed back into recession.
The Bundesbank has finally woken up to this fact and recognises the need for a substantial change in policy. It is openly speaking in a new language. It sounds eerily like monetary appeasement. New policy options - quantitative easing (QE), negative interest rates and a weaker euro - have entered the discussion.
These were all hinted at by Bundesbank chief Jens Weidmann in a speech last week, in a moment that could be an epiphany for euro zone policy. At the very least it is a symbolic departure from the Bundesbank's old ways.
The Bundesbank is well aware the ECB's conventional monetary tools are spent. Interest rates are close to zero. The economy is awash with a glut of cheap emergency funds. The ECB bought distressed government bonds, but sterilised the monetary effects. That policy response has fallen short of the mark needed to generate a sustained economic recovery.
The growth-starved euro zone desperately craves new monetary initiative. With the ECB mulling a shift to QE and negative rates and expressing a preference for a weaker euro, there is some hope.
But there will be market consequences. The euro would be left standing on a trapdoor. The currency could fall far - and fast.
Policymakers tend to get their way on currencies. Markets think they are in the driving seat, but it is the central banks that move the steering wheel. If the ECB wants a weaker euro to help boost exports, revitalise growth and act as a foil against deflation, then that is what it will get.
The danger for the euro is that ECB pushes a little too hard at a time when the currency's fundamentals have already turned negative. Relative rate dynamics shifted against the euro the minute the US Federal Reserve began hinting that its own tightening cycle could kick off from as early as 2015 - months earlier than the market consensus had expected.
Meanwhile, the ECB is laying the groundwork for euro- zone rates to dip into negative territory. They could stay very low for years to come, while US rates rise as US growth accelerates.
This is not good news for the euro. Not only would it be less attractive to hold as an investment, it would become liable to be used as a funding currency for carry trades into higher yielding assets. The US dollar has filled this role in recent years. If the euro takes over the role, the US dollar will fly and the euro will sink.
Relative bond spreads have also tipped against the euro.
With the Fed's asset-buying programme gradually being tapered down, US Treasury yields have been trending higher. Meanwhile, the euro zone inflation slump and speculation about QE have depressed euro-zone yields. The 10-year German-US government yield spread has turned negative against the euro to the tune of 120 basis points.
In the euphoria about new ECB easing initiatives, Italian, Spanish, Portuguese and Irish bond yields have also sunk to new lows, sapping the euro's relative yield appeal even more.
Foreign exchange markets like picking winners. And they really like currencies backed by strong growth fundamentals.
The US economy is already enjoying the fruits of the Fed's super-stimulus, with underlying growth trending over 3 per cent. Euro-zone growth is barely scraping above 1 per cent. It is clear that market psychology will back the US dollar against the euro. The ECB might want a weaker euro. The risk is that the markets will end up overshooting. Fair value for the euro, implied by purchasing power parity is probably closer to US$1.20, not too far adrift from the euro's inaugural rate of US$1.1743. A move down to these levels would bring great joy to hard pressed euro zone exporters - especially in France, Italy, and Spain.
But currency targeting is a blunt tool. A cheaper, more competitive euro simply means that Germany's trade surplus gets even bigger. And that has been anything but good news for its euro-zone partners for the last decade or so.
David Brown is chief executive of New View Economics