Cooler euro lets ECB off the hook
The unfolding trade war will be the elephant in the room at Thursday's meeting, with no clarity yet on whether Washington will follow through on its threat of up to 30% blanket tariffs on European goods from next month. But another major discussion point may be the euro exchange rate, which has been a thorny issue for the central bank to navigate.
On one level, euro appreciation had broadly been welcomed by the ECB's top brass this year, as they embraced the potential benefits of a 'global euro' and apparent investor move from U.S. assets to European markets.
Policymakers appear to believe that siphoning off at least some of America's long-standing "exorbitant privilege" to cheapen its own hefty investment needs is, on balance, worth any marginal burn to export competitiveness.
And the strong euro also played into the hands of interest rate doves, as it weighed down on import and commodity prices.
But rumblings of unease about the euro's 15% surge against the dollar this year started to emerge within ECB ranks at midyear, and this has coincided with a 1.5% retreat of the supercharged single currency from its near four-year high above $1.18 on July 1.
At the ECB's annual conference in Sintra in Portugal, ECB vice-president Luis de Guindos said the central bank could ignore the euro's rise against the dollar up to $1.20, but not higher. "Beyond that, it will be much more complicated."
Latvia's central bank boss Martins Kazaks was more pointed: "If there is a 10% tariff plus a 10%-plus appreciation of the exchange rate, this is large enough to affect export dynamics."
De Guindos then doubled down on that view last week when he said, "Let's hope it (the euro) will stabilise somewhat and that it won't have any further negative impact from the point of view of ... economic growth."
What is clear amid all these statements is that there is an ECB pain threshold for euro gains in the middle of trade war. And the higher the tariffs eventually turn out to be, the more acute the hit.
For the doves, further appreciation helps the case for a resumption of rate cuts below the current 2% level, considered a neutral setting by most. But additional strengthening would agitate hawks who fear euro distortions may lead to an outright stimulative policy inappropriate given worrying price dynamics from wages and upcoming fiscal stimuli.
Whether public ECB warnings were partly responsible for the euro retreat this month is a moot point.
But something of a game of chicken may now be underway, not least because the dollar has stabilized and the recently broken relationship between currencies and the Transatlantic interest rate and yield gaps has re-asserted itself to some degree.
U.S. policy disruption and institutional concerns caused the dollar to plunge earlier this year despite the widening U.S. bond yield premia over Europe , but it's started to shift again.
Any renewed euro surge combined with sharply higher tariffs would surely embolden the ECB ease again in September, more confident it can rein in the currency this time at least. Markets are priced for at least one more in the current cycle.
Deutsche Bank, which retains its call for a "terminal" ECB rate as low as 1.5%, said the risks may have risen that ECB is slightly more cautious than that.
Deutsche's Mark Wall claims there's a key difference in what the ECB will see as an "exogenous" euro shock that happens regardless of interest rates and economic strength and one that eventually builds as the economy improves under fiscal stimulus.
"Not all FX appreciation is the same," they said.
So, in effect, the central bank is juggling with timing and sequencing - easing now to guard against deflationary pressures in a relatively weak economy while preparing to reverse that next year when Germany's giant spending boost kicks in.
"As this transition occurs, FX could become less of a constraint on monetary policy," Deutsche reckons.
The ECB may get summer off, but it has tricky fall ahead.
The opinions expressed here are those of the author, a columnist for Reuters
-- Enjoying this column? Check out Reuters Open Interest (ROI), your essential new source for global financial commentary. Follow ROI on LinkedIn. Plus, sign up for my weekday newsletter Morning Bid U.S.
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