Frankfurt, London: For all the European Central Bank’s signalling of an interest rate “lift-off” next year, it might not get very far off the ground.
Some investors suspect even modestly higher borrowing costs will unleash a rally in the euro that undermines economic growth and curbs inflation. That could leave the currency bloc trapped with near-zero rates for years to come.
Spillovers from a potential slowdown in the US, the world’s largest economy, may also weigh on the ECB’s scope to tighten policy.
The dilemma for central bankers is that the Eurozone’s focus on exports and retrenchment in spending since the double-dip recession means that the bloc is now running a large current-account surplus. That puts upward pressure on the exchange rate, so far countered by the ECB’s ultra-loose monetary stance.
“It highlights that the ECB’s job is impossible,” said James Athey, a money manager at Aberdeen Standard Investments, who says the institution may not even be able to raise the deposit rate above zero, from minus 0.4 per cent currently. “It’s going to be difficult to carefully tighten financial conditions without an accident.”
Back in 2014, when the single currency was flirting with $1.40 (Dh5.96), the ECB cut the deposit rate below zero and laid the ground for an asset-purchase programme that will reach €2.6 trillion (Dh11 trillion or $3 trillion) by December. The euro almost plunged to parity with the dollar before slowly picking up as the economy recovered, and even those gains prompted some policymakers to express concern as it climbed to almost $1.26 earlier this year. It’s now around $1.16.
That currency slide helped boost the current-account surplus by making Eurozone exports more competitive. The monthly surplus is now typically well above 20 billion euros, compared with a persistent deficit in the run-up to the global financial crisis.
The asset-purchase programme will be capped at the end of December, and ECB officials have signalled their comfort with market expectations for an interest-rate increase around the final quarter of 2019. Executive Board members Peter Praet and Benoit Coeure have both said there will soon be a need to provide guidance on what happens after lift-off.
“The region is obviously sensitive to exports, so if then the exchange rate strengthens too much, it will disrupt trade,” said Richard Ford, head of European fixed income at Morgan Stanley Investment Management. “If your base case is that the euro is going to rally above $1.25, then Europe may have some challenges.”
The central bank is already struggling to revive consumer prices. Inflation data published Friday (September 28) showed the core rate unexpectedly slowing to just 0.9 per cent. The headline rate was boosted by energy costs.
A counter argument, for example by Claudio Borio, the head of the Bank for International Settlements’ economics department, is that central banks need to accept that reversing crisis-era monetary policy will be bumpy and just get on with it. The BIS warned in September that years of low interest rates have spawned a surge in zombie firms that are weighing down productivity.
Even the ECB’s Praet has acknowledged that keeping rates low for a long time can lead to a build-up of financial stability risks such as overextended home prices. “It may be the case that going to a more normal state is beneficial,” said Bob Michele, chief investment officer and global head of fixed income at JPMorgan Asset Management. “The risk in Europe is entrenching a disinflationary mindset by not acting.”
“In a perfect world, euro-zone recovery would be accompanied by higher interest rates and a stable currency,” said Keith Wade, the chief economist. “There is a danger that, like Japan before it, another economy with a current-account surplus and inability to create inflation, the Eurozone will find itself stuck with a very loose monetary policy for an indefinite period.”