A Stronger Euro Will Ruin The QE Taper Plans
Just like any good (or mediocre) telenovela, the plot twists at the central banks all over the world aren’t only very predictable, it’s also laughable how the presidents and chairman of the respective banks try to ‘guide’ the market by using specific words.
In just the past few months alone, we have seen several central banks making bold statements only trying to walk them back a few weeks later. An example? The Fed which was expected to hike the benchmark interest rates once again in September and to reduce the size of its balance sheet by winding down the trillions of ‘investments’ in securities.
The ECB followed suit, and Mario Draghi sounded extremely ambitious as he was already hinting at ‘normalizing the interest rates’ and to reduce the buyback rate of the securities. However, the recent ‘crash’ of the US Dollar versus the Euro might have some serious consequences for the Eurozone, and more specifically for the ECB.
In 2010, the OECD published a report discussing the impact of several economic (mini-) shocks on the GDP levels of several first-tier economic countries and areas. Based on the evidence from the next three charts, we would argue the ECB is still lightyears away from hiking the benchmark interest rate to a ‘normalized’ level.
Argument 1: the stronger Euro. In its 36-pager, the OECD has investigated the impact of a 10% depreciation of the US Dollar. According to its calculations, the recent 10% depreciation would have an impact of 0.1% on the inflation rate in the first year, increasing to 0.3% from Y3 on.
Argument 2: A sustained increase of 1% of the US benchmark interest rate (which has almost been reached) would only have a minimal impact on the inflation rate in the Eurozone. Whilst a negative impact of 0.1% might indeed seem to be negligible, but a 0.2% reduction of the Eurozone’s GDP is nothing to sneeze at either.
Argument 3: an increase of the Eurozone’s interest rates would only make things worse. The impact on the Eurozone GDP would be -0.7% from year five on, and the inflation in the Eurozone would actually DECREASE, as more people will want to save cash to take advantage of the higher interest rates. In fact, we would think this effect might even be underestimated because then the OECD made its calculations, it didn’t take into consideration consumers would be coming out of a prolonged period of NIRP and ZIRP policies. This could result in consumers being relieved to receive ‘anything’ on their savings accounts, further building up their equity to get a decent interest income.
So, taking all these parameters into account, there’s only one parameter the ECB has an influence on and that’s its own benchmark interest rate. It won’t really be able to actively steer the Euro-Dollar ratio (not unless it pumps more cash in the system) and it definitely won’t be able to do or say anything to rewind the rate hikes of the Federal Reserve.
The three parameters currently on the table would reduce the inflation rate by 0.6%, and have a negative impact on the GDP of approximately 1.6%. This could be dramatic as it’s could reduce the GDP growth rate of the Eurozone to zero.