Anyone who doubts that European Central Bank President Christine Lagarde has a euro problem has not been paying attention to that currency’s recent swoon.
Between the pandemic's effect on public finances and the war in Ukraine, the euro zone finds itself in a tough spot.
A nyone who doubts that European Central Bank (ECB) president Christine Lagarde has a euro problem has not been paying attention to that currency’s recent swoon. A weakening currency is the last thing that Lagarde needs at a time when the ECB is trying to tame euro zone inflation, which is now running at 7.5 percent, the fastest rate since the euro’s 1999 launch. A depreciated euro adds to inflationary pressure by raising import costs in general and the cost of dollar-denominated commodity imports in particular.
Those doubting Lagarde’s euro problem have also not been paying attention to the serious damage that the Covid-19 pandemic has wrought on Europe’s public finances in general and on Italy’s in particular. That deterioration makes it difficult for the European Central Bank to defend the euro by hiking interest rates or by curtailing large-scale ECB bond buying for fear of triggering another round of the euro zone sovereign-debt crisis.
Since the start of the year, in the space of a few months, the euro has lost around 8 percent in value against the dollar and is showing no sign of stabilizing. As a result, it is now trading at lower levels than those plumbed during the depth of the 2010 euro zone sovereign-debt crisis.
The principal factor driving the euro lower has been the divergence in monetary-policy stances between the Federal Reserve and the ECB. Whereas the Fed appears to be at the start of a meaningful interest-rate-hiking cycle to regain control over inflation, the ECB keeps insisting that there is no need for higher ECB interest rates despite record-high inflation. As in the past, higher U.S. interest rates than those in Europe have increased the dollar’s allure.
Similarly, whereas the Fed is planning to reduce dollar liquidity by $95 billion per month through not rolling over its bond holdings at maturity, the ECB keeps adding to euro liquidity by continuing with its bond-buying program. Also supporting the U.S. dollar has been its status as a safe-haven currency at a time of heightened global economic uncertainty.
The general way to defend a weakening currency is for the central bank to raise interest rates and to stop printing money through bond purchases. However, as illustrated by Italy’s very compromised public finances, that avenue would seem to be severely constrained for the ECB for fear of inviting another round of the euro zone sovereign-debt crisis.
In the wake of the pandemic, Italy’s budget deficit ballooned to around 10 percent of GDP while its public-debt-to-GDP ratio skyrocketed to 155 percent or to the highest level in the country’s 150-year history. The only things that have kept Italy afloat over the past two years have been the ECB’s negative-interest-rate policy and its massive bond-buying program. It certainly has helped Italy that the ECB’s bond buying involved the purchase of the entirety of the Italian government’s net debt issuance and that ultra-low interest rates kept Italy’s debt-service costs in check.
Lagarde now seems to be faced with a difficult policy dilemma. She can leave interest rates unchanged and continue bond buying to support the euro zone’s troubled economic periphery — but at the cost of inviting further euro weakness. Alternatively, she can start raising interest rates and end the ECB’s bond buying program to support the currency — but at the cost of inviting another round of the euro zone sovereign debt crisis.
One way out of Lagarde’s dilemma would be an early end to the Fed interest-rate-hiking cycle as well as to the geopolitical troubles that are increasing the dollar’s safe-haven appeal. However, with U.S. inflation so high and with no end in sight of Russia’s Ukrainian war, I would not bet the farm on that happening anytime soon.