Can we expect a stronger euro?

Escrito el 18 marzo 2008 por Gonzalo Garland en Uncategorized

The euro has moved up quite fast in recent weeks, and some European politicians are complaining about the effects this strong euro will have on euro-zone exports. In fact the euro is approaching the 1.6 dollar exchange rate, and several analysts are asking not if, but when it will break that mark. So an important question is: what can we expect regarding the euro and dollar in the next weeks and months?
It is almost certain that the Federal Reserve will continue decreasing interest rates, even today. As long as the financial crisis continues and expectations continue to be negative, there is a need to control the effects on the real economy and to try to stimulate demand. And this, we know, increases the interest rate differential with a euro-zone where interest rates are unchanged, and where if interest rates eventually fall, it is quite clear that it will not be at the speed that the Federal Reserve has applied. Therefore, there is a short term fundamental reason for the dollar to continue to be weak, and for the euro to continue to appreciate.

And even though the latest data on the US current account deficit shows a decreasing trend, the defiict is still very large, and therefore the pressure for a weakening dollar is also there.
In summary, we will continue to see a very strong euro and a weak dollar at still for a while. In past experiences, we have learned that the same way that the Federal Reserve decreases interest rates very fast when the economy is facing a slowdown, the Federal Reserve increases interest rates very fast when the recovery is underway. In this sense, monetary policy is much faster in the United States than in the euro-zone. So hopefully some indetermined number of months from now, and when the US economy will start recovering, we will start to see fast increases in interest rates in the United States, and that may mark the start of a recovery of the dollar that will also tend to calm down exporters in Europe. But for the time being we will continue to see dollar weakness and euro strength. It may be a good time for European exporters to make an effort on increasing productivity and reducing costs. This will leave them better prepared when the dollar becomes stronger. Germany is a good example of this. Despite the recent strength of the euro, German firms have been able to increase exports, and this remarkeble result has been prepared in recent years through a commitmment to contain cost and iincrease productivity. It is not an easy task, but there are no easy ways out of the present situation.


Fernando Peral 18 marzo 2008 - 15:31

As has been said in previous questions raised in this blog, the main problem is that the Fed works on economic activity (i.e. growth) as well as on inflation, while the ECB concentrates exclusively on inflation. For as long as this is so, every decrease in interest rates in the US will affect negatively the exchange rate with the euro.

As soon as the ECB behaves to prove to the markets a fundamental change (i.e. a deviation from its constitutional mandate) the exchange rate will start to adapt. The problem is that the ECB inflation figures are based on the eurozone economy, and not in particular countries, with very different consequences depending on each economic situation. Therefore, Germany, Netherlands, France, Belgium and Italy outweigh the other euro countries when determining inflation in the euro zone, and the present situation varies from 1.8% in the Netherlands and 4.4% in Spain.

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