A stronger euro is not really what Mario Draghi, president of the European Central Bank (ECB) is waiting for. On the contrary, he should welcome a stronger European currency in the coming days or a few weeks.
No, I didn't find it strange that Mario Draghi sounded rather hawkish at the most important annual ECB meeting in Sintra (Portugal). His speech could best be interpreted as a clear hint that monetary policy in the eurozone will soon become less accommodative.
I didn't find that strange. Not because Draghi wants that so much, but because I can imagine that more and more of his colleagues are starting to grumble. It is an open secret that some directors have never really been big supporters of the policy of 0% interest rates and quantitative easing. However, many did support that line, because the economy was hardly growing and the danger of recession was present, as was the danger of long-term deflation. Central bankers consider falling prices to be about the worst thing an economy can experience.
However, now that the economy of the currency union is growing reasonably well (since the beginning of 2016, the eurozone has performed better than the American economy every quarter) and the danger of deflation has passed, according to Draghi, more and more ECB members believe that the bank is moving towards a normal monetary policy must go. And otherwise she must at least indicate that she is going to take that path.
Don't get me wrong, but a very large majority has absolutely no appetite for normalization of monetary policy. They just want to make it slightly less loose, mainly out of fear of what could happen if that policy remains very loose in an environment of rising inflation and reasonable economic growth. It could then be that the credibility of the ECB, the most important activity of a central bank, is at risk.
Dollar less attractive
One of the consequences of Draghi's speech was that the EUR/USD rose considerably. Logically, if the ECB announces that interest rates will rise. This means that the euro will become more attractive. In other words: it will yield more. Anyone who wants to make a profit by then would do well to buy the European currency now at its current value. The demand for the euro ensures that the stronger euro will not come later, but almost immediately.
The euro also received help from the United States, where people are increasingly questioning whether Trump can implement his many plans. For example, he promised huge investments in infrastructure and tax cuts. Both things should boost the economy in the United States, something that made the dollar more attractive. That is why the EUR/USD fell sharply after the American elections.
However, now that the question is whether Trump can implement those plans, like the whole scene surrounding the repeal of Obamacare, that takes some of the shine off the dollar. On top of that, investors are also wondering whether the Fed will raise official interest rates in the United States 2018 times between now and the end of 4. The prospect of interest rate increases has also pushed the EUR/USD down in recent quarters.
Un-Draghi-esque
No, I didn't find it strange that Draghi sounded un-Draghi-like in Portugal. What I did find strange is that a week later he did not seize the golden opportunity to talk the euro down again.
Exactly a week after Sintra, the ECB board met. The press conference afterwards was an excellent opportunity to talk down the EUR/USD. Draghi is known as a central banker who is generally not a fan of a strong currency. He certainly does not want to see a stronger currency now, because it could jeopardize the economic recovery and push down inflation in the euro zone.
Knowing that Draghi is a very experienced central banker, it would have been easy for him to push down the EUR/USD last Thursday. An extra dramatic pause here, or a strategic 'slip of the tongue' there, or a well-timed hint in one of his answers would have sufficed.
But although it seemed that the journalists present did their best and competed to see who would give Draghi the best cross to head in a weaker euro, the ECB leader still did not do so. I thought that was strange. Very weird.
After the meeting I went for a walk and as I walked I couldn't help but wonder why he wasn't using it. And then under the shade of a large lime tree, which encloses my favorite walking path in the neighborhood, I thought: it makes a lot of sense.
Sophisticated strategy
Back to the core: what does Draghi want with the ECB's monetary policy? Keep that for as long as possible and as widely as possible. Can he do that? No, because the danger of deflation has passed and the eurozone economy is growing reasonably well. So it is very unlikely that he will be able to convince his board not to tighten monetary rules.
In addition, the ECB economists' inflation forecasts for 2018 and 2019 show that inflation will not rise to the target rate of 2%, but will not fall either. The latter is crucial for the governance of the ECB: inflation is expected to remain around 1,5%. At that percentage, it is not necessary to purchase government bonds (for €60 billion per month) and it is also not necessary to keep the interest rate at 0%.
In September, economists will publish their new inflation forecasts. The only way Draghi can convince his administration to slowly phase out quantitative easing and keep interest rates at 0% is if those new estimates show that inflation is far from the target rate.
But what does that have to do with the euro? Everything! Draghit cannot instruct the economists to do their calculations in such a way that he gets a desired result from the calculations. However, he can do something else to influence the outcome.
Sly Fox
When economists make their estimates, they use, among other things, the average rate of the EUR/USD. They use this in the 10 days prior to the day on which the estimates are made (the so-called 'cut off date'). They assume that this rate will remain the same throughout the entire duration of the predictions.
In short, early August EUR/USD will be crucial for September estimates. If the rate remains around 1,15, it will be considerably higher than the rate used in June. At that time, the ECB economists worked with an exchange rate of 1,07/1,08. If they were indeed to use a rate of 1,15 for their September estimates, this would certainly result in a lower inflation estimate.
That may explain why Draghi first talked up the EUR/USD and then passed up the opportunity to bring the rate down. Allowing the euro to temporarily strengthen in order to push down the September estimates for eurozone inflation in 2018 and 2019 could be the reason. Draghi is a very experienced banker and it is therefore impossible that his boosting the EUR/USD is a coincidence.
If the price were to move towards 1,20, Draghi would intervene. However, a few weeks of fluctuating at 1,15 and 1,20 would suit the Italian cunning fox very well. The great thing about this is that the EUR/USD will naturally fall again if investors get the idea that the reduction in the euro zone will be slower than they think and the first interest rate increase is still years away.