The year 2017 ended with a development that probably no one had anticipated, namely that Germany would face political uncertainty. However, that is exactly what happened with our eastern neighbours.
After the German elections, it was almost immediately clear that the coalition between Angela Merkel's CDU/CSU and the SPD would come to an end. The SPD lost considerably and announced that it would be in the opposition. Merkel, who also scored less well, had to sit down with 2 other parties.
One party was very skeptical about the euro and about the plans for deeper integration of the eurozone. The other party (the Greens) were very pro. No wonder those conversations came to nothing.
Two possibilities
Then there were only 2 options left: new elections or the CDU/CSU and the SPD would still continue together. However, as previously stated, the SPD was not actually in favor, but in the country's interest that party still went to talk to Merkel. Those talks also went smoothly, but on Friday January 12 it was announced that the parties had achieved a breakthrough. It seems that there is nothing to prevent the two parties from governing Germany for the next 2 years.
(Text continues below the tweet)
Eurozone integrates further
This does not mean that nothing has changed in the political field in Germany. The situation is indeed different, with all its consequences for the eurozone and the interest rate policy of the European Central Bank (ECB). Where the CDU/CSU does not want further integration of the eurozone (joint government bonds, a European Monetary Fund, its own Ministry of Finance and its own budget), the coalition partner is in favor of that.
In recent years, the CDU/CSU was by far the largest and strongest party and was able to determine Germany's European course. That would be different if the new coalition continued. The SPD does not have to participate in government and only does so because Merkel needs it. And that means that the SPD can and will get quite a lot at the negotiating table.
France has the advantage
One of those demands is Merkel's position later this year, when further integration of the currency union is discussed. We must take into account that Germany will grant more wishes from France and other countries. In short, this means that Germany will pay more money and, for example, will agree to such a European Monetary Fund.
What does that have to do with ECB policy? First of all, Germany's changed position means that the chance of tensions between the two largest euro countries (Germany and France) has become much smaller. In addition, it means that there is less uncertainty about the continued existence of the euro, which increases the chance that the common currency can rise in value (against the dollar).
This is especially true because political and economic uncertainty is expected in the United States (US) in the second half of the year (Americans will then elect a new parliament). It could be that President Donald Trump's Republican party loses its majority and that the US can pass all kinds of laws. In short: political uncertainty affects the economy and would make the dollar less attractive.
(Text continues below the tweet)
Policy longer broad
From the ECB's perspective, the above scenario would mean that the bank can keep its very loose monetary policy loose for longer. Mario Draghi's current intention is to phase out the purchasing program of government and corporate bonds from September and to stop it completely after a few months. However, should the euro strengthen over the course of this year, the outlook for inflation would be negatively affected.
A strong euro means that everything imported by the euro countries becomes cheaper. That is something that drives inflation down. Knowing that the forecasts for 2018, 2019 and 2020 show that inflation will be too low for those years, it will not be surprising if the ECB decides to take things a bit easier in phasing out the purchasing programs.
Strong euro
In addition, a stronger euro makes exports from the euro countries more expensive, expressed in other currencies. There may therefore be some headwinds for economic growth from that angle, which will not prompt the ECB to restrict monetary policy more quickly.
In concrete terms, all this means that interest rates for all maturities in the euro will remain low for longer. This is not the same as saying that prices will not increase. Long-term interest rates in particular are likely to rise. This is due to continued economic growth, inflation and the prospect of a less loose monetary policy. However, a rapid increase seems very unlikely.