The European Central Bank (ECB) has been involved in loose monetary policy since October 2008. Of the market manipulation activity the ECB has been involved in over this period are manipulating short-term and long-term interest rates (to varying degrees of success).
The market intervention in the short-term market has come in the form of lowering the ECB's EURIBOR short-term interest rate from a high of 4.5% in September 2008 to a recent low of about 0.1% in October 2013 (top right chart of the following figure).
On the long-term interest rate side, the ECB has implemented two longer-term bond purchase programs (bottom two charts of the following figure).
The first of the two began in July 2009. The program reached a peak of about €1.9 trillion in July 2010, after which the program has declined to about €1.3 trillion at the end of September 2013.
The second of the two began in began in November 2011, reaching a high point of about €507 billion in October 2012. Since October 2012, the program has declined to about €474 billion at the end of September 2013.
Over the same period of the ECB's EURIBOR and covered bond purchase programs (September 2008 to current), the Euro per Dollar exchange rate is up about 5.9%, from €0.6970/$ to €0.7378/$ (top left chart of the figure on the first page and the figure below).
Two questions:
- Why is the Euro up even though the ECB has been so active at increasing the money supply (inflation risk) and lowering short-term and long-term interest rates?
- Would ECB tightening hurt the Euro?
On the first question, the relative strength in the Euro is likely due to a few factors. First, European economic growth has generally beaten very low expectations, pushing demand for the Euro higher. Second, competing economies, and particularly the United States, are performing below expectations. This is partially due to the job-killing health care and political stalemate between the President and the Congress. Third, austerity appears to be working in Europe, at least when it comes to Euro demand. Fourth, and this is certainly more controversial, is that the Euro may be gaining a reputation as being more stable than the Dollar, perhaps in a direction towards replacing the Dollar as the world's reserve currency. Of course, the last statement is not going to happen overnight, but may happen gradually. The process happens slowly as international confidence shifts among investors and businesses.
Now, to the question of interest - would ECB tightening hurt the Euro? Let us look at Euro performance relative to the U.S. Dollar when initial easing actions were taken.
Following the initial steps to lower the EURIBOR, the Euro gained a good deal of ground, peaking at up almost 13% relative to the dollar in November 2008 relative to September 2008. Part of this strength might have been due to the U.S. presidential election. Most of this was likely due to the view among investors that the housing market induced U.S. recession would be worse then the Euro recession.
The next initial easing step was in July 2009, when the ECB announced the first covered bond purchase program. Foreign currency investors did not like the move, pushing the Euro lower for the next four months. In November 2009, the Euro gained strength in a big way, gaining more than 20% from November 2009 to June 2010. The Euro gave some of that gain back by the end of 2010, but still ended the year is strong positive territory.
The next major ECB easing action was in November 2011, when the ECB announced the second covered bond purchase program. The market liked this program almost as much as the first, boosting the Euro up almost 11% from November 2011 to July 2012.
Overall, all three ECB easing actions were followed by strong euro performance. One might conclude from this that ECB tightening might hurt the Euro.
Interestingly, the Euro is now on a downward trajectory, and has been on this direction sinceJuly 2012. This might be due to competing central bank policy messages. In the United States, the issue has been how quickly the Federal Reserve might tighten its monetary policyby tapering its $85 billion per month bond purchase program. At the same time, the ECB has been quietly signaling that more easing might be on the way. One might interpret the signaling story along with the downward trend in the Euro/Dollar exchange rate as a sign that it's time for the ECB to get serious about monetary policy tightening, at least if the ECBintends to keep the Euro strong.
Overall, the Euro has strengthened over the period of monetary policy easing, contrary to what one might have expected. The gain in the Euro has various explanations, including stronger than expected economic growth and benefits from austerity. On whether ECBtightening would hurt the Euro - it depends on which story you want to believe.
