If Christine Lagarde hoped that merely referencing the currency’s strength would be enough to take the wind out of the euro, she will have been disappointed
If Christine Lagarde hoped that merely referencing the currency’s strength would be enough to take the wind out of the euro, she will have been disappointed © Simon Dawson/Bloomberg

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Currency wars are back. The eurozone’s central banker in chief, Christine Lagarde, on Thursday made a nod to the strength of the euro, saying policymakers “will carefully assess incoming information, including developments in the exchange rate”. The European Central Bank president added later that the stronger single currency was “discussed extensively” during deliberations. It is the first time that the ECB has referenced the exchange rate in its policy statement since 2018. If Ms Lagarde hoped that merely referencing the currency’s strength would be enough to take the wind out of the euro, she will have been disappointed: the euro rose against the dollar.

One explanation is that Ms Lagarde did little to spell out how the ECB would react should the currency’s appreciation continue as it has done over the summer. The ECB president even appeared oddly optimistic on the region’s prospects. Ahead of the meeting the news on the economy had been downbeat, signalling that the recovery that followed the easing of lockdowns was petering out — notably in the dominant services industry that makes up the biggest share of output.

The most worrisome piece of news was a sharp fall in inflation, with the core reading that strips out changes in oil and food prices sinking below zero. A stronger euro will be unhelpful, further suppressing price pressures by lowering the cost of imports. Yet Ms Lagarde appeared dismissive of the inflation data, saying much of the sharp fall was largely down to temporary factors. While that is true, the ECB president should perhaps tread with caution here given the bank’s poor record in producing enough inflation to hit its two per cent goal. What is more, the latest round of quarterly forecasts showed inflation hitting just 1.3 per cent in 2022. Despite that, Ms Lagarde said there had been no discussion among policymakers on adding to the stimulus.

Few expected additional support to come as soon as today, with the ECB far from exhausting its Pepp crisis weapon, under which it can buy up to €1.35tn-worth of bonds, and rates already deep in negative territory. The currency outlook is uncertain. If the euro stays where it is, the damage to growth will be easy to contain — many of the region’s exporters will be able to handle a rate of $1.20 against the dollar, which is still significantly below the all-time highs around $1.55. The euro’s appreciation is also less stark when weighed against a broader basket of currencies. It also speaks of improved confidence in the collective response of eurozone policymakers, including governments, compared to the uncertainty rife in the US.

A more fundamental problem for the ECB is not the level of the currency, but what it says about people’s view of the central bank. There is a perception in markets that the eurozone’s monetary guardian is less dovish than its US counterpart and reacts too slowly to bad news. That perception was reinforced by Federal Reserve chair Jay Powell saying last month that he will tolerate higher inflation to create more jobs by moving to what is known in central bank parlance as “average inflation targeting” — a more flexible regime than the ECB’s, which corrects earlier undershooting of targets.

Neither the Fed nor the ECB can produce a recovery on its own. As Ms Lagarde noted, monetary policy will have to work “hand in hand” with fiscal policy if the eurozone economy is to see a fuller revival. Yet there is still more that the eurozone’s central bank can do. By doing little to stress what it has left in its armoury, Ms Lagarde has not allayed markets’ suspicions that the ECB is behind the curve.

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