ECB: What can it do about a strong Euro? - ING

Given that a central bank cannot target inflation and the exchange rate at the same time, the ECB’s primary route to slowing the EUR rally will be through its impact on inflation, according to analysts at ING.

Key Quotes

“Research by the ECB pointed to a 1% depreciation in the trade weighted exchange rate increasing HICP by 0.1% after one year. Whether a negative pass-through of a similar magnitude applies to EUR appreciation remains to be seen. But our point is here that the ECB’s most credible path to curtailing EUR strength is through its impact on inflation and hence monetary policy. As above, we expect the ECB staff forecasts for 2018 and 2019 inflation to be revised lower from 1.3% and 1.6% respectively on September 7th.”

“In terms of monetary policy, a downward revision of the ECB’s own inflation forecasts would make the case for tapering even more complicated. We expect the ECB to change its narrative, away from a pure inflation-focus towards the strong economic performance of the eurozone and the bond scarcity issue.” 

“Nevertheless, even if the stronger euro is no reason to panic, it could affect the ECB’s taper game plan in the coming months, particularity once it would start to harm the current recovery.”

“Therefore, the stronger euro makes the case for a dovish tapering even stronger. The ECB will take some solace from the fact that a stronger euro has not been accompanied by higher interest rates. Talking down the euro would be counteractive to any tapering plans. This is why we expect the ECB to package any tapering plans in the most dovish way possible.”

“For example, they could do this by keeping the easing bias for QE in the official communication but also by stressing the (still) benign impact of a strong euro on the economy and strong domestic activity in the Eurozone. It could also mean that any tapering announcement in the next three months will be combined with an extension of the eligible assets for QE purchases, in order to avoid what the ECB often refers to as “unwarranted tightening of financial conditions”. However, all of these measures would probably not be enough to turn around market sentiment; it could only help capping a further appreciation of the euro.”

“If and when the ECB would really want to reverse current euro sentiment, only a clear announcement of a postponement of tapering would in our view help. However, bond scarcity makes it extremely hard not to start tapering at all.”