eco TV Week

The headaches of the ECB


The Covid-19 represents a massive disinflationary shock because of the demand shortfall it creates. This has triggered a very strong reaction of central banks across the globe, including the ECB. The ECB’s action –in particular the PEPP- has been successful in maintaining fluid financing, both bank-based and capital-market based. Nevertheless, the ECB has a headache, three actually. Inflation is too low and declining, the strong euro reinforces this development and there is concern that the change in the longer-term goal of the Fed, which will now target inflation averaging 2 percent over time, will complicate matters.


TRANSCRIPT // The headaches of the ECB : September 2020

Part 1: negative inflation in August

The first one is that inflation is low and declining.

August -0.2% versus median consensus of +0.2%. Core hit record low, in part explained by discounting during summer sales.

Part 2: The second one is the strengthening of the euro

The most eyecatching has been versus dollar with euro reaching 1.20 but also versus other currencies, so on an effective exchange rate basis, it has appreciated.

For good reasons: Next Generation EU 750 bn recovery fund. Euro undervalued versus dollar.

For reasons which are source of concern: change in Fed longer run goals (more on that in a minute).



1.           Risk of more downward pressure on inflation


Since the lows this year the euro has strengthened about 12% versus the dollar and 7 percent on an effective exchange rate basis.

ECB calculations shows 1% appreciation causes over a 3 year time span a decline in inflation of about 0.05%, so 5 basis points. A 10% appreciation would thus exert downward pressure to the tune of 50 basis points, which would be a real issue.

2.           Impact on competitiveness

3.           Tightening of financial and monetary conditions

Creates balancing act in terms of communication: need to express it is being monitored (so the issue is not neglected) but avoiding to express too much concern (which would raise expectations of significant policy action).

Philip Lane’s comment takes the middle ground by saying that the euro’s level does matter for monetary policy. This was enough to cause some euro profit taking.

“Europe’s common currency touched $1.2011 on Tuesday, its highest since May 2018, before tumbling back to $1.1907, or 0.3% lower on the day. Options-related selling around the day’s highs and a rebound in the dollar helped fuel the reversal, as did ECB member Philip Lane’s comment that euro’s level “does matter” for monetary policy.” (Euro Falters After Eclipsing Key Level as ECB’s Lane Weighs In, Bloomberg, September 1, 2020)


Part 3: The third headache is the Fed’s new policy


The Federal Reserve has changed it longer-run goals: achieve inflation averaging 2 percent over time. Puts the onus on ECB and its own strategy review.

Clearly, an objective of “inflation close to but below 2%” sounds far less dovish than the Fed’s new inflation averaging approach.

This could structurally underpin the euro, making it even more difficult to generate enough inflation.

Clearly, next week’s ECB meeting is more important than ever in terms of the messages it may bring.


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