It’s no secret that the euro is now hitting record highs in its exchange rate with the dollar. It is also pretty apparent that some EU leaders are becoming rather preoccupied about the consequences of this for those eurozone economies which are driven by exports. What is much less clear though is what can be done about it.
The dollar early today was trading at $1.3065 per euro in Tokyo, signalling that the $1.30 psychological threshold may now lie behind us. Some experts are suggesting that the ECB would be reluctant to see the euro rise above $1.35, but since what is happening is more a dollar slide story than a euro rise one it is hard to see what they can effectively do about the situation.
Clearly this push-shove problem has been looming all year. Things seemed to get more relaxed in the late spring as comparatively strong US economic growth numbers distracted attention away from the problem of the liklehood of a continuing downward correction in the value of the dollar. The euro even fell back significantly and seemed to be happily hovering around the $1.20 mark. Now however this can be better seen for what it really was: a temporary respite on the road upwards.
The reasons for the dollar decline are also relatively well known: those dreaded twin deficits (trade and federal budget) and the continuing weakness in the US labour market. To be sure this latter situation has improved somewhat in the last couple of months, but it is still far too early to draw any definitive conclusions. I personally have my doubts that the recent momentum can be maintained as the impact of higher oil prices and rising interest rates make themselves felt.
Then there is the budget deficit. George Bush played mein host to a selection of top US bankers over at the White House earlier in the week in an attempt to reassure them that he was serious about reducing it. If he is, then obviously this will also act as another short term brake on the US expansion, and while in the longer run this would prove a plus for the dollar, the immediate consequence would be to encourage selling.
Up to now many in Europe have been cushioned from the full impact of rising oil prices by the upward movement in the euro, and Germany (Europe’s most export dependent economy) has managed against all fears to the contrary to ride out the storm (at least as far as exporting goes). But there is a limit to these benign consequences, and there will come a point where the negative impact will be all too apparent. It may well be that with both France and Germany now into a growth ‘soft patch’ that point is approaching.
So what could be done? European Union Monetary Affairs Commissioner Joaquin Almunia yesterday suggested – in a widely quoted interview – that the U.S. should help in avoiding sharp fluctuations in the currency markets.
“If the markets perceive or see that the political leaders and the economic leaders don’t want these sharper changes in the exchange rates, they will take notice of this message,” he is cited as saying.
This is to misunderstand the problem. Politically directed ‘talking up’ or ‘talking down’ may work in cases of short term fluctuations, but they can do little to prevent a long term correction.
US Treasury Secretary John Snow’s response was swift and to the point:
“The history of efforts to impose nonmarket valuations on currencies is at best unrewarding and checkered,” Mr. Snow said in response to a question on whether he would support an agreement with Europeans to manage the pace of the dollar’s decline. He made the comments after a speech in London.
In big picture terms Snow is undoubtedly right, although he himself has been trying hard over the past twelve months to disimmulate by repeatedly insisting that the US administration stood by a ‘strong dollar policy’.
Of course the ECB could respond by selling euros and buying dollars, ie by intervening directly. The Japanese did this earlier in the year, acquiring huge quantities of dollar denominated assets in the process, but to little real effect. It is unlikely than any such intervention by the ECB would fare much better.
Another possibility would be to lower interest rates, but with these already at historic lows of 2% there doesn’t seem to be much room to manoeuvre on that front either, especially since any prudent central banker would want to save some ammunition for later, just in case economic conditions should deteriorate.
So where does that leave us? Watching and waiting I suspect.