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One size does not fit all in the eurozone

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For years, when discussing the flaws in the euro, economists have cited the problems with the one-size-fits-all monetary policy and the fact that, denied the traditional escape route of currency devaluation, underperforming member states would be forced to undergo a painful period of deflation in order to restore competitiveness. For years, Southern Europe has been on the cusp of outright deflation, while unemployment levels have been (and remain) alarmingly high, particularly in the case of the youth figures.This has left Southern Europe stagnating.   

Meanwhile, Germany with its massive exporting machine, riding on the back of a euro that was always much weaker than the old Deutsch Mark would have been, was spared the worst of the post-2008 fallout. In a deflationary world, a weak currency is a positive boon.

Times change, however, and almost a decade’s worth of ultra-loose monetary policy is, at last, having an effect. Eurozone inflation in the year to December 2016 was 1.1% - not exactly out of control but moving steadily towards the ‘close to but below 2%’ target. In Germany though, the rate as of December was already 1.7%. This too is unremarkable until one considers that the rate for the year to November was only 0.7%. While it is true that the increase was mostly down to the sharp rise in fuel prices, and core inflation remains subdued, rising fuel prices have a nasty habit of eventually feeding a more general increase in the price level.

If it is too politically painful (just ask Matteo Renzi) to pursue competitiveness through deflation in Southern Europe, might it be politically more acceptable to pursue a European rebalancing via a little more inflation in Northern Europe? If one were considering any other region in the world, it would be tempting to answer in the affirmative. Unfortunately, the thought of running above target inflation in Germany is simply anathema. The German elections are to be held in September, and if the inflation rate were above 2% by then, candidates would need to make it very clear that they were going to do something about it – notwithstanding ECB independence.

Hence the ECB could soon find itself between a rock and a hard place. Monetary policy has not been sufficiently loose to protect Southern Europe from the worst of the post-Great Recession fallout. But for Germany, benefitting all along from a weak currency, monetary policy was much closer to ideal. Now, as the eurozone recovers, monetary policy is beginning to look more appropriate for the South and increasingly too loose in the North – particularly in Germany itself.

The ECB must choose between keeping policy sufficiently loose to consolidate the recovery in the South (and running the risk of German overheating and politically toxic inflation) and setting policy with more of an eye on Germany, meaning a quick end to QE and possibly even higher rates that risk nipping the Southern recovery in the bud. Effectively Mario Draghi and colleagues face the unenviable task of being vilified by the North for inflation or by the South for a return to stagnation. It was ever thus, but the prospect of above-target inflation looks set to test the European credentials of even the most pro-European cohorts of the German electorate.  

On the foreign exchange markets, participants appear to have entered a period of uneasy limbo ahead of the inauguration of President-elect Trump on 20 January. Many are forecasting a EUR/USD rate of 1.000 or lower on the back of Trump’s dollar-positive combination of looser fiscal and tighter monetary policy. However, much is already factored in. The Fed could disappoint by remaining ‘behind the curve’ and Trump himself could deliver less than the markets expect on the fiscal stimulus front. Meanwhile, recovery in the eurozone itself maintains its steady, if undramatic, course. Unemployment remains unacceptably high at 9.8%, but November’s level was the lowest since July 2009. Meanwhile, in the three months to September 2016, GDP growth was 1.7% higher than in the same quarter of 2015.

There is little doubt that the markets are positioned for further dollar strength against the euro. The big surprise would be if the ECB did indeed bow to German pressure and eurozone monetary policy turned out to be significantly tighter in 2017 than markets currently expect. This would strengthen the euro, placate Germany and compound the problems of Southern Europe. It would only take President Trump to disappoint the markets by reining in his plans for fiscal stimulus (not so unlikely as he begins to appreciate the responsibility and limitations of office) to lead to a big upward move in EUR/USD. 

All views expressed here are the author’s own and are based on information available at the time of writing.

 

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