The European economy and the weakening of the dollar

The euro area economy experienced an unprecedented shock, so price increases are in the doldrums. Europe’s monetary authorities are fighting the turmoil of the corona pandemic with billions of euros in credit programmes and are emphasising the positive effects. With the low interest rates, it will stay for now, the European Central Bank (ECB) leaves the key interest rate at 0%.

In the ongoing Corona crisis, Europe’s monetary authorities are taking a break for the time being. Despite worryingly low Inflation and the deep economic slump, the ECB is sticking to its loose course. This policy is based on the assessment that the slump in the European economy is likely to be somewhat smaller than previously assumed. For this year, the economic performance of the 19 euro countries is expected to shrink by 8.0% t.

But the slump is predicted a little less than three months ago. The ECB had assumed a contraction of 8.7%. For 2021, the expected recovery of the economy was slightly reduced from 5.2% to 5.0%, and for 2022, the ECB expects growth of 3.2% (previously 3.3%).

ECB chief economist Philip Lane had previously warned against an overly optimistic assessment of the economic recovery following the corona slump. The recent global increase in new infections will continue to weigh on consumer sentiment and business sentiment for some time to come. It will take some time before the economy fully recovers, which is why government aid measures and an active monetary policy are still necessary.

In the second quarter, economic activity in the Euro area fell by 11.8% due to the standstill in economic and social life in many member states. Since then, we have seen a fragile but continuous upward trend, with business in manufacturing in particular continuing to improve in contrast to the services sector, the central bank’s economists report. However, they still see more risks than opportunities in future development, which depend heavily on success in containing the Virus. The recovery in Europe is supported by favourable refinancing conditions, expansionary monetary policy and a strengthening of global demand and economic activity.

In the corona crisis, the trend towards weak inflation rates has intensified. In August, consumer prices in the Eurozone fell again for the first time since 2016. According to an initial estimate by the statistical office Eurostat, the inflation rate fell to minus 0.2%, and in July the Rate was still up 0.4%. This is a far cry from the target of just under 2% that the ECB is aiming for in the medium term.

Falling consumer prices are a potential risk for the economy. They can trigger a downward spiral if consumers and companies focus on falling prices and push back on investments and purchases by consumers. The European Central Bank and national governments are therefore striving to combat a deflationary downward spiral.

However, the monetary authorities around central bank head Christine Lagarde did not decide on any major new support steps at their interest rate meeting. The central bankers left it at the announcement to adjust all their monetary policy instruments if necessary. Lagarde has not ruled out the possibility of a key interest rate cut: “there may be circumstances in which Asset purchase programs are more efficient to achieve our goals, and there may be circumstances in which interest rates are more efficient.” In recent months, the Governing Council has found that purchase programmes are the right Instrument, but it does not exclude any of the other instruments available.

The ECB president praised the fiscal measures in the EU and the individual member states. The Governing Council welcomed the €750 billion reconstruction fund agreed in Brussels. However, this fund still lacks the approval of the European Parliament and its impact has not yet been incorporated into the central bank’s economic projections. Lagarde also positively highlighted the three safety nets for workers, companies and states approved by the EU Commission for a total of € 540 billion.

In the wake of the unprecedented economic downturn following the Corona crisis, the euro central bank had launched extensive aid measures. In June, it increased its major pandemic bond-buying program PEPP by € 600 billion to € 1.35 trillion. net purchases under the Asset Purchase programme (APP) will continue at a monthly pace of 20 billion euros, along with purchases under the additional temporary turnover of 120 billion euros by the end of the year. These securities purchases help states like companies, they do not have to offer such high interest rates when a central bank acts as a large buyer on the market.

At their meeting, ECB monetary authorities were presented with new projections by their economists, which gave a somewhat clearer picture of the extent of the crisis. The ECB is particularly concerned about weak Inflation. The euro central bankers left the key interest rate at the record low of 0%, at which it has been since March 2016. Economists expect it to remain there in the fourth quarter of 2021.

There were no changes in the penalty rates for banks either: the deposit rate remains at minus 0.5%. A negative rate means that cash houses have to pay interest if they park excess liquidity at the central bank. Since last autumn, however, the ECB has been granting exemptions from penalty rates in order to relieve the banks. The ECB first lowered the deposit rate to below 0% in 2014.

The economic recovery in Germany and the Eurozone lost momentum in August. The Purchasing Managers ' Index, which includes service providers and industry, fell by 0.9 points to 54.4 points in Germany. This was announced by the IHS Markit Institute on the basis of the monthly survey results. While industry accelerated its upward trend recently, the pace of service providers declined. Markit economist Phil Smith said:" in consumer sectors, the first upswing following the end of the lockdown has already eased somewhat."

Compared with other major euro countries, however, Germany is still doing well: in Italy, the comparable Index has already fallen below the 50 mark to 49.5 points, signalling a decline in business, while in France it stands at 51.6 points. In the Eurozone as a whole, it fell by 3.0 to 51.9. “The economic growth of the monetary union clearly lost momentum in August,” concludes Markit. Chief economist Chris Williamson explains: “the deterioration has largely been linked to concerns about the rising numbers of infections. Consumer companies were particularly affected, especially in Spain and Italy, where particularly strict containment measures remained in force.”

Experts predict a significant recovery for the current summer quarter. Without at least simultaneous recovery processes of the European internal market or the globalized world economy, however, there can be no return to the usual dynamism of the export-heavy economy of the “Berlin Republic”.

It is also a Problem that the Euro has gained about 10% against the Dollar in the last four months. This reflects, above all, a rather surprising weakness in the dollar. Because the US currency is usually in demand, especially in times of crisis, because it has a special position on the international financial markets and because Americans usually react extremely actively to economic weaknesses of the national economy. After a two-year downward trend, the European single currency has climbed from $ 1.07 to temporarily above $ 1.19 against the Dollar since March.

The European economy and the weaking of the Dollar

An important driver of exchange rates is always the monetary policy of central banks, because it determines the level of interest rates in an economy. A weak Dollar is ostensibly positive for consumers, because they have an advantage from falling prices of imported goods; in addition, several companies will be happy about cheaper inputs and intermediates for their own goods.

In addition, a hard currency attracts capital, so that refinancing costs tend to fall in a national or European economy. This favours an expansion of investments, which are certainly positive effects in the battered economy. Thus, a weak Dollar should contribute to the fact that funds from American investors tend to be invested in other currency areas – typically in Asia, but also in Europe.

While the ECB has been extremely expansionary in recent years, the US Federal Reserve has repeatedly underpinned its determination to exit from monetary policy, which has been very expansionary since the financial crisis. It raised interest rates earlier and also somewhat more aggressively than the ECB and several other central banks. Interest rates in the USA reached almost 2% again, whereas in the Euro area they remain at -0.5% until today.

However, this interest rate differential has narrowed in recent months. Due to the Coronavirus crisis and the subsequent massive economic downturn in the United States, the Fed has also cut interest rates to nearly 0%. In relative terms, this has increased the attractiveness of the Euro. For the ECB, the increase comes at an inconvenient time, as the euro economy is at best hesitant to recover from the severe crisis in which it was hit by the corona pandemic. Because with the rise in prices, products from the Euro zone tend to become more expensive on the world market. This worsens the competitiveness of European companies.

A hard currency attracts capital, so refinancing costs tend to fall in an economy. And above all, saving in economies with strong currencies is worthwhile, which in simple terms could lead to higher investments, more jobs and thus to rising incomes of workers and employees, thus also to a strengthening of consumer demand.

According to President Lagarde, the ECB will pay the necessary attention to the recent appreciation of the Euro. However, the euro exchange rate is not a monetary policy objective. The council’s monetary policy statement, read by Lagarde, States: “in the current context of increased uncertainty, the council will closely examine the incoming information, including the development of the exchange rate and its implications for the medium-term inflation outlook.”

However, the ECB’s monetary policy does not target the exchange rate, Lagarde said, referring to US policy and the disputes over punitive tariffs. In the world of central bankers, it is currently highly risky – at least externally – to weaken one’s own currency. However, the expansionary monetary policy of recent years amounts to such a weakening of the own currency. Critical observers have been speculating for some time about a global competitive devaluation of the various central banks among themselves.

However, there are signs of a tightening of competition among the most important nation states, a number of unease about the elimination of WTO arbitration and growing resentment about the recourse to “punitive tariffs”. The American economy in particular tends to lose competitive advantages because of the enormous government deficit and the high corporate debt, which cannot be compensated by aggressive customs policies or discrediting practices towards other nation-state (especially Chinese) companies.

At present, the Dollar accounts for about half of all foreign reserves held by international central banks and half of all foreign assets held by countries outside the United States. This illustrates the exceptional position of the American currency and is still an important reason why it is in demand in times of crisis and its liquidity is second to none. As an analysis by the bank for International Settlements (BIS) shows, the Dollar is involved in some form in 88% of all international foreign exchange transactions.

Even in the UK, according to the Bank of England, around a third of all invoices for international trade transactions are issued in dollars, even though the pound itself was once a reserve currency. Only a small part of this relates to business with the USA. In emerging markets, the percentage of Dollar-billed transactions is likely to be much higher as the prices of many of their currencies either fluctuate sharply, markets are illiquid or currencies are becoming weaker due to misguided central banks – such as in Turkey.

Trade in raw materials is also largely conducted in dollars worldwide. For example, Dollar demand has increased in recent years solely due to the considerable economic growth in China or India, as they needed more and more raw materials and energy sources such as oil and natural gas for their Boom. At the same time, the local companies had to finance their activities and took advantage of the “cheap money”. In this respect, the issuance of dollar bonds has also increased steadily in recent years.

Finally, economic dynamism in several rapidly growing countries has led to substantial surpluses in the current account. While the Fed has become a little looser in monetary policy than it was just a few months ago, this has done little harm to the Dollar, as many of the other central banks have also cut interest rates in the past year.

Interest rate differentials and expectations do not weigh on the price of the US currency – on the contrary, interest rates and yields in the US are still relatively attractive compared to many other countries and their companies. Ultimately, this also speaks for rather than against the Dollar. This would probably only change if the economic situation in the USA became more pronounced or if Europe developed surprisingly dynamically.

At present, however, US companies are still deep in the fight against the corona pandemic, and government intervention is not convincing either in terms of pandemic control or in terms of national support programs. In this Situation, as in the Great Financial and economic crisis of 2008, the contribution of the Chinese economy to the recovery of international trade should not be underestimated, whereas the USA hardly scores points with its trade and innovation policy.

A weaker Dollar like today helps many emerging and developing countries. Firstly, their dollar liabilities can be processed better and secondly, when the dollar weakens, energy and raw material prices usually rise - and this would boost the economy in resource-rich countries as well as international trade.

From a possible change of administration in the US to the Democrats, a return to multilateral agreements can be expected within narrow limits, which could promote the hesitant, fragile reconstruction of World Trade and international economic relations. On the other hand, a devaluation of national currencies and a further tightening of international trade would certainly significantly affect the reconstruction of national reproduction processes from the damage caused by the corona pandemic.