The European central banks are currently facing an age-old dilemma: the depreciation of their respective currencies is anticipated as a consequence of reducing interest rates in response to a deceleration in inflation. Consequently, the inflationary decline toward their canonical 2% objective may be delayed.
The Swedish Riksbank personally witnessed this phenomenon when it reduced rates on May 8 and observed the Swedish krona depreciate against the euro and US dollar. In anticipation of this action, the krona had already experienced a depreciation of several percentage points. If the European Central Bank (ECB) implements the rate cuts that are widely anticipated, the euro could face comparable circumstances on June 6.
In general, traders are placing substantial wagers that the currencies of countries whose central banks are expected to reduce interest rates will experience a significant decline. For instance, the British pound is currently experiencing this phenomenon, as the Bank of England has recently indicated that it may begin to implement rate cuts in June.
The division that spans the Atlantic Ocean
In recent years, the inflationary surge and subsequent decline were largely coordinated in the developed world, which has obscured the concern that interest rate cuts will result in currency depreciation, despite the fact that this concern is not new. This implied that their monetary policies were in alignment, resulting in currencies that were approximately equivalent.
However, substantial distinctions have recently emerged. In contrast to the euro area and the United Kingdom, which have both experienced stagnant growth in recent quarters and continue to confront considerably bleaker economic prospects, the United States economy continues to exhibit robust performance. Inflationary pressure in the United States has been relatively higher than in Europe as a result.
The comparison of the GDP development of the United States and Europe
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This disparity in economic expansion has significant implications for monetary policy, despite the fact that inflation figures have been moderately volatile thus far. Central banks endeavor to act in accordance with the trajectory of inflation, rather than its recent trajectory, understanding that their decisions require time to materialize.
Consequently, the significance of discrepancies in GDP growth is greater than that of inflation readings when the euro area, the UK, and Sweden are contemplating rate cuts, while the US Federal Reserve is advocating for “higher for longer.”
Inflationary Trends in the United States and Europe
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By examining medium-term interest rates, which are determined by the debt markets rather than central banks, and by considering expectations regarding the likely actions of central banks in the future, this can be observed. For instance, the 1-year interest rate in the United States has remained above 5% and has been in close proximity to the Federal Reserve’s benchmark interest rate target of 5.25% to 5.50%.. This suggests that investors expect the Federal Reserve to preserve the present benchmark rate for an additional year.
In contrast, the 1-year rate in the euro area is 3.4%, which is over 0.6 percentage points lower than the ECB’s benchmark rate. The situation is comparable in the United Kingdom.
The US dollar’s appeal to investors is heightened by the significant disparity in expectations, as it generally indicates that they can earn a higher rate of return by purchasing and investing dollars. This has persisted throughout the inflationary period of the past few years, as evidenced by recent research conducted by the Federal Reserve.
The disparity in medium-term interest rates would be further exacerbated by a reduction implemented by the European central banks. This has the potential to substantially devalue their currencies.
The consequences
While a depreciated currency encourages expansion, it also places inflationary pressure on imports. The direct effect of a central bank interest rate reduction is further exacerbated when inflation is excessively low. At present, however, there is a possibility that a depreciated currency could exacerbate inflationary pressures and result in a protracted period of time required to regain the 2% target.
Nevertheless, is this a valid concern? It appears to be otherwise.
The value of a currency in relation to a collection of international competitors is defined by nominal effective rates, which render concerns regarding a currency’s depreciation implausible. At present, the nominal effective rate of the euro is in close proximity to its historical optimum. In comparison to the recent past, the UK pound is not trading at a low level and has appreciated by approximately 10% over the past 18 months.
Base rate in euros that is effective
The exchange rate’s minimal impact on inflation is attributed to retailers. Despite the fact that currency depreciation necessitates them to pay a premium for imported products, they frequently maintain stable prices.
Therefore, there is a low probability that European central banks will be prevented from instituting rate reductions as a result of currency depreciation. The atypically high level of uncertainty that presently surrounds the trajectory of inflation should cause them to be hesitant. This is due to the fact that we are presently dealing with a distinctive combination of factors, such as the recovery from the COVID-19 recession and the aftermath of the energy-price spike that was precipitated by the Ukraine conflict.
In such unusual circumstances, it is unlikely that standard economic models will be of any assistance to central bankers, as they would anticipate a gradual return of inflation to the 2% target. According to a recent report from the International Monetary Fund (IMF), this uncertainty is a valid reason to proceed cautiously with rate cuts in order to preserve the credibility of central banks as inflation fighters.
The IMF posits that the degree of disruption caused by maintaining high interest rates in the present environment is less severe than that of implementing sharp rate cuts, only to discover that inflation persists and rates must be raised rapidly once more. The principle of “better safe than sorry” implies that interest rates should remain constant until inflation reaches the intended level.
