Home > How the Market Is Forcing the ECB’s Hand

How the Market Is Forcing the ECB’s Hand

The European Central Bank (ECB) delivered its last monetary policy decision for the year a few days ago. Last Thursday, it eased the financial conditions in the Euro area to unprecedented levels. Also, it expressed concerns about the ongoing strength in the Euro exchange rates, as it puts pressure on inflation. 

ECB has an inflation-targeting mandate. It aims at price stability below but close to two percent. Therefore, a stronger currency weighs on inflation, and this is particularly a problem in times when inflation is close to the zero level as it is now.

Yet, the chart below reflects something else. It shows the three main Euro exchange rates – EURUSD, EURGBP and EURJPY, and how they keep rising, despite the ECB’s efforts.

Euro at 2020 Highs

If it manages to close the year at the current levels, the common currency will close at 2020 highs. While many focus only on the EURUSD pair, it is not just about the EURUSD, but other pairs reflect the same strength. In other words, the market puts pressure on the central bank.

It would not be for the first time such a thing happened. We all remember what happened when George Soros bet against the Bank of England paid handsomely.

Only this time, things are different in the sense that central banks have more tools to intervene. They also act in a concerted manner if we only consider the regular meetings of the world’s central bankers at the Bank for International Settlements.

Yet, one cannot escape the feeling that the ECB is losing credibility. It is not about the current exchange rates, which continue to rise despite the ECB’s desire. Instead, it is about the message that the market sends to the ECB.

On the one hand, the ECB complains that the higher exchange rate pressures inflation. Hence, it should/would not tolerate a higher Euro.

On the other hand, the Euro keeps rising, with the market participants calling the ECB bluff. After all, what can the central bank do except talking the currency down?

As always, it is about perceptions. And, timing.

If the market participants continue to perceive conditions tighter in the Euro area than in other parts of the world, the selling will continue. Timing matters too.

The ECB lost its chance to act in October and waited for December. However, in December, no one takes a risk to open large positions, no matter what the ECB says or does. In other words, the price action is driven by trading algorithms waiting for some other events (e.g. Fed’s Statement tomorrow).

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