Eurozone: The Welcome Appreciation Of The Euro

The recent strengthening of the euro exchange rate provides new arguments for the ECB to eventually step up its Pandemic Emergency Purchase Programme.

EUR at its highest level in two years

It is one of the more interesting summer themes in financial markets: the strengthening of the euro. Since May, the euro has gained almost 10% vis-à-vis the US dollar and is at the highest level in more than two years. The nominal effective exchange rate of the euro, however, has only appreciated by some 5% during the same period but is at its highest level in more than six years. Different strategies to tackle the virus on both sides of the Atlantic and the agreement on a European Recovery Fund seem to have given a nice tailwind to the euro (FXE).

As with every more abrupt movement of currencies, the recent strengthening also raises the question about its potential impact on the economy and possible policy reactions. Given that recoveries in the eurozone are often kick-started by net exports, a stronger euro could hamper any recovery going into the second half of the year and beyond; particularly as the strengthening comes at a time at which global trade continues to suffer and eurozone exporters are already being battered. Just think of the ongoing trade conflicts, Brexit uncertainty and dramatic loss of external demand due to the COVID-19 crisis, which has put pressure on supply chains. In these circumstances, it's not really surprising that European exporters have scaled back their perceived competitiveness in export markets. Should eurozone policymakers, and should the ECB worry?

Should the ECB worry?

When the ECB staff conducts the next round of macro projections in the coming days, the strengthening of the euro will not go unnoticed. The underlying technical assumption for the forecasts is this: keep exchange rates unchanged over the entire forecast horizon at their average level of the two weeks prior to the cut-off date for the forecasts. This should be the last week of August. If the euro maintains its current strength for the next three weeks, these technical assumptions will have to be revised significantly. Compared with the June forecasts, which had their cut-off date on 18 May, the bilateral euro-dollar exchange rate would be some 8% higher for 2021 and 2022. The nominal effective exchange rate would be some 4% higher than in the June forecasts.

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