Photo by Charlotte Venema on Unsplash
 

Over the past couple of months, senior ECB officials have repeatedly stated that inflation and interest rates are in the right place. But nothing is permanent in the economy, and it’s only a matter of time before the situation changes. Until quite recently, economists and the market had been expecting the next move from the shared central bank to be a rate cut.

However, recently the Euro has risen to multi-week highs as the outlook has shifted. The reasons for expecting a cut have diminished somewhat, and traders are starting to eye the inflation rate with some concern. The ECB and Eurostat project that the European economy will pick up next year, which will likely increase upward pressure on consumer prices.
 

Not Quite On Target

After a few years of inflation exceeding the target by more than a whole percentage point, recent Eurozone CPI figures have been relatively benign. However, the central bank’s objective is to keep inflation “around” 2.0%, not persistently a couple of decimals above. The inflation rate is supposed to move above and below that level to even out. And more concerning, the trend over the last couple of months has been upward.

Inflation being persistently just above target can also be a problem for the central bank. If the trend continues, the ECB would likely have to take action, with a quarter-point interest rate hike as the likely outcome. Or, at the very least, try to “jawbone” the inflation rate lower by taking a more hawkish stance. German ECB policymaker Isabel Schnabel is among the first to make this case, suggesting the ECB should consider raising rates to prevent inflation from rising.
 

The Growth Problem

Over the past year, the EU Commission and national governments have promised to increase spending, particularly on defense and infrastructure. Most notably, Germany has suspended its “debt brake” to increase spending. This would likely expand the monetary base and improve economic activity, both of which would push inflation higher. After announcing the spending increases, it has taken several months for governments to complete the approval process and begin the promised spending.

That has kept inflation contained lately, but as the economy picks up with higher spending next year, CPI could begin to rise. This could provide a double tailwind for the Euro. Higher rates would naturally support the shared currency, but they have also been increased as investors pile into European assets in anticipation of accelerated growth. This has helped power European stock markets to new records, which could see further gains if the economy takes off. This would attract more buyers for the Euro.
 

The Issue is Still Timing

While economists make rosy projections for the Eurozone, they may not come to pass. And the ECB raising  too early could extinguish the green shoots. For that reason, it might be some time before a rate hike, if the shared central bank actually goes through with it. After all, a stronger Euro, driven by growth and expectations of a hike, would reduce inflationary pressures.

For now, however, it seems that markets are positioning ahead of a more hawkish ECB next year, which has helped support the Euro of late. Coupled with a more dovish Fed, this could leave the EURUSD trending higher into the holidays.

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