September 7, 2017

Breakingviews: Draghi and Carneys FX Headaches have Similar Cure

by Breakingviews

It’s all too easy to covet other people’s problems. European Central Bank President Mario Draghi has too little inflation and is grappling with a rising euro that makes imports cheaper. His Bank of England counterpart Mark Carney has too much inflation yet sterling’s weakness is boosting import prices. The good news is that the same fix can alleviate both problems.

A trade-weighted measure of the euro’s value has risen nearly 6 percent in the past five months, helped by brighter euro zone economic prospects and the weakening of some other major currencies. One of them is sterling, whose trade-weighted index has fallen by as much the euro’s has risen in an even shorter space of time as the British economy loses momentum and investors fret about Brexit.

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Neither central bank welcomes the swings. ECB officials reckon a 10 percent rise in the trade-weighted euro shaves roughly 0.4-0.5 percentage points off euro zone inflation. That’s the last thing Draghi needs when inflation is 1.5 percent – some way short of his target of just below 2 percent. British prices are overshooting Carney’s 2 percent target by an even greater margin, and the latest decline will make the problem worse. BoE models suggest a 10 percent drop in the trade-weighted sterling index could boost the UK inflation rate by at least 0.6 percentage points in the following 12 months.

Currency traders are testing the limits of both central bankers’ tolerance. The euro hit its highest level in nearly two years against the dollar following the last ECB policy meeting on July 20, mainly because Draghi showed no visible concern about the currency’s rise.

Rate-setters can tackle the problem by telling traders that policy will adapt to such swings. The euro’s tendency to rise would be curbed if Draghi on Thursday signals that currency strength might delay an expected reduction in the ECB’s asset purchases. The BoE could have the opposite effect on sterling when its Monetary Policy Committee meets the following week by making it clear that a further pronounced weakness in sterling increases the chances of a UK rate hike. Even better, one policymaker could help the other. The more Draghi does this week to counteract contrary currency swings, the less Carney has to do.

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