The ECB is running ahead, the dollar could be Europe’s executioner

The European Central Bank (ECB) did what it had to do, and even exceeded expectations, which somewhat surprised the markets when it decided to raise interest rates by 50 basis points at its July meeting, and at the same time found a solution to remedy the issues arising from the development gap between the member states of the eurozone.

The board led by Christine Lagarde was forced to act, in June inflation was 8.6 percent in the euro zone, so that the ECB still could not shake off the criticism that it reacts with a snail’s pace only to all those economic processes that scream for responses.

The ECB has delayed stronger action until now because despite high inflation, interest rate hikes can have drastically different effects in individual member states, which results from significant economic differences between countries that use a common currency. For this reason, the board of governors had rather put off taking a stand until now, and now the decision has been made.

As it rains, it puffs

Opinions are divided as to how much President Christine Lagarde’s press conference improved or damaged the credibility of the ECB. It can be taken for certain that, in contrast to the previous practice, in the future there is no need to expect forward-looking guidelines from the central bank, the uncertainty is so great that they decide what to do from meeting to meeting.

– Let’s remember that Lagarde already gave a guideline in her name last year, according to which she does not expect an interest rate hike at all in 2022.

And the guideline formulated at the time of the interest rate decision in June was at least as unnecessary as it was wrong

– Carsten Brzeski, ING’s chief economist, commented on the events.

The deviation in July from the previously repeated guidelines definitely undermines the central bank’s credibility, said Jan von Gerich, an expert at investment bank Nordea. At the same time, he and other analysts took it overall as a positive that the ECB is finally reacting to actual events, rather than aligning itself to its own previous plans at all costs. Based on these, the markets should also look at the data, and not the statements or blog entries of individual decision-makers.

The dollar is broken

Lagarde admitted that the rapid strengthening of the dollar against the euro played a significant role in the larger-than-expected interest rate hike, so much so that in the past few days parity has been achieved between the two currencies. If the Federal Reserve once again puts its faith in the strict policy in the United States at the interest rate meeting in July – and this will certainly happen – then the American money may even more thoroughly outperform the European one.

This will have different effects. For example, exporting, industrially stronger EU member states and, to a certain extent, countries that rely on tourism can also be happy, which will thus become more attractive destinations for potential American travelers.

On the import side, on the other hand, price increases are to be expected, fueling the already critically high inflation in Europe even further. This only adds to the worries that Europe could sink into recession already this year due to the energy crisis caused by the war in Ukraine, which is causing problems from Covid. These fears are supported by the latest BMI data, which measures investor confidence in the future.

On the part of ING, according to Brzeski, the fact that the ECB reached a decision in this situation and made it clear what it sees as the primary goal in its current situation, and that is price stability, should be viewed favorably.

The interest rate hike in July, and the others that may follow, all serve to reduce inflation expectations and at the same time can restore the ECB’s damaged credibility as a central bank fighting inflation on merit

– said the ING economist. According to Brzeski, it has become clear that it is more important for the ECB to be credible than predictable.

Lagarde is reluctant

By selling the message, Christine Lagarde also caused some confusion, which is clearly shown by the fact that the strengthening of the euro following the news of the interest rate hike corrected spectacularly by the end of the press conference. Even though the ECB raised it a lot, according to Lagarde, it is not changing its interest rate target, all that is happening is that it wants to reach it faster, in response to inflation exceeding expectations.

According to Jan von Gerich, there is a prospect of a 75-point increase in September, which may be followed by further, but smaller, expected interest rate increases of 25 basis points.

Several analysts also assume that the 50 points in July are the result of a special deal. The shells of the governing council were able to assert their demand for greater rigor by going into the launch of the new transmission protection instrument (TPI). In this way, the ECB can provide targeted support to the members of the southern zone in a worse economic situation, while raising interest rates as a whole.

The question remains for the coming months as to how much the ECB will be willing to override its remaining directives, as in July, however, with the transition in July, this possibility for decision-making on a case-by-case basis will already be available in the future, without the credibility of the Governing Council being undermined.