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Friday, January 31, 2003

Is There a Critical Level For The Euro?

What is the level beyond which the rising Euro means things start to turn nasty, or, indeed is there such a level in sight? Morgan Stanley's Stephen Jen argues that there is - and that that level is 1.08 dollars (pretty much the current level). Jen's argument, and it looks pretty sound to me, is that any further Euro upside would have to be met by the ECB with an extremely aggressive bout of rate cutting, a bout which would be more than welcome in Germany, but would leave the euro zone's inflation prone mediterranean fringe looking helplessly skywards. This is all the more the case since the tacit acceptance by all parties of a more-or-less stable dollar-yen parity means that the euro is about to do the heavy lifting.

We believe the US dollar's structural descent will continue, and expect the euro to be one of the biggest beneficiaries. This euro/dollar ascent is decidedly a rally by default, not by merit, in our view. Because this rally in the euro reflects capital repelled by the US rather than capital attracted to Euroland due to Euroland-specific factors, a strengthening euro will have important economic and policy implications. At this juncture, the investment strategies of the two major groups of currency players -- (1) the Asian central banks and (2) the owners of petrodollars -- are likely to remain positive for euro/dollar for some time, despite the inferior cyclical fundamentals in Euroland. This rise in euro/dollar is so far rather "healthy." However, we note that euro/dollar has already reached an important level for the Euroland economy. Not only is $1.08 what we believe to be the PPP fair value of euro/dollar, it is also a level, if maintained for the rest of the year, that could in theory force the ECB to push the refi rate below the federal funds target rate of 1.25%.

In our view, the main reason that the Euroland policy makers prefer a strong and appreciating euro is to help contain inflationary pressures. However, in light of the extraordinarily weak cyclical economic fundamentals in Euroland, the only source of persistent inflationary pressures is structural. (We would classify high oil prices as a cyclical pressure.) For most of the rest of the world, the challenge of the monetary authorities has shifted from fighting inflation to forestalling outright deflation. In a sense, Euroland is forced to fight "yesterday's war" only because it has unresolved structural issues.

Euroland’s strong-currency bias is one reason why the euro may rally against both the dollar and the yen in the coming months (though we believe that eventually the yen will catch up to the euro in this dollar descent). Since the beginning of 2002, the Fed’s major dollar index has declined by some 11.3%, while the broad dollar index has shed some 3.5% of its value. So far this year, this ratio of 3:1 has largely held. In addition, we recall the result of our back-of-the-envelope calculation that, if dollar/yen is held fixed by the Japanese Ministry of Finance, then, all else equal, to achieve a 1% decline in the major dollar index, a 1.8% rise in euro/dollar is required. Combining these two ratios, we find that to generate 1% decline in the broad dollar index, euro/dollar will need to rise by 5.4%, with all the assumptions mentioned above.

My colleague Joachim Fels and I have pointed out that interest rate cuts could potentially offset the effects on growth of a strong euro. As a rule of thumb, a 10% trade-weighted appreciation of the euro is equivalent to a 150 bp hike in the refi rate. Since euro/dollar averaged $0.95 in 2002, if the euro remains at current levels for the rest of the year, the ECB, in theory, would need to trim its refi rate by some 150 bp just to neutralise the contractionary effect on GDP growth. Such cuts would bring the refi rate in line with the federal funds target rate, currently at 1.25%. That said, the ECB is officially an inflation targeter, not a growth targeter. Using the same rule-of-thumb approach, however, suggests the ECB would need to trim its policy rates much more aggressively to offset the impact on inflation of a 10% euro TWI appreciation. Theoretically, the bank would need to cut the refi rate more than three times more aggressively than if it only tried to offset the effect of a strong euro on growth.
Source: Morgan Stanley Global Economic Forum

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