Imported Inflation – Euro plunges to 5-year low

There was no surprise when the leadership of the US Federal Reserve (Fed) announced the result of its meeting on Wednesday: the base rate rose 50 basis points, or 0.5 percent. The 25bp interest rate hike in March was followed by two swift steps in which the Fed is trying to dampen very high inflation in the US. It had hit 8.5 percent in March – and is now viewed by many Americans as the number one domestic political issue.

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As interest rates rise in the US, the gap between the euro area and the dollar area widens enormously. Because in her last meeting in April, ECB President Christine Lagarde announced that the benchmark interest rate would remain at zero for the time being, despite record inflation of 7.4 percent – and the deposit rate in the range. negative. The consequences of monetary policy in Frankfurt on the one hand and Washington on the other can be seen in the euro exchange rate: just before the Fed interest rate hike, the common currency fell to its lowest level since March 2017. At the beginning of 2021 there was still 1 for a 0.22 dollar euro. When Fed Chairman Jerome Powell announced Wednesday that the 0.5 percentage point hike would not be followed shortly by another rate hike, the euro recovered minimally, from $ 1.05 to $ 1.06. The message was: things could have been worse for the common currency. This changes nothing of the rapid depreciation of the euro since 2021. In a good year, the common currency lost as much as 15 percent of its external value. In April alone, it fell by 4.6% compared to March. Parity, a one-to-one euro-dollar exchange rate, is not far off.

It is not just zero interest rates in the euro zone that are driving investors to withdraw money from there on a large scale to invest in dollar bonds. The gloomy economic outlook in the euro area also means that investors view the continent with great skepticism, especially as no one knows how long the war in Ukraine will last and whether it will lead to a major energy crisis in the EU. “We have to to see that the war in Ukraine will affect the eurozone more than the United States in both the short and long term, “said Andreas Dombret, former member of the board of the Bundesbank and now a consultant and lecturer at the Columbia School of International and Public Affairs YOU. “Not only for the lower growth, but also for a further increase in public debt to cushion these effects”, says Dombret: “Investors are aware of this. In this sense, they diversify outside the euro zone”.

Analysts Shaun Osborne and Juan Manuel Herrera of Canada’s Scotia Bank have a similar assessment of the situation. “The looming recession in the eurozone and a possible shutdown of Russian natural gas supplies have dragged the euro to a five-year low – and a psychologically important test of $ 1.05 is a real possibility,” they both write. a recent report from their bank.

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For the euro zone, the collapse of the currency means that all imports from the dollar zone will automatically become more expensive. This will be particularly painful when importing liquid gas from the United States. These imports have increased since March to ease Western and Central Europe’s dependence on Russian natural gas. LPG, which has to be brought into the tank, is already more expensive than the pipeline. The weak euro makes fuel more expensive. The euro area is also increasingly suffering from so-called imported inflation, the increase in the prices of goods from economic areas with stronger currencies.

So far, there is nothing to suggest that the trend will change. Holger Schmieding, chief economist at Berenberg-Bank, expects the ECB to raise interest rates in September 2022 at the earliest, if at all. And then the correction will most likely be very temporary – most experts calculate with an increase of up to 0.25 percent. This would mean that the ECB would chase inflation as the Fed is already preparing for the third rate hike.

Eurozone currency watchers are stuck in a trap, caught between two evils: if they were to raise interest rates as much as the Fed, the inflation rate would drop significantly again. But the demise of easy money could plunge the eurozone into a protracted recession, kicking out even hitherto stubborn investors and sending the currency even worse. Because under the pressure of higher interest rates, heavily indebted euro countries such as Italy and France could slide into a serious political crisis.

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