Last Thursday, it turned out that not even Mario Draghi is able to string out the foreign exchange market. However hard he stressed that the ECB is far from planning to reign things in, the euro only got stronger. During the press conference the currency added no less than one and a half cents to reach $ 1.2537, which is one-fifth more expensive than it was a year ago.
Draghi had to do something about that advance, but in the eyes of the traders he has failed. What ‘divine’ intervention they had expected is not clear to me. I think he could not have sounded more dovish.
Meanwhile, it’s unclear which forces are behind the euro appreciation. The ECB is still printing money, while the Fed has long stopped doing so and has been on the path of interest rate hikes for quite some time now. According to the law of supply and demand, more euros in the system and less dollars mean that the ‘greenback’ has to rise.
Attract foreign investors
In fact, in the US we now see a combination of monetary tightening and fiscal easing (in the form of lower taxes). According to the Mundell-Flemming model, which is commonly used in monetary circles, this mix should lead to relatively higher interest rates and that is indeed what is currently happening. These higher interest rates should attract foreign investors to invest in the US. Demand for dollars should therefore rise and with that the exchange rate. But that does not happen.
Then there is the story that the value of a currency is determined by relative growth differences and surprises. Indeed, the euro zone is clearly doing better than expected, Draghi also said that, but the same applies to the US. Due to Trump’s tax plan, economists assume that already high US growth is accelerating even further, making the country more attractive to put money to work, which must be supportive to the dollar.
The only thing I can think of is that there is simply insufficient confidence in the economic management of the Trump government and that the forex market assumes that the American economy will at some point derail due to a silly protectionist policy or a sharp rise in inflation.
On the other hand, it might be pointless to argue where the exchange rate is going. On the basis of the trade balance and purchasing power ratios, the IMF holds for the euro an equilibrium rate of approximately $ 1.19, where the currency was far below in the first four years of its existence and very far above between 2004 and 2014. It is telling that people at the Fund have been saying for years now that it’s high time that the Nobel Prize Committee opens a competition for economists to really fathom the foreign exchange market.
- This column was first published in Het Financieele Dagblad on Monday, January 29th (in Dutch)