Towards $1.50?

By: Wolfgang Münchau

 

It is true that we care too much about bilateral exchange rates. We would instead talk about the real effective exchange of the euro. The trouble with the latter is that it is so much of date that it is mainly of interest to economic historians. We could opt for a compromise and talk about the euro’s weighted nominal exchange rate, and discover that it appreciated by only half as much since the beginning of this year – about 2.5% - compared with the bilateral rate with the dollar.

 

I accept this argument, but please, the effective exchange rate story is not that fundamentally different from the bilateral story over long periods. It has been this year though. The reason that the effective rate has appreciated less is logically the consequence of third currencies having appreciated against the dollar even more than the euro. That will not always be the case. The day may come when the effective rate rises faster than the dollar.

 

We can’t really get around the fact that the euro exchange is appreciating fact, and that, rightly or wrongly, it is becoming a political issue. This is not only a Sarkozy problem, even though the French have been crying out the loudest. Now that the euro has broken through $1.40, the German companies are going to join the chorus. The pressure for an exchange rate policy will mount, and since the European Central Bank will resist any formal policy, it may well compromise on interest rates. To head off a direct challenge from Mr Sarkozy, the ECB may find life far more comfortable if it decided a surprising 0.5% cut in interest rates at one of its next meetings. I am not predicting that this is going to happen in October. On the contrary, I am predicting that this is not going to happen in October. I am merely saying that when faced with political pressures, cutting interest rates is the way to go.

 

What about intervention? Intervention is not the answer when the reason for the dollar weakness is not a fleeting market sentiment, but heavy selling by international central banks, who have begun the process to shift their reserve exposures. The latest flow of funds data from the US show a particularly alarming drop in foreign demand for dollar assets. As we are heading towards an exchange rate of $1.50, the pressure will gradually intensify. There may be some intervention, and it may even have some short-term effect, but it is not going to change what is after all a very fundamental policy shift. Cutting interest rates is the most painless way out of the dilemma for the ECB.

 

The €64,000 is whether the ECB chooses this painless way out, or whether it takes a principled stance and risks fight with the politicians. My hunch – it is no more – is that the ECB will ultimately not want to fight a fight that it is likely to lose.

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