Action is not the answer to currency freefall


Sustained depreciation of the dollar will be a concern for both theEuropean and Japanese monetary authorities, writes Danny McCoy

The lunge upward in the value of the euro in recent weeks confirms that forecasting the currency market is not for the faint hearted. The new consensus expectation of a sustained rise in the value of the euro against the dollar is certainly an unfamiliar one, given its performance over the previous three years.

The global dominance of the US economy in the past decade means the current gyration is as much a story of a weakening dollar than a new-found belief in the potency of the European economy among market participants.

Confidence is slipping in both currency blocks. It is noteworthy that both the euro and dollar have hit multi-year lows against the traditional benchmark monetary standard, gold. The dollar, it seems, is just falling faster.

While a rising euro may start to erode the competitiveness of European economies, particularly those with a large proportion of trade in non-euro-zone member-states, such as the Republic, the recent currency appreciation potentially changes the outlook for European interest rates decisions.

The European Central Bank (ECB) within the past month had put us on effective notice, albeit cryptically through what its president, Mr Wim Duisenberg, didn't say: that interest rates were likely to rise in the near term as euro-zone inflation remained stubbornly above its target.

Their counterparts at the US Federal Reserve are increasingly unlikely to alter interest rates anytime soon either, given the turmoil currently playing out in the global equity markets.

In this context, European interest rate moves must now be on hold temporarily as the ECB ascertains whether the rise in the euro is to be sustained.

There are a number of reasons to believe that, against the dollar in particular, it will be but, even on a trade-weighted basis, an appreciation may be anticipated.

An appreciating currency can do the work of an interest rates rise to bring inflation down.

Even since May this year, when the ECB started to turn more hawkish about inflationary threats, the euro has appreciated by more than 10 per cent against the dollar and by more than 5 per cent on a trade-weighted basis. This level of appreciation on a trade-weighted basis would be expected to curb inflation by close to a half a percentage point, or the equivalent of about a percentage point rise in interest rates.

The euro, on the basis of the past performance of its constituents, is still very weak on a historical basis. The extent of its under valuation is difficult to call but a rate in the $1.10 to $1.15 range could be supported on economic fundamentals.

The lesson from foreign exchange markets is that currencies tend to overshoot these fundamental valuations in both directions. Also this overshooting can often be quite rapid.

Appreciation beyond fundamental values would have significant deflationary impacts upon real economic activity.

An immediate 20 per cent appreciation of the euro to $1.20 would knock up to two percentage points off GDP growth in the euro area in the first year and a further half percentage point in the subsequent year.

At a time of faltering recovery in the global economy, if this were to occur, it would constitute a serious set back to all our economic prospects.

An appreciation of this extent might not transpire and, if it does, it is to be hoped that it will be gradual. The unfolding revelations about corporate accounting practices this week, however, will further undermine the confidence of the all-important consumer in the US, heightening the prospect of significant capital outflows weighing down on the dollar.

Sustained depreciation of the dollar will be a concern for both the European and Japanese monetary authorities. Indeed the Bank of Japan has tried unsuccessfully to intervene in the market this week to stall the yen's appreciation.

Both Japan and Europe have become dependent on export-led growth and their reaction is more likely to be an easing of monetary policy if present trends persist to counteract the competitive advantage these currency swings would deliver to the United States.

It is much too soon to state that the next move in European interest rates will be downwards rather than upward as expected.

One compelling strategy for dealing with the current uncertainty is the "don't just do something, stand there" variety.

Monetary activism may yet well be required internationally to deal with the current fallout in the equity and currency markets. Good advice in a freefall is to sit tight. Perhaps the ECB will take it and variable mortgage holders everywhere can breathe a temporary sigh of relief.

Danny McCoy is an economist at the Economic and Social Research Institute