Is Draghi Playing a Shrewd Game with the EUR/USD Rate?

August 2 2017

No, it did not surprise me that Mario Draghi, President of the European Central Bank (ECB) sounded rather hawkish at the important annual ECB meeting in Sintra (Portugal). His speech could be best interpreted as a clear signal that monetary policy in the Eurozone will soon be less expansionary.

That did not surprise me. Not because of Draghi´s eagerness to tighten monetary policy, but because I can very well imagine that more and more of his colleagues who are part of ECB board are beginning to speak up. It is a public secret that several board members have never been big proponents of the zero-interest rate policy and quantitative easing. Many others did defend these policies, because the economy was barely growing, a recession threat was looming, as well as a secular deflation threat (a declining general price level is to central bankers close to one of the worst possible things that could happen to an economy).

But since the economy of the currency union is growing pretty solidly (since the beginning of 2016 the Eurozone economy has been outperforming the US economy!) and the deflation threat has been wearing off according to Draghi himself, an increasing number of ECB members are starting to think that the central bank should gradually move toward somewhat of a normal monetary policy or should at least suggest that they will be moving in that direction. Do not misunderstand me: a very large majority has absolutely no desire to normalize monetary policy, but wants to make it a bit less expansionary, especially out of fear of what could happen when monetary policy remains loose in a situation of rising inflation and fairly positive economic growth. It could be, after all, the case that the ECB´s credibility, the most important asset of a central bank, becomes subject to public debate.

Dollar Less Attractive

One of the consequences of Draghi´s remarks was that EUR/USD rallied sharply. An outcome which was to be expected: if the ECB announces to raise rates down the line, then that means that the euro will be a more attractive currency (read: will yield more in the future). Whoever wants to earn a tidy profit, might be advised to buy the European currency today against its current price. The demand for euro´s results in the fact that a stronger euro is not a thing of the future, but a thing of the, almost immediate, present.

The euro also received support from the US where doubts are growing regarding whether or not President Trump will be able to execute his plans. For instance, he promised enormous investments in infrastructure and tax reductions. Both things would stimulate the US economy, something which would make the dollar more attractive. That is the main reason that the EUR/USD rate declined significantly after the US presidential elections.

Now it remains to be seen whether president Trump is able to make whole on his promises – he also wanted to dismantle Obamacare just like most other Republicans but still he did not succeed in reforming Obamacare despite a majority for Republicans in Congress! – the dollar appears to be a little bit less bright.

Add to that the fact that investors are starting to ask themselves whether the Fed will raise the official rate in the US another four times between now and the end of 2018, as the central bank has more or less promised. The outlook of all these rate hikes also pressed down the euro against the dollar in the past few quarters.

Not Like Draghi

No, it did not surprise me that Draghi not sounded like himself in Portugal. What did surprise me, was that he did not seize a golden opportunity to talk the euro back down.

Exactly a week after Sintra, the ECB board had a meeting. The press conference after the meeting was an excellent opportunity to talk the EUR/USD back down. Draghi is known as a central banker who, in general, is not a big fan of a strong currency; and he wants to avoid a strong currency at any cost because it could threaten the economic recovery and lower inflation in the Eurozone.

As we know that Mario Draghi is a very experienced central banker, it would have been a small effort to push down the EUR/USD rate last week on Thursday. A dramatic pause here or a “slip of tongue” there, or even a well-timed cue here in one of his answers would have been sufficient to do so.

Yet, even though it seemed that the journalists present at the press conference did their best in outdoing each other in giving Draghi the best possible assist to take the weaker euro game home, the ECB Chair opted out. That was quite surprising. Very surprising.

After the ECB meeting I took a stroll and during my walk I could not help myself but to reminiscence why Draghi did not seize the press conference to talk down the euro. It made no sense. And then, under the shadow of enormous lime trees that encircle my favorite path, I thought: wait, it is a logical move after all! It makes sense!

A Nifty Strategy

Back to our key point: what does Draghi want to achieve with ECB monetary policy? To keep it as loose as possible for as long as possible, preferably as loose as currently is the case. Is he able to do that? No, because, as we have remarked earlier, the deflation threat has largely disappeared and the Eurozone economy is growing at a solid pace. Thus, it is very unlikely that he will be able to convince his fellow board members to not tighten the monetary reins. Add to that the fact that the inflation forecasts of the ECB economists for 2018 and 2019 reveal that inflation will not climb toward the target inflation rate of two percent but will neither decrease any further. The latter is vital for the ECB board: their own economists say that inflation will remain at around 1.5 percent. Buying up 60 billion euro a month of government debt and keeping the official rate at zero percent do not blend well with such forecasts.

And there lies the rub! That o so important or, feel free to say, decisive inflation estimate for 2018 and 2019.

In September, the ECB economists publish their revised Eurozone inflation estimates for 2018 and 2019. The only way for Draghi to convince his board to only gradually taper quantitative easing and keep interest rates at zero percent for years to come, is when these revised estimates come to show that inflation will be further removed from the target inflation rate of two percent in 2018 and 2019. But what does this have to do with the euro? Everything!

Draghi cannot force the ECB economists to adjust their calculations in such a way that they will yield his desired outcome. But he can do something else to influence the outcome of such calculations.

When ECB economists put together their estimates, they use as one of the, if not the, most important ingredients the average EUR/USD exchange rate in the ten days prior to the day to which they publish their estimates (the so-called cutoff date). They proceed to assume that this exchange rate will remain equal during the remaining period of the estimate.

A Cunning Old Fox

In concrete terms, this means that the EUR/USD exchange rate for the September estimates will be the exchange rate of the first week and a half of August. If the EUR/USD exchange rate remains at about 1.15, then the ECB economists will use a considerably higher rate than the rate used in the June estimates.

In that period, the ECB economists used an exchange rate of 1.07 / 1.08 for EUR/USD. If they will indeed use a, for instance, EUR/USD exchange rate of 1.15 for their September estimates, then that will definitely lead to a lower inflation estimate for both 2018 and 2019. Since the June estimate for 2019 amounted to an annualized inflation rate of 1.6 percent – too low according to the ECB´s inflation target – then a lower September inflation estimate could influence the decision of the ECB board about when and to what degree to taper quantitative easing.

That could explain why Draghi first talked the EUR/USD rate up and then left an opportunity unused to talk the exchange rate back down. To let the euro strengthen temporarily (read: until mid-August) to push down the September inflation estimate for the Eurozone in 2018 and 2019 and therefore lower the need for a less loose monetary policy, could have been the reason. Mario Draghi is an experienced central banker and we can therefore rule out that him trying to talk up the EUR/USD rate without trying to undo it at a later point is pure coincidence. EUR/USD at 1.20 will not be viewed as favorable by Draghi and if the exchange rate would head that way he would most definitely intervene. But having several weeks of the EUR/USD rate hovering between the 1.15 and 1.20 would actually suit the cunning old Italian fox very well. And the best of it all? After that, the EUR/USD rate can fall, as investors will get the impression that a tapering of quantitative easing in the Eurozone will take longer than initially expected and that a first rate hike is many, many years away.

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