Euro / Dollar Struggles, Even After Record Surge in Eurozone Inflation

• EUR/USD stalls after inflation hits new milestone high
• As ECB seen as unlikely to respond with policy change
• Likely to wait patiently in 2022 for inflation to dissipate
• Lagging behind Fed, leaving EUR struggling for traction

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The Euro to Dollar exchange rate was unable to capitalise on data revealing a further increase in Eurozone price pressures at year-end but could benefit if the prospect of a more prolonged inflation overshoot was to impact the policy stance of the European Central Bank (ECB) in the months ahead.

Europe’s single currency was buoyant above the 1.13 handle on Friday but stalled in its climb after Eurostat data showed the Eurozone’s consumer price index rising to a new milestone high of five percent in December.

“Another slight tick up for eurozone inflation means that the highest rate since 1985 has now been reached,” says Bert Colijn, a senior Eurozone economist at ING.

“The rise was mainly due to higher trending food and goods prices, which have been affected by higher transport costs and shortages,” Colijn and colleagues said in review of the data.

Eurozone inflation edged higher from 4.9% to 5% when the consensus among economists had envisaged it edging lower to 4.8%, while the more important core inflation rate held steady at 2.6% when many forecasters had looked for it to ease back to 2.5%. 

Above: Euro-Dollar shown at 15 minute intervals.

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“The 5.0% y/y flash estimate for the Dec euro-area HICP inflation likely marks the peak. Inflation will fall through 2022 but remain above the ECB’s target, at least in the first half of the year. Core inflation will be key to the ECB outlook,” says Anders Svendsen, an economist at Nordea Markets.

The core inflation rate often tends to garner more attention from policymakers because it overlooks changes in the cost of energy, food and regulated price items like tobacco, which can be influenced by non-economic or otherwise international factors.

These outcomes could potentially galvanise ‘hawkish’ members of the ECB’s Governing Council when it comes to the outlook for the bank’s quantitative easing programmes and its interest rates, although such members have been too few in number to alter the bank’s policy stance thus far.

“Second round effects from high inflation on wage growth remain mostly absent for now. This dampens GDP growth somewhat, but also means that the ECB still has time to see how quickly the current supply side inflation declines over the course of the year before it decides on further action.

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ECB policymakers have for the most part judged that Eurozone inflation pressures are likely to melt away of their own accord over the course of 2022, which may be why the Euro to Dollar rate’s climb above 1.13 stalled in the wake of Friday’s data rather than extending further.

Few, if any, in the market see the ECB as likely to change its monetary policy settings in response to current or any other short-term increases in inflation while the bank itself has insisted it can afford to patiently observe inflation outcomes over the course of this year.

“We also suspect that energy inflation will fall, due to base effects. If we are right, markets, and the ECB, will breathe a sigh of relief, but we think it will be short-lived,” says Claus Vistesen, chief Eurozone economist at Pantheon Macroeconomics.

“Energy inflation will come down only slowly, and with food inflation now seemingly on the rise, the headline will remain high overall through most of this year, and certainly a good deal above the ECB’s 2% target,” Vistesen and colleagues said on Friday.

Above: Euro-Dollar shown at daily intervals.

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The ECB announced in December that its €1.85 trillion Pandemic Emergency Purchase Programme will end in March but that its original quantitative easing scheme known as the Asset Purchase Programme will be temporarily increased until October this year.

That decision means the ECB will go from buying close to €100BN of Eurozone government bonds each month to only €40BN in the second quarter and then just €30BN throughout the third quarter, with the Asset Purchase Programme then returning to its original size of €20BN per month.

This slow and steady adaptation of the ECB’s bond buying programme contrasts with the approach in the U.S. where last month the Federal Reserve accelerated the tapering schedule announced just previously in November, such that its $120BN per month QE programme is now set to end in March.

“The ECB has a little more time than the Fed to tighten policy – in the US excessive fiscal stimulus has exacerbated inflation beyond a transitory surge. But we think that rising medium-term price pressures will necessitate a monetary policy reaction earlier than current ECB guidance suggests,” says Salamon Fiedler, an economist at Berenberg, who sees the ECB ending its bond purchases in Spring 2023 and lifting its interest rate in June that year.

The Fed will no longer increase its balance sheet through government bond purchases after that point and could begin lifting interest rates as soon as March, according to December’s policy decision and forecasts.

This Transatlantic monetary policy divergence has proven supportive of the Dollar and a burden for the Euro in recent times and could continue to contain the single currency unless current and future inflation pressures were to prompt the ECB to move further in the direction of the Federal Reserve.