Why the ECB’s jumbo rate hike isn’t helping the beaten-down euro

Blame it on the energy crisis that’s fueling surging eurozone inflation and appears set to tumble the eurozone economy into recession.

“Worries about the prospect of a recession due to constraints to Europe’s gas supply should continue to outweigh the benefit to the EUR (euro) from monetary tightening, and so long as growth prospects remain superior for the U.S. in H2 (second half) 2022,” said Thierry Wizman, global FX and rates strategist at Macquarie, in a note.

The euro
EURUSD,
+1.06%
fell 0.7% to $0.9949, not far off the nearly 20-year low below $0.99 earlier this week.

A weak euro only makes the inflation picture worse, making imported goods more expensive to eurozone buyers. “The depreciation of the euro has also added to the buildup of inflationary pressures,” ECB President Christine Lagarde noted at a news conference.

Lagarde emphasized that the ECB doesn’t — and will not — target a specific euro exchange rate, but said the weakening currency’s effect on the economy has been noted by policy makers.

“What is interesting is that the ECB is starting to focus on the euro as a source of imported inflation when it before was focused implicitly on a competitive devaluation,” said Sebastien Galy, senior macro strategist at Nordea, in a note.

Lifting the euro would be a tough task for the ECB, he said, against a backdrop in which the differential between interest rates in the U.S. and the eurozone are too narrow to shake a market already “bulled up” on long dollar bets, Galy said.

Indeed, the U.S. dollar has been on a rampage versus its major rivals, trading this week at its strongest since 1998 versus the Japanese yen
USDJPY,
-1.38%
and a 35-year high versus the British pound
GBPUSD,
+1.21%.

“What the ECB needs is to convince the market that it wants a strong euro without delivering too many rate hikes. Given that the euro’s level is inherently unstable due to large dollar long positions, we could over a period of months see a sharp rise in volatility though range trading is more likely in the next few weeks,” Galy wrote.

In a statement, the ECB Governing Council said more rate hikes were likely to come in response to inflation that remains “far too high” and “likely to stay above target for an extended period.”

Analysts had debated whether the ECB would lift rates by 50 basis points or 75 basis points. The decision means the interest rate on the ECB’s deposit facility will rise from 0% to 0.75%, while the rate on the main refinancing operations will rise to 1.25% and the rate on the marginal lending facility will rise to 1.5%. The move is the largest since a 75 basis point move in 1999, which was aimed at stabilizing the then newly launched single currency.

Thursday’s move follows a 50 basis point hike in July and echoes outsize moves by other major central banks, including the U.S. Federal Reserve, which is expected to deliver a third 75 basis point move later this month.

“With today’s decision, it is clear that the ECB has given up on inflation targeting and forecasting and has joined the group of central banks focusing on bringing down actual inflation,” said Carsten Brzeski, global head of macro at ING, in a note.

The decision reflected a lack of alternatives, the economist said.

It remains unclear how “monetary policy can bring down inflation that is mainly driven by (external) supply-side factors. Even the impact of policy rate hikes on inflation expectations is anything but certain,” he wrote. “At the same time, the size of today’s rate hike will not determine whether or not the eurozone economy slides into recession and will also not make the recession more or less severe. Any recession in the eurozone in the winter will be driven by energy prices and not by interest rates.”

Eurozone inflation hit 9.1% in August and is expected to rise further as Russia curtails energy supply in response to sweeping sanctions imposed by Western powers following its invasion of Ukraine.

In its statement, the ECB said recent data point to a substantial slowdown in euro area economic growth, with the economy expected to stagnate later in the year and in the first quarter of 2023.

“Very high energy prices are reducing the purchasing power of people’s incomes and, although supply bottlenecks are easing, they are still constraining economic activity. In addition, the adverse geopolitical situation, especially Russia’s unjustified aggression towards Ukraine, is weighing on the confidence of businesses and consumers,” the ECB said.

ECB staff sharply revised down forecasts for economic growth, with gross domestic product in 2022 now seen at 3.1%, 0.9% in 2023 and 1.9% in 2024.