Will ECB Look Past Decade High Inflation?

By Kathy Lien

The European Central Bank has a monetary policy announcement on Thursday and many investors are wondering if euro will fall to the same fate as the Canadian and Australian dollars. Both currencies were sold after the rate announcements despite a tinge of optimism from their central banks. So far, the ECB has been one of the most dovish central banks. Back in July when they last met, they promised to keep rates low for longer amidst weak inflation and concerns about the COVID-19 Delta variant.

Seven weeks later inflation is at a 10 year high. The Delta variant is wrecking havoc across the globe, leading to tightened restrictions and worries about more cases in the Fall. Yet Europe is doing a much better job controlling the spread than other countries. Cases in Germany have been on the rise, but new infections in France, Italy and Spain have been trending lower this summer.

Europe eased restrictions and welcomed back travelers leading to major improvements in economic data in May, June and July but the momentum is fading in August with nearly every major Eurozone economic report outside of inflation weakening. The PMIs are lower, and the expectations component of the German ZEW survey which measures investor sentiment, dropped to its lowest level since March 2020. The IFO business confidence index also declined but not as steeply as ZEW.

On inflation alone, the ECB should begin reducing asset purchases but many central banks have taken a pause in recent weeks. Most policymakers are optimistic and believe that the recovery will continue but they also see the increase in inflation as transitory. Add virus uncertainty to the mix and they’ve been in no rush to take away the punch bowl.

The ECB faces the same decision tomorrow but unlike the Federal Reserve and other central banks they have a bit more room to maneuver. They are buying bonds under both the Pandemic Emergency Purchase Program (PEPP) and the Asset Purchase Program (APP), so they could reduce PEPP and not really taper until APP purchases are reduced. Still any change in bond purchases would be perceived as positive for euro. In addition to the rate decision, the central bank will update their economic projections. Inflation and growth projections are expected to increase. So while EUR/USD traded lower for 3 days in a row, if asset purchases are reduced and economic forecasts upgraded, the single currency could buck the trend of post policy meeting weakness and trade higher. Of course, if the ECB makes no changes to their forecasts and the tone of President Lagarde’s press conference is cautious, EUR/USD could slip to 1.1750.

The Canadian dollar traded lower after the Bank of Canada left interest rates and their Quantitative Easing program unchanged. Although the loonie’s decline can be partially attributed to the central bank’s decision to forgo more taper this month, their outlook remains positive. The BoC expects a stronger recovery and sees solid momentum into Q3 for the global economy. They noted the risks of supply chain disruptions and the virus but from what they can see, employment, consumption and business investment are strong.

The U.S. dollar held steady or traded higher against most of the major currencies despite a slightly more dovish Beige Book report. According to the Fed districts, economic growth downshifted slightly to a moderate pace in early July through August. Investors also shrugged off the decline in yields in favor of parking their money in the safety of U.S. dollars as stocks tumbled for the third day in a row.