Policy Manoeuvres in the Dark

01 February 2021 (5 min read)

Key points

There is some talk of taking the deposit rate further down in some quarters of the European Central Bank (ECB), to try to stem the recent appreciation of the euro. We argue that the growth differential, fuelled by the divergent performance on vaccination, will actually favour the dollar, especially if more political volatility materializes in Europe.

Some members of the ECB Governing Council are clearly worried by the euro appreciation, to the point of talking up the possibility of cutting the deposit rate further, an instrument which had largely been ignored in the recent policy discussions focused on the PEPP/TLTRO duet providing support to the economy by making fiscal policy financially possible and helping banks. We continue to think that we are very close to the “reversal rate”, i.e. the point beyond which cutting rates does more harm than good, especially since the ECB’s capacity to mitigate the impact of such policy on banks is limited. We are also surprised by the prominence of the exchange rate issue. As of last Friday, the euro has appreciated by less than 3% relative to the ECB forecast for 2021 published on December 10th, which would hardly move the needle for inflation and growth.

In our opinion the pendulum has already swung back on the exchange rate. While we will see volatility as Biden will have to compromise to get his fiscal policy push through, there are many reasons to think the US economy will significantly outperform Europe in 2021, and the push higher in US long-term interest rates should ultimately re-create foreign interest in dollar-denominated assets. Beyond the role of fiscal policy – and the fact that the US economy was in any case more resilient before the Covid winter wave struck – the gap on the sanitary front is also widening. The US is not doing as well as the UK on vaccination, but it is still vastly outperforming Europe.

This goes beyond the exchange rate, or even purely macroeconomic considerations. We are concerned that “lockdown fatigue”, exacerbated by mounting criticism on Brussels’ handling of vaccination procurement, could fuel populist movements which so far did not fare that well in Europe since the start of the pandemic. Early elections can still be avoided in Italy if another coalition contract is found between PD, M5S and Italia Viva. If this base case does not materialize, we will have an important test for Europe in the first half of 2021. The US was the main source of “political volatility” these last few months. Hopefully, Europe will manage to avoid taking up that role now.

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