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Text/Teng Tai, President of Wanbo New Economic Research Institute
Recently, the depreciation of the euro has become a hot topic. On Tuesday (July 12, Beijing time), the euro touched an intraday low of 0.9999 against the dollar, a new low since 2002, and the euro fell below parity against the dollar.
With regard to the short-term exchange rate movement of the euro, it is mainly affected by the balance of income and expenditure of the current account and capital account in the euro area, as well as the allocation of financial assets caused by expected factors. But in the long run, the exchange rate trend of the euro, mainly depending on the economic growth of the eurozone countries, will it fall into recession? The second is the price movement of the euro area, including the consumer price index, the producer price index and the price comparison between the United States and other regions, as well as the respective interest rate changes and interest rate differentials with the US dollar and the euro area.
On the whole, the ECB's launch of interest rate hikes can cool down aggregate demand, but the inflation factors brought about by the supply shock are ineffective, so the overall inflation suppression is limited, and it is probably more difficult to reverse the depreciation trend of the euro by relying on a small interest rate hike.
Three influencing factors: economic growth rate, prices and interest rates
We will focus on three factors that will affect the euro's exchange rate in the future: economic growth, prices and interest rates.
From the perspective of economic growth, the economic growth of the eurozone countries into recession should be a high probability event, which is also a major reason for the deterioration of the short-term expectations mentioned earlier, causing financial institutions to sell the euro in exchange for other currencies.
In the case of the relatively stable economic structure of European countries, the economic growth rate is relatively low, and once faced with a supply shock like the Russo-Ukrainian War, the impact of the new crown epidemic on supply and the suppression of consumption, the risk of their economy falling into recession begins to gradually increase.
This round of supply shock, in addition to the impact of the epidemic, mainly the impact of the Russo-Ukrainian war, its impact on Europe, than any region in the world, Germany's producer price index (PPI) actually exceeded 30%, which is a new high since World War II, which is undoubtedly inseparable from the Russian-Ukrainian war brought about by the price increase of crude oil, natural gas, and other raw materials.
The supply shock of raw materials not only affects prices, but also affects production, because the cost increases, manufacturers will decrease, production will decrease, consumers will reduce demand, so overall, the russian-Ukrainian war brought about by this upstream energy and raw material supply shock, is not only the cause of the relatively high inflation rate in Europe, but also an important reason for its economic recession.
The second important factor is prices. At present, the increase in the price of CPI in the euro area in May is similar to that of the United States, which is more than 8%, but the increase in its PPI is far greater than that of the United States, and the PPI in Germany is more than 30%.
Considering that the economic growth rate of the United States, especially in 2021, is relatively high, although there is also a risk of inflation, it is generally expected that the economic growth rate of the United States will be significantly higher than that of Europe, and its price decline will also be faster than that of Europe.
Third, interest rates are an important factor affecting the exchange rate, from the perspective of capital, high interest rates attract capital inflows, while under the relatively low interest rates in Europe, the direction of spread trading is not the same. Judging from the policies and judgments adopted by the Fed and the European Central Bank after this round of inflation, its central bank, represented by the Federal Reserve, made a wrong judgment last year. The Fed made a "inflation is short-term" misjudgment last year, and did not take timely measures to deal with inflation in the second half of 2021, but since March 2022, it has raised interest rates three times in a row, starting with 25 points, then adding 50 points, the most recent increase of 75 points, and may have another sharp rate hike in July, with a high probability of 50 points or 75 points. Therefore, such a large, high-frequency interest rate hike has undoubtedly widened the interest rate differential between the dollar and the euro, attracted the return of the dollar, and people have allocated more dollars and sold the euro, which is also one of the important reasons for the strong dollar and weak euro.
Overall, looking ahead, people think that the economic growth rate of the United States will be significantly higher than that of Europe, the interest rate of the United States has risen before the interest rate of the euro area, the spread is gradually expanding, and everyone believes that the price decline rate of the United States will also lead Europe, so the role of several reasons has caused the euro to continue to fall and the dollar index to rise.
The ECB's launch of interest rate hikes has had a limited effect on overall inflation and the depreciation of the euro
Regarding the ecbloc's judgment that the ECB's initiation of interest rate hikes has limited overall inflation suppression, I think there is some truth. In order to control inflation, the ECB will most likely raise interest rates appropriately, but it is necessary to carefully balance between the three objectives of economic growth, employment and prices, and the ECB has much less room to raise interest rates than the Federal Reserve.
Moreover, from the perspective of the complex causes of inflation, it is not enough to simply raise interest rates.
This round of global inflation, whether it is inflation in the United States or inflation in Europe, or other countries, is actually affected by about six factors.
First, the lagging effects of long-term accumulation of currency overexpression. Why is it said that the long-term accumulation of currency is over-issued? For the United States, a lot of quantitative easing should have begun in 2008 during the subprime mortgage crisis, and after the outbreak of the epidemic (2020), there was bottomless quantitative easing. Relative to 2008, the Fed's balance sheet has expanded almost eightfold, so it is a long-term cumulative monetary overshoot, not a short-term one, not just quantitative easing after the pandemic.
Why lag effects? Because most of these over-issued currencies have been absorbed by the asset market. Specifically, it was absorbed by their real estate market and stock market, and as a result, a large number of over-issued currencies did not impact the real economy and prices, and now their real estate market and stock market have appeared in a huge bubble, and they can no longer absorb excess money, so this lagging effect will impact prices, which is the first factor causing inflation in Europe and the United States, and it is the lagging effect of long-term accumulation of over-issued currencies, and the euro area is similar to the situation in the United States analyzed earlier.
According to the "unit capacity" and "money supply" indicators that we have been using for more than a decade, it will be roughly until the first half of 2024 to return to normal levels. Therefore, even if the ECB raises interest rates in the short term, it will be difficult to suppress inflation quickly.
But rate hikes are useful, as they reduce consumption, reduce investment, and thus reduce aggregate demand. Price control is useful in terms of slowing aggregate demand growth, but long-term over-issued currencies are difficult to absorb in the short term.
The second important shock is unrelated to interest rate hikes, but comes from the impact of supply shocks, such as the Russo-Ukrainian War, or the implementation of long-term dual carbon emissions targets. Among them, even if the impact of the Russo-Ukrainian war is likely to be alleviated or even ended in the next few months, the long-term factor of carbon emission reduction that affects energy supply cannot be eliminated, and it will continue to impact prices and affect European economic growth.
The third factor is that changes in the supply of labor are driving wages up. Since the outbreak of the new crown epidemic in 2020, the willingness of workers in various countries to work has declined, superimposed on the decline in fertility rates for a long time, the aging of the European population, etc., making the rise in wages a continuous factor, which should also be one of the most important influencing factors for the promotion of prices.
The fourth factor is the impact of global trade protectionism, which drives up the cost of supply chains.
The fifth factor is the price of food, and the supply of food affects the price of food. Ukraine is the breadbasket of Europe, so the Russo-Ukrainian War also contributed to the rise in food prices in Europe.
Finally, in recent years, due to the borderless, no-regional and low-cost expansion of Internet technology, many fields and industries have monopolized and headed the trend, which is also one of the important factors causing price increases.
On the whole, the ECB's interest rate hikes have a certain effect on controlling inflation, which can cool down aggregate demand, but the impact on the supply of energy raw materials, the impact of labor and wage costs, the impact of food supply shocks and food prices, as well as the impact of trade protectionism on supply chain costs, as well as the impact of monopoly on supply costs, are useless, so the inhibition effect of interest rate hikes on overall inflation is limited, and it is probably more difficult to reverse the depreciation trend of the euro by relying on small interest rate hikes alone.
If the euro is to reverse the depreciation trend, the core is to enhance the economic vitality of Europe, and then increase the economic growth rate. At the same time, it is necessary to reduce inflation from the supply side, suppress the depreciation of the euro from purchasing power parity, and raise interest rates without harming the economy, so that the exchange rate of the euro will gradually stabilize.
Economic inflation and recession under the stagflation crisis
Speaking of stagflation, there is a great risk that the eurozone will fall into an economic pattern similar to stagflation next year. If inflation does not fall as expected, and economic growth begins to decline rapidly, it becomes a superposition of inflation and recession. I came out with a book called Global Inflation and Recession at the beginning of this year, why not call it stagflation, but global inflation and recession? There are several layers of meaning here, first, the rise in prices and the recession do not occur at the same time, but there is "inflation" first, followed by "recession". Inflation is already a realistic "grey rhino risk" for Europe and the United States today, and a recession is a "black swan risk" that follows inflation, that is, it may or may not happen.
Therefore, it is very likely that each round of particularly serious inflation will be followed by a sharp increase in interest rates and tightening by the government in order to control inflation, resulting in a plunge in the financial market, causing the balance sheet of enterprises and residents to shrink the balance sheet, and then there is a possibility of recession, and this situation may become a reality in Europe in 2023.
The current depreciation of the euro and the potential crisis in the European economy, similar to the risk of inflation and recession in the United States, will seriously affect the global economy. The fastest transmission path affecting the global economy may be finance, which may affect emerging market economies by causing exchange rate changes and short-term capital flows, and the return of funds to the United States and Europe. In the medium and long term, it will also cause a sharp contraction in demand in Europe and the United States, which will affect the export of emerging market economies.
As for how China responds, I think the first and most important point is to insist on starting from itself and deciding its own policies according to its own situation. Judging from the current economic situation, the consumer price index is below 3%, and the main challenge is the economic downturn. The phrase is "Whoever is sick takes medicine, and what disease is taken." "The United States and Europe are both 'inflation-ridden', so they have to raise interest rates to fight inflation, and China's current CPI is normal, but the economy does have downward pressure, so we have to cut interest rates to stabilize growth.
From the perspective of foreign trade and foreign policy, the depreciation of the euro and the economic recession in Europe are likely to cause social problems, and for China, it may also be an important opportunity to develop trade and diplomatic relations with Europe.
Historically, China-EU economic and trade relations have been very close, and Europe has always been a stabilizing force for global peace in history, so for China, whether Europe is facing inflation or the risk of economic recession, we should unswervingly develop closer economic and trade exchanges and friendly cooperative relations with Europe.
Edited by Chen Li Proofreader Fu Chunyan