The euro’s path to parity depends on the actions of the European Central Bank (ECB) and US Federal Reserve (Fed) signals, analysts have cautioned. The risks for the euro have increased due to the ECB’s comments on multiple rate cuts this year which have led more investors betting on further declines in the euro. As was noted, a return to parity is not unlikely if the ECB cuts rates more than the market currently expects (three times in 2024) and if the Fed indicates a delay in rate cuts until the last quarter of the year. This suggests that the summer will be especially volatile for the euro as market participants scrutinise the ECB’s policy direction and impact on the euro-dollar exchange rate.
ECB to Cut Rates Earlier than the Fed
ECB officials continue to favour cutting rates several times this year, despite the ongoing Middle East conflict and higher US inflation which will delay any rate cuts by the Fed. The European Central Bank is expected to reduce its deposit rate in June, three months ahead of the Fed’s expected rate cut and to cut rates twice more this year according to a Reuters poll.
Investors are changing their mind about what to expect in regard to the global easing cycle as the persistence of inflationary pressures in the US has slowed down plans of lowering borrowing costs. The Fed was expected to be the first central bank to start reducing rates, but stubborn price growth has allowed the US central bank to keep rates higher and for longer.
ECB hints at multiple rate cuts
The EU central bank president Christine Lagarde has been hinting very strongly that Eurozone’s central bank still has plans to cut the rate of deposits (from a new record high of 4%) in June but is open to all possible options for the path beyond it. Most of the policymakers from the bloc’s 20 national central banks have been even more vocal, saying that further rate cuts should be expected so that inflation gradually goes down to reach the ECB’s 2% target by the end of next year.
All of them have also highlighted that the ECB’s decisions will be based on incoming economic data and reports, especially those relating to wages, profits and productivity.
Last week, Madis Muller, Estonia’s central bank head, told Reuters that as long as the economy develops at the same pace as forecast, the expectation for more rate cuts after June will be reasonable. Klaas Knott, the hawkish head of the central bank of the Netherlands, made a remark that he is “not uncomfortable” with three cuts in 2024.
Lithuania’s Gediminas Simkus has insisted that more than three rate cuts were plausible, while Germany’s Joachim Nagel warned of a “cautious gliding flight.”
With the ongoing Middle East conflict, caution is possibly important, but the situation in the Eurozone hasn’t changed, Francois Villeroy de Galhau, the French Central Bank governor stated.
Nonetheless, with the bloc’s inflation declining (except services) officials believe a June rate cut is highly likely.
Rate cut concerns
Not everyone is convinced that the ECB will deliver three rate cuts by December. Traders speculate that the ECB will have to follow the Fed in order to protect the euro from depreciating. Economists at Morgan Stanley said in a note that “The FX-inflation channel is what gives us cause for concern in Europe versus the more aggressive (rate-cutting) path we had previously.” But ECB policymakers feel confident about the euro.
Governor of the Bank of Italy Fabio Panetta focused on the fact that a depreciation of the euro would be offset by an increase of bond yields and commodity prices which will then result in tighter financing conditions. Overall, all central bank governors have stressed that the economic environment in the Eurozone was different than in the United States. So, the differentials between the Fed and ECB monetary policies are not new and could also widen as some ECB officials argued. As the New York Times put it, Europe’s central bankers are trying to get out of the shadow of the United States.”
Gabriel Makhlouf, governor of Ireland’s central bank, stressed the divergence in policy between the Eurozone and US by emphasising the differences. Whereas the eurozone stagnated for five quarters, the United States has expanded unpredictably.
But several of the central bank’s policymakers have noted that the council remained cautious and did not want to ease monetary policy too early and risking the return of higher inflationary pressures. Inflation in the services sector has remained stubborn at 4% for the past few months, and geopolitical risks, such as in the Middle East, could have massive and unexpected economic consequences.
As the ECB hints at potential rate cuts, contrasting with expectations of delayed Fed rate cuts due to high inflation, the euro faces downward pressure, with analysts worried that the euro could reach parity with the dollar in what promises to be a volatile summer ahead.