Â·ECB staff revise growth
forecasts down significantly
Â·Latvia wants to maintain peg
to euro, but under massive pressure to devaluate
goes into wait-and-see mode
Since rallying at the end of last week, EUR-USD has been
moving sideways for the most part, hovering around 1.42. Towards the middle of
the week, the euroâ€™s attempt to breach 1.43 was thwarted by some disappointing
indicators from the US and guarded comments on the economic outlook from Fed chairman Ben Bernanke. The impending
release of the US labour market report could have played a part too.
At the moment, currency turbulence in eastern Europe,
currently focused on the Latvian lats, is supporting the euro to some extent.
Against the backdrop of a dramatic economic collapse, the
lats, which has a fixed exchange rate against the euro, has
come under increased pressure to devaluate. The Latvian government is having to
make drastic budget cuts (which have already been passed in the first reading
and are due to be introduced on 17 June) before receiving the next tranche of
the bailout loan (over â‚¬1.4bn) from the EU and the International Monetary Fund.
Speculation came to a head this week after a failed bond auction. Furthermore,
a government adviser had said that devaluation of the Latvian currency was just
a matter of time. Both the central bank and the government have, however,
emphasized their determination to keep the peg to the euro, and at Thursdayâ€™s
press conference, ECB president Jean-Claude Trichet himself supported maintaining
the currency peg. The turbulence around the lats is having a widespread impact.
On the one hand, because Estonia and Lithuania in particular are not much better off either. Hungary and Poland â€“ both in a difficult budget situation and with high
current account deficits â€“ are also feeling the repercussions. On the other
hand, because devaluation could prove risky for the banking system in Latvia and the whole of the Baltic region. Swedish banks too are
heavily exposed here, which is reflected in the Swedish kronaâ€™s marked
weakness. Only a few days ago, the Swedish Riksbank, with the help of the
finance ministry, increased its foreign currency reserves in order to have
sufficient funds at its disposal again.
end of easing for the time being
The ECB has left the refinancing rate on hold at1.0%. President Trichetâ€™s comments at the press
conference indicate that the ECB sees no necessity for
further interest rate cuts or additional unconventional measures at the moment.
The ECB governing council regards the current interest rate level as â€śappropriateâ€ť
and growth and inflation risks as â€śbalancedâ€ť.
The sideways movement of monetary policy is in direct
contrast to the assessment of the economic environment. The ECB governing
council admits that the economic outlook has deteriorated significantly in the
last three months, both in the eurozone and world wide. According to the
statement, the contraction in economic activity will continue until the middle
of next year, when a gradual recovery is expected to set in. The ECB staff
projections envisage real GDP at around â€“4.6% this year, and falling by a
further 0.2% next year (middle of the range). Prices will continue to be
dampened by weak demand for some time to come. The staff
projections see the inflation rate at a mere 1% in 2010 â€“ significantly below
the ECBâ€™s stability target.
The ECB council meeting did not have a sustained impact on
the forex market. Shortly before the meeting, EUR-USD had dropped well below 1.41
for a time, only to climb back to 1.42 after the decision had been announced.
The short end of the yield curve reacted differently, however; it shot up.
Yields on 2-year Bunds rose by almost 20 points to 1.59, the interest rate
advantage over the equivalent US Treasuries widened by more than 10 points.
The ECBâ€™s policy stance â€“ the end of monetary policy
loosening, at least for the time being â€“ should fundamentally support the euro.
In the longer term, things will depend on whether the ECBâ€™s economic
projections prove to be correct or not. In our view, action still needs to be
taken. On the basis of the ECB projections, the output gap will increase during
the whole of the forecast period, and presumably even longer. Thus the deflationary
impetus will not only continue, but actually intensify. At the same time, the
inflation rate will remain below the stability norm. Against this backdrop, we
still see a possibility of further monetary loosening, even if this is not
acute at the moment. EUR-USD could thus suffer a setback, despite the fact that
the sharp increase in US government debt and the growing need for US current account correction are structurally against the
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