Readers Question: Europe is in grip of real deflation and low growth period but then why Euro is on a rise
In recent months, European inflation has fallen to 0.5%. In several countries within the Eurozone, countries are now experiencing actual deflation. In the past year, the Euro has appreciated against a basket of currencies, such as the Dollar, the Pound and also other Emerging market currencies.
Why has the Euro appreciated?
- Up until 2012, there were concerns over the liquidity of many sovereign European countries – bond yields in countries such as Ireland, Italy, Portugal and Spain were rising to dangerous levels. Since 2012, the ECB has been more willing to act and intervene in the bond markets. This has helped reduce bond yields, giving more confidence in holding Euro securities. The worst fears of the Euro bond crisis have eased, causing an appreciation in the Euro.
- Low inflation does make a currency more attractive. In the long term, relative inflation rates play an important role in determining the level of a currency. If prices in Europe are rising at a slower rate than elsewhere, European goods become relatively more attractive and therefore, there is higher demand for Euros. Europe has one of the lowest inflation rates in the world, so it’s goods are relatively competitive.
- Another reason for the relative strength of the Euro are signs of improving economic activity. This might sound surprising given that European unemployment is still at critical levels, but investors often look for small signs of the economy turning the corner. They may think that signs of improved private sector activity leads to the possibility of future growth; therefore in the medium / long term, there is the prospect of a return to more normal economic activity and therefore higher interest rates. (in the long term)
- Currencies often don’t perform as you would expect. There are many economic reasons to explain changes in the currency (e.g. see: factors that influence the exchange rate). However, in the real world, it can appear exchange rates don’t seem to follow the logic of economic theory. This is because:
- It may be due to speculation about future changes in the economy, with investors trying to predict what may happen in a year or two.
- It may just be a correction to a previous decline. For example, since the start of the Euro crisis in 2010, the Euro was weak, therefore, to some extent the recent strength of the Euro could be a correction for that previous weakness.
- It may because investors are nervous about the performance of all currencies, given the general global economic weakness. Therefore, a currency like the Euro benefits from being relatively less bad than others.
- The strength of the Euro, may prove to be short lived. Even the ECB is becoming concerned about the strength of the Euro. The ECB has said it believes the strong Euro is an important factor in reducing inflation to 0.5%, and also reducing exports and economic growth. The ECB are even hinting at unorthodox monetary policy, such as quantitative easing. If the ECB do loosen monetary policy and target higher inflation, then we can expect to see the Euro to weaken in the coming months.