The euro has weakened relative to the US dollar this year, reflecting the strengthening American economy, Europe’s push to boost exports and the European Central Bank’s (ECB) plan to begin quantitative easing.
Earlier this month, the ECB cut interest rates by 10 basis points and announced a program to buy asset-backed securities and covered bonds that will start in October. Although the ECB hasn’t confirmed the size of this effort, an emerging consensus calls for the central bank to purchase about EUR500billion of securities.
However, the effectiveness of this quantitative easing depends in part on the extent to which larger economies such as France and Italy implement much-needed economic reforms. Stern words from ECB President Mario Draghi and the German Chancellor Angela Merkel emphasized the importance of these structural changes.
ECB economists estimate that an 8 percent to 10 percent drop in the euro relative to the US dollar adds about 0.5 percent to inflation and bolsters the EU’s gross domestic product (GDP) by between 0.7 and 1 percent.
The central bank’s mandate targets a medium-term inflation rate of almost 2 percent; current forecasts call for EU inflation of 1.1 percent in 2015 and 1.4 percent in 2016.
Instead of focusing on inflation, investors should take heart that Draghi and the ECB remain committed to using quantitative easing and other means to boost the EU’s flagging economy.
In the past, corporate earnings have responded favorable to weakness in the euro, a trend that we expect to continue as policymakers seek to pump life into the eurozone economy; about 58 percent of EU corporate earnings come from outside the Continent, while the region’s current account surplus appears to have peaked at about 2.5 percent of GDP.