Sinking euro: The ECB’s approach to fighting inflation is messy and modest compared with the Fed’s

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Dear Canadians, forget that holiday in Muskoka or Banff or Cape Breton. Come to Europe instead. The euro is selling off, creating sweet bargains for travellers. In recent days, it hit parity with the U.S. dollar, dealing a psychological blow to the guardians of the currency.

Since its launch in 1999, the currency used in 19 of the European Union’s 27 member states has consistently traded above the greenback since 2002 – it had a rough go in the early years.

In recent days, it has traded on either side of the dollar, marginally so, but could go lower as a war-induced recession marches ever closer and the European Central Bank puts out mixed messages as it tries to placate everyone – and no one. The U.S. Federal Reserve has been much more consistent in its messaging; as far as it is concerned, the only concern is the speed and frequency of interest rate increases, not who might get hurt along the way.

The euro is not in crisis – far from it. The crisis happened a decade ago, when Greece was on the verge of bolting from the euro zone and Mario Draghi – then ECB president, now Prime Minister of Italy – said he would do “whatever it takes” to keep the euro zone from burning. His firefighting effort worked.

But the euro is sinking alarmingly fast. It has lost 15 per cent against the dollar over a year, with most of that fall coming since January, when it traded at US$1.13. Apparently sensing an easy kill, the short-sellers piled in and the euro kept sinking. They will get blown out of the water when the market senses the euro is oversold. It’s anyone’s guess when that will happen.

Currency moves are exceedingly hard to forecast – even harder than oil moves. As economist Megan Greene told me, “To some degree there’s a mental lower bound as traders think that the euro should be above parity, so when it dips below, they think it’s cheap and buy it, and that keeps a floor on it.”

The question is where that floor is, and it may not be at or just below parity. That’s because the ECB and the Fed are diverging. The Fed appears to be engaged in the single-minded pursuit of busting inflation. The latest U.S. reading had inflation running at 9.1 per cent as housing, gasoline and food costs galloped ahead.

So the Fed is firmly in the rate-boosting game, and the only question asked by economists, analysts and the business press is whether the next rate hike will be 50, 75 or 100 basis points (100 basis points equals one percentage point). It has raised rates three times this year and has signalled a second hefty, 75-basis-point hike later this month. And damn the torpedoes! The markets will be allowed to find their own level as rates rise. If hyper-inflated asset prices – tech shares, for instance – get trashed along the way, that’s a fair price to pay for knocking inflation down (the S&P 500 is down more than 20 per cent since January).

The ECB, for its part, has been sitting on the sidelines – it has not raised interest rates in a decade, though it is expected to do so next Thursday. The European Commission this week made inaction impossible when it forecast that euro-zone inflation will hit 7.7 per cent this year, up from its previous estimate of 6.1 per cent.

There are a lot of voices vying for space in the ECB’s (and the EU’s) head, and not all of them are obsessed with crunching inflation.

European industry, especially in Germany and Italy, would like a truce in Ukraine in the hope of a return to cheap gas from Russia, which is driving prices skyward by cutting deliveries via pipeline to Germany and elsewhere.

Meanwhile, Italy, the ECB’s and the EU’s eternal problem child, seems on the verge of a twin political and debt crisis, as Mr. Draghi’s government faces a premature demise and Italian borrowing costs rise. On Thursday, Mr. Draghi lost the support of the second-biggest party in his national unity government and submitted his resignation, which was rejected by the President. All eyes are on Italy, the EU’s third-biggest economy. If it goes into the tank, so does the rest of Europe.

Fear of recession and an Italian blow-up, in other words, probably will prevent the ECB from hiking as forcefully as the Fed, which in turn suggests the EU economy is weaker than America’s; it probably is, since the United States, a net energy exporter, is somewhat more insulated from high energy costs than Europe, a net energy importer.

The ECB’s lack of zeal to hike rates as quickly as the Fed goes a long way to explain why the euro is sinking against the dollar, while the Fed’s consistently hawkish message goes a long way to explain the strength of the dollar.

The war forms the backdrop to the ECB’s dilemma. By pushing up energy and food costs, the war increases the chance of a European recession and less speedy interest rate increases. In the face of recession – and high inflation – support for Ukraine might wane, dividing Europe even further. Euro-zone central bankers are being pulled in every direction.

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