July 25, 2022

Chart of the Week: Euro trapped between Scylla and Charybdis

by Fathom Consulting.

The European Central Bank (ECB) took the largely unexpected step of hiking by 50 basis points last Thursday, rather than the pre-committed 25 basis points. The euro has lost more than 10% of its value against the dollar since the start of the year, briefly falling below parity, and yet there had been no strong hints that this was causing the ECB concern. Clearly, it was. With inflation reaching multi-decade highs, driven in part by fears of gas shortages, the ECB apparently felt that the prospect of more expensive imports was an added hit that Europe did not need. Until last week the ECB had lagged behind a rapidly tightening Federal Reserve, wishing to protect the peripheral economies while it was drawing up the new Transmission Protection Instrument (TPI) — a bond-purchasing tool to give authorities leverage over euro area sovereign bond spreads. That tool went live last week, and the ECB was done with sitting on its hands. But any support the ECB’s belated hike might have given the euro against the Scylla of falling exchange values was immediately negated by the Charybdis waiting around the corner — in the form of another Italian political crisis, which will put the TPI to the test immediately. Will the ECB’s new tool control spreads and allay fears of fragmentation, providing space to battle inflation? We should know by the time the next ECB meeting comes round in September.

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