The problem with euro-dollar parity

The euro is nearly level with the dollar. It should not matter in theory, because of the relatively low share of the US in EU trade. But it does in practice.

Some predict that the euro will fall below parity. There is a straightforward explanation for this: the war in Ukraine and unpredictable Russian gas supplies to Europe make the dollar a safe haven for investors. On top of this, US interest rates offer a higher return on investment. But it is not only the dollar. Looking at the broader picture, the European Central Bank's measure of the euro's real effective exchange rate against 42 partner countries confirms this trend towards a new historic low:

really bad news comes from the combination of the euro's falling value, the energy crisis, and the return of inflation. Global energy commodities are denominated in dollars. Energy prices thus not only rise due to supply shortages but also due to exchange rate movements between the dollar and the euro. The price of Brent crude oil in June, for instance, was down 19 per cent compared to its 2008 peak in dollars, but 20 per cent up on the same peak in euros.

European inflation reached 8.1 per cent in May, with the trend still pointing upwards. A couple of years ago, when the main concern for the ECB was deflation, a depreciation of the euro towards the dollar and other currencies would have been more than welcome. But now, in this inflationary environment it is a totally different matter. Allianz estimated that a 7 per cent depreciation of the euro against the dollar would increase inflation by 0.8 percentage points at the end of the year. Since the beginning of this year, the euro already depreciated by 12 per cent.

In theory, a falling exchange rate would boost Europe’s export industry just when the home economy is about to slow down. But this is not happening in real life because industry is supply-constrained. Germany has experienced a big drop in exports, so much so that it recorded its first monthly trade deficit in a generation. A slowing economy, rising inflation, ongoing supply constraints and geopolitical uncertainty are the current parameters for the ECB’s decision making. The dollar appreciation adds another unhappy ingredient to the mix.