In recent days, however, market developments have started to make the ECB’s ‘good place’ a little less comfortable. The weakening of the US dollar and hence the strengthening of the euro have led to some unease at the Bank. Austrian central bank governor Martin Kocher said that “if the euro appreciates further and further, at some stage this might create, of course a certain necessity to react in terms of monetary policy. But not because of the exchange rate itself, but because the exchange rate translates into less inflation, and then this is, of course, a monetary policy issue.” French central bank governor, Francois Villeroy de Galhau, hinted that the stronger euro was a key factor in guiding monetary policy in the months ahead. And ECB vice-president Luis de Guindos said last summer that an exchange rate of 1.20 versus the dollar was acceptable but levels beyond that could become more complicated. Well, we are at that level now.
From a monetary policy perspective, the recent strengthening of the euro would lower the ECB’s December inflation forecasts by some 0.1 percentage point. Compared with December, the euro has appreciated by some 3.5 percent vis-à-vis the US dollar and by some 1.5 percent vis-à-vis a basket of currencies (nominal effective exchange rate). All else equal, the ECB’s projections would now show headline inflation falling below 2% for the next three years – a development that is likely to revive concerns among those Governing Council members who have long feared an inflation undershoot and view it as a risk to the ECB’s credibility.