Top of Mind - Will the rising euro trigger ECB cuts? Probably not
The euro has broken the 1.20 mark vs the dollar in recent days, having risen around 4% over the past week. This has prompted speculation – helped by remarks of some Governing Council members – that the ECB might have to cut rates at some point to offset the tightening of financial conditions that comes with a rising euro. So far, at least, this looks unlikely given the type of move we have seen in the euro.
This is clearly a dollar-driven move; on a trade-weighted basis, the euro has risen around 0.8% over the past week. The move being dollar-driven also means that the key channels through which a stronger euro can lower inflation, namely commodity prices, are significantly blunted. For instance, oil in euros has actually risen by around 3.5% over the past week, not fallen. Indeed, commodities (which are priced in dollars) generally are rising, suggesting the weaker dollar has some role to play. What about other imported goods? Rule of thumb estimates suggest a 10% rise in the trade-weighted value of the euro would lower goods inflation by 0.5-1pp over a 1-2 year horizon. With goods making up 25% of the inflation basket, this implies at most around a 0.3pp fall in headline inflation over two years. The current move we are seeing (only a 0.8% rise in the TWI) is therefore essentially negligible in its impact.
We do expect a significant rise in EUR/USD over the next two years, to 1.25 by end-2026, and then to 1.30 by end-2027. But, this is largely on the back of a weaker dollar, and we expect a much more modest move in the euro vs other currencies. Given this, what we are seeing right now is consistent with our base case. Of course, matters could change: president Trump has sounded relaxed about the weakening dollar, and it is possible that market moves get out of hand. However, based on what we are seeing so far, we do not expect the ECB to significantly change its forecasts on the back of current FX market moves, nor for the Governing Council to respond with rate cuts. Our base case sees the ECB staying on hold at 2% over our forecast horizon.