HomeWhy Higher Inflation in Europe Is Bad for the Common Currency

Why Higher Inflation in Europe Is Bad for the Common Currency

Inflation is part of every central bank’s mandate. Depending on the bank, the definition of price stability means bringing inflation to an area that is far away from zero, so to avoid the threat of deflation, but not much higher than the target so to avoid negative effects higher inflation brings. 

In the Euro area, the European Central Bank’s (ECB) price stability definition means inflation below, but close to 2%. One may say that a level of 1.8% to 2% is in line with the price stability as defined by the ECB. In some other parts, like Australia, the central bank sees price stability if inflation reaches a band between 2% and 3%. Or, in the United States, if it averages 2% over a certain period of time.

The price stability definition helps the central banks calibrating their measures. Put it simply, when inflation drops below target, central banks ease the policy. When it runs above the target, central banks intervene with a contractionary monetary policy.

Hence, higher inflation is typically met with a hawkish stance from the central bank, which should be bullish for the currency in short to medium term. Not this time in Europe – and here is why.

Inflation Reaching 1.4% in January

Yesterday’s inflation data failed to trigger the much-expected bounce in the Euro pairs. In fact, just the opposite happened – the higher inflation data put further pressure on the common currency.

The core data, the one favored by the ECB and the one that excludes energy prices as considered too volatile, reached 1.4% in January. While still below the 2% ECB’s threshold, the jump is nothing but impressive – a five-year high.

This is the largest ever increase in basis points terms – 118 bp when compared to the previous record of 56 bp. The problem for the Euro is that the ECB is not about to do anything to steam this inflation, as it made it clear in several interventions that made headlines in the financial media. As such, with the ECB willing to let inflation even higher, it remains to be seen if the upside pressures are transitory, as the ECB believes, or not.

In the meantime, the lack of action from the ECB puts pressure on the Euro. Isn’t this just what the ECB wanted a few months ago and warned everybody that the exchange rate is too high?

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