The European Central Bank left monetary policy unchanged, but comments from Mario Draghi sent the euro tumbling more than a full cent against the U.S. dollar. At first, it was Draghi’s subdued tone that sent the EUR/USD lower but the selling gained momentum as the ECB President started to talk about the currency. Taking a deep breath before answering the question posed by a reporter, Draghi said the euro appreciation is a sign that confidence is returning BUT exchange rages should reflect fundamentals. He said the real and nominal exchange rates of the euro are near their long-term average but if the appreciation is sustained, it may alter their view on price stability. In plain English, this means he’s comfortable with the current level of the euro but watching it carefully to see if the rally continues and if it does, they will have to reevaluate the impact on inflation.
While Draghi believes that the exchange rate is not a policy target, the amount of time he spent talking about inflation in his prepared commentary suggests that the euro rally is impacting their view on monetary policy. Draghi said inflation rates could fall below 2% in the coming months but right now, the risks are broadly balanced. Indirect taxes and oil prices could drive prices inflation but appreciation of the exchange rate could drive CPI lower. Since price stability is the ECB’s number one priority, if the euro gets too strong, it could tip the balance in favor of lower prices, which could push the central bank to talk down the currency.
According to Draghi, monetary policy remains accommodative because the risks to euro area growth continue to be to the downside. He believes that there will be weakness in early 2013 as balance sheet adjustments weigh on the economy followed by a gradual recovery later in the year that will be supported by accommodative monetary policy. So the message from the ECB is crystal clear, monetary policy is accommodative and they ARE watching the euro.
The question that many currency traders now have is whether Draghi has permanently killed the EUR/USD rally and our answer is no. Fundamentals remain intact – the tail risks have receded, the Eurozone economy is still recovering and capital is returning to the region. However, we cannot ignore the short term impact that Draghi’s comments have had on the euro. The currency appreciated significantly since the beginning of the year due in large part to Mario Draghi’s nonchalant attitude towards the currency. The euro is now on his radar and this reality could drive additional profit taking in the EUR/USD. However we believe losses should be limited to support around 1.3270. Back when ECB President Trichet called the move in the euro brutal or excessive, the currency pair recovered quickly before topping out later on (see charts).