Here’s a graphic reminder* of just how overvalued the euro has become:
That’s from the fixed income team at Deutsche Bank, who note that the euro’s recent appreciation means the currency is now overvalued, on a purchasing power parity basis, by 17 per cent to the US dollar and 12 per cent to the British pound. And while holidaying continental European tourists might not mind a stronger currency — they can buy lots of American and British goodies on the cheap — it could pose a wider monetary policy problem.
As the Deutsche analysts note, an overvalued euro effectively equates to tighter monetary policy — something the European Central Bank may not yet want:
An overvalued currency via its negative impact on growth and inflation is effectively akin to tight monetary conditions. The extent of the tightening depends on the degree of openness of the corresponding economy and the persistence of the currency overvaluation. Standard models assume that a 1% appreciation of the euro in trade weighted terms is equivalent to a 25bp hike. Conversely, a weakening currency will be akin to further monetary easing.
While small deviations from PPP may not always have a material impact on the competitive position of an economy and can persist for long periods of time, significant overvaluations have proven more difficult to sustain. Thus one would expect these deviations to be ultimately corrected either via a rise in the expected inflation differential or via an adjustment to the FX.Watch this space.
*And no, we don’t know how DB has managed to chart EUR/GBP and EUR/USD all the way back to 1975. But as they’re a German bank we assume their methodology is sound.
Related links:
Gotcha! QE and devaluation – FT Alphaville
QE and the ECB – FT Alphaville