EUR Q3 Fundamental Forecast: ECB Review May Lead to Euro Weakness

As predicted at the end of March in the second quarter forecast, EUR/USD rallied strongly in Q2, rising from a low of 1.1704 on March 31 to a high of 1.2266 on May 25 before dropping back. Now, after the end of Q2, it looks as though it has further to fall ahead of the results of a European Central Bank strategy review that will likely be unveiled in September but could emerge earlier.

The review of the ECBs monetary policy strategy was announced in January 2020 by its policy-making Governing Council and the results were due to be published by the end of last year. Not surprisingly, that deadline was missed. However, since then the review has been largely ignored by the markets, which have concentrated on the coronavirus pandemic, the ensuing global economic downturn, and more recently, the recovery from that slump and the prospect of rising inflation.

The ECB has already made clear that it has no intention of tightening policy near term, in line with other central banks that have described inflation as likely to be transient. The results of the review will likely reinforce that message by stating more formally that the ECB will tolerate inflation that it regards as temporary, and the Euro will likely ease further ahead of its publication as investors begin to focus on what it might say.

EUR/USD PRICE CHART, DAILY TIMEFRAME (JANUARY 4 – JUNE 24, 2021) (CHART 1)

Source: IG

REVISED INFLATION TARGET NEGATIVE FOR EURO

One outcome of the review could be a revised inflation target, with the ECB moving from the current definition of price stability as “a year-on-year increase in the Harmonised Index of Consumer Prices (HICP) for the Euro area of below 2%” The Governing Council clarified in 2003 that in the pursuit of price stability it aims to maintain inflation rates below, but close to, 2% over the medium term.

This year that could change to a symmetric medium-term inflation target of 2%, with the ECB tolerating inflation above or below that level. In the current situation that would mean continuing low interest rates, bond-buying and quantitative easing even if inflation rises well above 2% so as not to throttle the recovery in its infancy.

LISTEN OUT FOR CHRISTINE LAGARDE

As mentioned earlier, market pricing reflects expectations so Euro weakness could well precede publication of the review. That indicates traders will need to be on the lookout for hints about its contents from Governing Council members and in particular from ECB President Christine Lagarde. She dropped one such hint in mid-June, when she suggested to Politico.EU that the US Federal Reserves policy framework could provide a template:

“We looked at what the Federal Reserve had come out with – its average inflation targeting with asymmetric symmetry and focus on employment. This is what they do, this is what worked for their strategy review,” she said. However, it does not prejudge what will work for us, and our work has not yet been finalized, she added.