19 January 2004

EZA 576: Euro-Economy

Implications of a weaker dollar for the euro area and ECB - why this is different from 1987/1988
US dollar weakness will be a major theme for 2004 across both the euro area and the world economy in this a US presidential election year. However, the weakness of the dollar will be different from previous periods of weakness, most specifically the dollar decline between 1985 and 1988 which is the most recent parallel to the dollar’s fall, The dollar decline from its 1985 peak was accompanied by a substantial reflation of domestic demand in Europe and Japan particularly, in 1987/88. The scale of this demand reflation in Europe and Japan was much greater than the demand reflation in 2002/3. This time, the US dollar fall has been accompanied by a much less significant easing in monetary and fiscal policy elsewhere in the G7.The ECB has reduced interest rates but only from 4.75% to 2% and far more cautiously than the US Fed. The euro area is likely to remain the region with the most uncertain growth prospects, particularly as fiscal policy remains constrained by the Stability & Growth Pact and the ECB’s reflation of demand has been much more modest than the US Federal Reserve’s.

SummaryAsset Conclusions: ECB policy locked between stronger euro exchange rate and disappointing inflation performance. Expect no change in policy for 1H04.

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