17 February 2023

CEPR's Ilzezki/Jain: Euro weakness in 2022

Analysts have described 2022 as the ‘worst year in the euro’s history’. The January 2023 CfM-CEPR survey asked the members of its European panel about the reasons for the euro’s deprecation against the dollar in 2022.

A majority of 56% of panellists thinks that monetary policy differences were the main cause for the euro’s decline, while nearly 30% attribute the value of the euro to developments in the real economy. The panel was nearly unanimous that the ECB shouldn’t respond to the euro’s devaluation, but focus on maintaining price stability.

While economies around the world have suffered the impact of an economic slowdown due to the pandemic and the Ukraine crisis, the effects of these events have been exacerbated across Europe this year. Three key factors have been identified as causing the depreciation of the euro in 2022:

1. Europe’s heavy dependence on Russian energy and the associated economic slowdown brought about by the Ukraine invasion.
2. The widening of the monetary policy gap between the Federal Reserve (Fed) and the ECB.
3. The role of the US dollar as a ‘safe haven’ during times of financial and political uncertainty.

Russia’s invasion of Ukraine greatly weakened the global economy through disruptions in trade, and food and fuel price shocks, but these effects have been felt more strongly in Europe compared to the rest of the world. In its Autumn 2022 Economic Forecast, the European Commission predicted that most EU member states would enter into recession in the last quarter of the year due to high inflation, weak growth rates, and elevated uncertainty (European Commission 2022). The over-reliance of large European economies such as Germany and Italy on Russian gas has also resulted in energy-driven inflation being significantly higher in Europe than other economies, notably the US.  Inflation in Europe reached 10.6% in October compared to just 7.2% in the US. Additionally, Bobasu and De Santis (2022) found that the Ukraine invasion and associated energy price increase has significantly increased uncertainty in the euro area, which negatively affected GDP and domestic demand in the euro area. With the energy crisis bringing the EU’s terms of trade to their lowest level in its history, the euro’s depreciation relative to the dollar was an inevitable consequence of the Ukraine invasion.

Some economists have also argued that the impact of the Chinese economic slowdown has hit Europe more than the US, leading to a weaker euro. Daniel Lacalle argues that the Chinese slowdown was also putting downward pressure on the euro area’s trade surplus, and consequently, the euro could no longer maintain its strength relative to the dollar.

Another driver of the euro’s depreciation is the relatively passive approach taken by the ECB to tackle inflation compared to the Fed. The Fed adopted a more hawkish stance towards rising inflation, sending clear signals in June 2021 that it would increase interest rates to rein inflation under control. It increased interest rates in March 2022, which was followed by further, faster hikes. In contrast, the ECB defended its loose monetary policy until July 2022, when it increased interest rates for the first time. This ‘shallower’ path adopted by the ECB for their policy rates led to a widening of the interest rate differentials between the two economies, leading investors to flock from European to American assets.  As a result, since the Fed’s first announcement in June 2021 that it might raise rates, the dollar has appreciated by roughly 20% against the euro. Beckworth and Leeper (2022) have suggested that the ECB’s soft stance is influenced by the high debt levels of some euro area economies. See also von Hagen (1999) for a historical perspective.

Authors

Ethan Ilzetzki

Associate Professor of Economics (with Tenure) London School of Economics and Political Science

Suryaansh Jain

BSc Economics student London School of Economics and Political Science

CEPR

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