Why Rate Cuts in Europe Could Do More Harm Than Good

The European Central Bank launched a fresh wave of loose-money policies Thursday to jolt its stubbornly low inflation rate. But many suspect its primary target was something else: the euro.The central bank cut interest rates and revived a bond-buying program at President

Mario Draghi

’s penultimate meeting. The euro fell about 0.4% against the dollar Thursday. While the ECB doesn’t target specific levels for the euro, the exchange rate has become a policy focus because of fears that currency strength squashes inflation.

“This [focus on the euro] is more true than it’s ever been,” said

Seema Shah,

chief strategist at

Principal Global Investors
.


PFG 0.05%

“Interest rates are so low that any further cut is not going to have much of an impact and runs the risk of making things worse. So why bother? Simply to target the euro.” But if that is the aim, success could come at a price. The further weakening of the euro, which has been falling against the dollar for almost 18 months, risks enraging President Trump and harming trade relations. Mr. Trump tweeted on Thursday that the ECB is “trying, and succeeding, in depreciating the Euro against the VERY strong Dollar, hurting U.S. exports.” The ECB reduced its key rate by 0.1 percentage point to minus 0.5% and said it would spend €20 billion ($22 billion) a month on buying bonds for “as long as necessary.”

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The central bank had to do something because inflation is low and falling: the latest reading in July was just 1%, half the ECB’s target level. But several board members had questioned the need for more bond buying, or quantitative easing, ahead of the meeting. Politically in Europe, cutting rates is easier, even though they were already negative. A rate cut “opens the door for Trump to come and accuse the ECB of actively weakening the currency,”

Daniel Tenengauzer,

head of markets strategy and insights at BNY Mellon in New York, said before the ECB decision was announced. If Europe’s problem is “an external demand shock from China, then the exchange rate isn’t going to help.” For the ECB, rate cuts are the tool of choice for influencing the exchange rate, as Mr. Draghi laid out in another major speech in Amsterdam in 2014. But some think this policy has stopped making sense. The euro has fallen this year even as inflation has tumbled, undermining the importance of their connection. On a trade-weighted basis, in which the Chinese yuan and the British pound are important alongside the dollar, the euro is also weaker than it was at the start of the year, although it has gained ground in recent months. The link between the euro and inflation has weakened, according to some observers, because more European trade is invoiced in euros and it is mainly only oil or other energy imports that are priced in dollars.

Meanwhile, cutting rates could hurt the economy if it prompts the White House to, for instance, make good on threats to impose tariffs on European car makers. There are other problems, too. Negative rates hurt bank profits and at some point will push lenders to charge more for loans, the exact opposite of what low rates are meant to achieve. The ECB is also trying to make things less painful for banks by exempting them from some of the costs, but this isn’t straightforward. The ECB’s own chief economist,

Philip R. Lane,

pointed out in a speech last week that negative rates have made a smaller contribution than other policy tools in managing inflation since 2016. Targeting the euro might also be fighting a losing battle—and a policy mistake. Mr. Tenengauzer doesn’t think the euro is going to weaken to the point where one euro buys one dollar.

ECB President Mario Draghi, pictured June 12.

Photo:

Andreas Arnold/Bloomberg News

“The monetary policy-gap between the U.S. and Europe has already gone past the widest it is going to be,” Mr. Tenengauzer said. “From now on, there will be more policy convergence, so the dollar is past its peak strength.” And if future U.S. rate cuts help to weaken the dollar, that could actually be good for Europe. “If the U.S. is easing [monetary policy] and pushing down the dollar because it is easing, that’s got to be better for global growth, including for Europe,” said

Dominic White,

chief economist at Absolute Strategy Research. Write to Paul J. Davies at paul.davies@wsj.com

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