The European Central Bank responded correctly to recent news of very low eurozone inflation by loosening policy further. The big question now is whether its decision – reducing the main financing rate from 0.5 to 0.25 per cent – will have a big enough impact to move inflation from less than 1 per cent a year back close to the ECB’s target of 2 per cent. The answer to this question lies in the foreign exchange markets.
A lower short-term interest rate will certainly not, by itself, raise inflation through increased spending by businesses and households. The primary route from a lower ECB interest rate to higher inflation would be through the exchange rate of the euro. The strength of the euro over the past year has depressed import prices and forced eurozone companies to keep prices down to be competitive at home and abroad.
Eurozone interest rates are still higher than rates in the US, a situation that maintains upward pressure on the international value of the single currency. The US Federal Reserve has reduced the short-term federal funds rate to just 0.08 per cent, and has promised not to raise it while the unemployment rate remains above 6.5 per cent and there is inadequate evidence of strong labour market conditions. Participants in the financial market are now betting that a rate rise will not happen until late 2014 or 2015.