The European Central Bank (ECB) would likely welcome a weaker euro exchange rate, albeit quietly, while being much more cautious about any strengthening—especially at an inopportune moment.
Given the subdued growth prospects and significant trade risks facing the eurozone in the coming year, the euro’s current strength may still be a hindrance. Rather than limiting monetary easing, further depreciation of the euro could be encouraged and might even support arguments for a deeper half-percentage-point interest rate cut at upcoming meetings.
The ECB is set to convene next Thursday for its final meeting of 2024, with most economists predicting another 25-basis-point rate cut—the fourth such move this year.
Market sentiment and ECB commentary suggest that inflation is largely under control, paving the way for the central bank to aim for a neutral policy rate, estimated around 2% if inflation remains within target. This would allow the ECB to hold steady and hope for a cyclical economic recovery while staying vigilant against political and trade uncertainties in 2025.
ECB President Christine Lagarde outlined this cautious scenario earlier this week during a European Parliament hearing, even as debates persist among policymakers over whether larger and faster rate cuts are needed to counter the eurozone’s pervasive economic stagnation, particularly in Germany.
If the more gradual approach prevails, the ECB is likely to opt for 25-basis-point cuts at each meeting through mid-2025, gradually reducing the current 3.25% deposit rate to the estimated neutral level.
The ECB’s anticipated easing of at least 125 basis points sharply contrasts with market expectations of only half that amount from the U.S. Federal Reserve.
However, many analysts argue that this divergence between the two central banks is already priced into the euro/dollar exchange rate, which has declined by about 5% over the past two months. The euro’s muted reaction to recent political turmoil in Paris seems to support this view.
On Thursday, Morgan Stanley raised concerns about the potential unintended consequences of the ECB’s cautious approach ahead of next week’s expected rate cut, warning it could create “upside risks” for the euro. “Markets are already sufficiently bearish on the eurozone outlook and the currency, so any hint of unchanged messaging could be interpreted as a hawkish signal,” the bank noted.
Preventing a Euro Rebound
The ECB has strong incentives to prevent a euro rebound at this time, especially given the trade-weighted index for the currency is significantly higher than its recent decline against the dollar might indicate.
While the euro is currently just 5% away from parity with the dollar—a level last seen after Russia’s invasion of Ukraine in 2022—the ECB’s nominal euro exchange rate index against its key trading partners is only 1% below the record highs reached in September.
The inflation-adjusted real effective exchange rate index is somewhat lower, reflecting the eurozone’s prolonged flirtation with deflation after the 2008 global financial crisis and the 2010-2012 euro debt crisis. Yet, even after recent declines, the index remains near its levels from a decade ago, showing limited overall movement despite the series of economic shocks in recent years.
For a region potentially facing 10%-20% U.S. tariffs under President-elect Donald Trump’s administration, ongoing trade tensions with China, and a contraction in Germany—its most vulnerable, export-reliant economy—a weaker currency would be a significant advantage.
Even with robust wage growth still posing a challenge for the ECB, a depreciating euro would help restore competitiveness amid global trade conflicts.
With consumer price inflation hovering near the ECB’s target and producer prices deflating at over 3%, the central bank has ample room to implement substantial monetary easing. While trade tariffs could slightly distort price projections, ECB Chief Economist Philip Lane has emphasized that the economic damage from a trade war would far outweigh any short-term inflationary effects from tariff hikes.
The only lingering question is whether a sharp drop in the euro, falling below dollar parity, might unsettle regional confidence—particularly amid political tensions in Germany and France.
However, currency weakness is not the eurozone’s issue right now; if anything, it may be exactly what the economy needs.
