Partly it’s because the inflationary impact of rising energy prices has been much higher in Europe than here, largely because of the Continent’s dependence on Russian natural gas. Partly that’s because in Europe they still have powerful unions, which can demand higher wages to offset the rising cost of living. Maybe that’s because Europe, more than America, appears vulnerable to a wage-price spiral, in which rising prices lead to rising wages, which lead to even more price increases, and so on. has been slow to move, investors appear to believe that it will eventually have to tighten a lot. On both sides of the Atlantic, rates have gone up by about 1.5 percentage points. But, in this case, the weak euro probably does reflect real economic weaknesses - especially the bad bet that Europe, and Germany in particular, made in relying on the reasonableness of autocrats. It’s a common observation that a weak currency need not be a symptom of a weak economy. There is, I’d argue, a deeper story behind the euro’s slide. Although European inflation is comparable to inflation here, many economists argue that it’s less fundamental, driven by temporary shocks rather than an overheated economy, so there’s less need for tight money.īut the more I’ve looked at it, the more I’ve become convinced this isn’t mainly a story about interest rates. And there are reasons for this policy divergence.
has indicated that it plans a modest hike next week). The Fed has increased its policy rate - the short-term interest rate it controls - repeatedly this year, while the E.C.B. The dollar-to-euro exchange rate therefore rises only to the level at which expected capital losses just offset the difference in yields between dollar and euro bonds.Īt first sight this looks like a good story about recent events. However, investors will normally expect an eventual reversion of the dollar to its long-run value, so that higher yields on dollar assets will be offset by expected capital losses from future dollar declines - and these losses will be bigger, the higher the dollar goes.
The higher yields on dollar assets will attract investment to the United States, pushing the value of the dollar up. Suppose the Federal Reserve raises interest rates while its counterpart, the European Central Bank, does not. Per Dornbusch, exchange rates are determined in the long run by fundamentals - roughly speaking, a country’s currency tends to settle at the level at which its industry is competitive on world markets.īut monetary policy can move a currency temporarily away from that long-run value. Most modern analysis of exchange rates builds on a classic paper, “ Expectations and Exchange Rate Dynamics,” by the late Massachusetts Institute of Technology economist Rudiger Dornbusch, which had an enormous and salutary influence on the field - I’ve argued it saved international macroeconomics.
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