The euro has weakened against the US dollar since the start of 2021, going from around US $ 1.23 to its current exchange rate of US $ 1.13. That’s a drop of around 9%, which is significant, especially since they are the two major currencies in the world. The decline also intensified in November, falling 3% since the start of the month, which saw violence in European capitals over Covid restrictions, migrant issues on the Belarus-Poland border and Russian troops. gathering at the border of Ukraine.

The decline must, however, be seen in a broader context. The euro is even stronger than a few years ago when it was around US $ 1.10. It also experienced high weekly volatility from February to April 2020 at the start of the Covid pandemic, rebounding between around US $ 1.07 and US $ 1.13 at a time when many investors fled to the US dollar for safety. and there was a lot of uncertainty about what the lockdowns would mean.

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Euro vs US Dollar Chart

Euro vs dollar chart
Trading view

Explaining currency movements on a weekly or even monthly basis is well known to be extremely difficult, especially when it comes to large economies like the United States and Eurozone countries. But we certainly have to look at what is happening in the two regions and not just in one or the other. Using this simple idea, there are several explanations for the recent depreciation of the euro.

Inflation differences

The first explanation concerns the Federal Reserve and the European Central Bank (ECB) stimulating their economies by using quantitative easing (QE), which essentially creates money to buy financial assets such as government bonds from governments. banks and other large investors. Both central banks have been doing this extensively since the start of the pandemic.

However, with annual inflation in the United States now reaching a serious level of 6.2%, compared to 4.1% less troublesome in the eurozone, the feeling is that the Fed will end its asset purchases sooner. This is because increasing the money supply has the potential to fuel inflation. Indeed, the Fed has already recently started to “shrink” or slow down the QE rate with a view to stopping it in the second half of 2022. On the other hand, the ECB has discussed a replacement of its 2.2 trillion. (£ 1.7 trillion) QE program ends in March 2022.

Added to this is a growing expectation that the United States may also have to embark on a series of interest rate hikes from mid-2022 to curb inflation, while ECB President Christine Lagarde, has just made it clear that the ECB is unlikely to start raising rates. until at least 2023. These emerging differences in the monetary policy positions of the United States and the euro zone have clearly favored a strengthening of the dollar (since QE and lower interest rates tend to depreciate a currency).

Covid and politics

A second crucial factor has been the recent relative strength of the US economy in its recovery from the pandemic compared to the euro area. In 2021, the International Monetary Fund forecasts a growth of the United States of 6% against 5% in the euro area, while in 2022, they are expected to grow by 5.2% and 4.3% respectively. Again, this indicates the strength of the dollar.

More Covid lockdowns in the United States seem unlikely (even if cases are on the rise again), but not in the euro area, where the rate of infections has risen sharply in recent weeks in countries like Germany, the United States. France, the Netherlands, Austria and Belgium. Austria is now stranded again and other eurozone countries may follow suit.

A final driver of recent dollar strength is greater political stability. The Biden administration has three more years in power and recently managed to push its $ 1.7 trillion Build Back Better stimulus package.

In contrast, euro area countries are facing a period of greater political instability. Germany sees the end of 16 years of relative stability for Angela Merkel. The question of whether Emmanuel Macron will succeed in the French elections in April 2022 against Marine Le Pen is also weighing on the minds of investors, as are the lingering trade friction between the EU and the UK over Brexit.

This comes at a time when the build-up of Russian forces near Ukraine raises the prospect of a military conflict on the borders of Europe – not to mention that Russia has already limited gas supplies to the region and that one of its main gas pipelines crosses Ukraine. . In addition, there have been major anti-vaccine protests in France, the Netherlands, Germany and Italy, and European governments are now under intense pressure to contain their spending.

So while short-term currency movements are very difficult to predict, there are many reasons to believe that the recent period of euro weakness will continue. This makes imports to the eurozone more expensive – especially energy – and while this has some advantages for a large exporter like Germany, it also undermines the credibility of the eurozone as a global economic force.

It could be a game-changer if the ECB recognizes that there is an inflation problem that needs to be addressed, ending its experience with QE and starting the process of raising interest rates. This, however, doesn’t seem likely any time soon.The conversation

Keith pilbeam, Professor of Economics, City, University of London

This article is republished from The Conversation under a Creative Commons license. Read the original article.