The G7 Will Get an Earful About the Euro

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However, in the current situation of fragile growth and increased uncertainty about the growth outlook, a rate hike is increasingly difficult to sell and could further weigh on business sentiment. So for now, some tightening of monetary conditions from the exchange rate movement may indeed be welcome to dampen medium-term inflation risks.

This may help to explain why ECB officials have so far remained calm regarding the euro's strength. And with the exception of French President Nicolas Sarkozy, most politicians have also remained optimistic. Politicians continue to say that they prefer a strong euro to a weak currency. Nevertheless, it is clear that concern is creeping in, and with the euro appreciating further vs. the dollar there may be more support for Sarkozy's calls on the ECB to react to the strength of the currency. What options does the central bank have to stem the euro's rise?

Sarkozy has suggested the ECB may follow the Fed and cut rates to prevent currency appreciation. However, while the ECB seems to have shelved the next rate hike for now, it continues to stress that there are upside risks to price stability. ECB policy maintains a tightening bias, and overall growth would have to deteriorate further before the ECB will consider a rate cut. In the central scenario of slowing but still relatively robust growth, a rate hike remains much more likely.

Divine Intervention

The only alternative is intervention in currency markets. Currency management in the euro zone is split between politicians, who can issue general guidelines or enter global currency agreements, and the ECB, which is in charge of day-to-day management and interventions. Former ECB President Wim Duisenberg famously called himself "Mr. Euro," and the bank's current chief, Jean-Claude Trichet, has also stressed that he has the last word on exchange rates. So Sarkozy has little influence on this, and the ECB is not considering such an option.

In any case, it is clear that unilateral intervention has little chance of success, and even coordinated intervention is problematic if exchange rate movements are indeed driven by fundamentals. The fact is that euro zone growth has outstripped annual growth in Japan over the past year. And the IMF now expects 2007 euro zone growth to be stronger than U.S. growth as well. It is not surprising then that an ECB official said this week that coordinated intervention may not work.

What remains is verbal intervention and exercises in damage limitation. Officials have started to repeat the familiar G7 line that "excess volatility" in exchange markets is undesirable, and that exchange rates should reflect fundamentals. Officials will want to prevent a rapid overshooting of the currency, which does not give exporters time to adjust to a stronger currency. The ECB has also indicated that it will discuss the currency at the G7 meeting next week.

What Trichet will likely want to see is a public message to markets that the U.S. is interested in a strong currency and will not passively encourage an ongoing rapid depreciation of the dollar. The ECB will also look for allies in its attempt to persuade Asian countries to take more of a share in the ongoing dollar depreciation that is mostly driven by the large U.S. current account deficits—largely with Asia—that still leaves the dollar a generally overvalued currency. However, China has continued to indicate resistance to more than a gradual pace of yuan appreciation.

All in all, we are likely to see a currency statement at next week's G7 meeting that will once again stress that "excess volatility" is undesirable, and that exchange rates should reflect fundamentals, while calling for increased flexibility for Asian foreign exchange markets. Any reference to the desire for a stronger U.S. dollar is unlikely, however, given the fundamental driver of the large U.S. current account deficit. And in the unlikely event that the ECB was seeking support for intervention to cool the euro's strength, it is unlikely that Japan or the U.S. would be interested in coordinated action at the moment.

Gewaltig is director of European economics for Action Economics .