Euro powers ahead after ECB shrugs off exchange rate worries

Mario Draghi insists ‘world is more resilient’ as currency nears nine-year high against sterling

THE euro has jumped to a two-year high against a basket of currencies and hit a post-crisis extreme against sterling after the European Central Bank shrugged off concerns about the strong exchange rate.

Mario Draghi, the ECB’S president, said the eurozone economy is firing on all cylinders as super-easy monetary policy continues to flush the system with liquidity. “It is before our eyes,” he said. Speaking at a forum of Nobel Prize economists at Lake Constance, Mr Draghi gave a clear signal that the ECB remains determined to wind down its €2.3trillion programme of bond purchases at the start of next year despite mounting jitters in financial markets.

The hawkish tilt came as IHS Markit’s gauge of eurozone manufacturing powered ahead in August, with export orders rising at the fastest pace in six-and-a-half years. “The strong industrial sector cycle continues, surprisingly unscathed by the strengthening of the euro,” said Citigroup.

The closely watched euro index jumped to 94.20 and has now risen 10pc since February, amounting to a sharp monetary tightening for the eurozone. The single currency is close to a nine-year high against sterling, touching 0.9211 this week as Brexitlinked worries fuel incipient capital flight from the UK.

Mr Draghi is unlikely to alter the message at the US Federal Reserve’s annual conclave later this week at Jackson Hole, where central bankers aim to coordinate their message closely as the Fed, the ECB, the Bank of England, and the Bank of Japan all prepare for the end of emergency policies. The ECB’S retreat from quantitative easing is likely to be slow – though not as glacial as markets would like – since core inflation is still pinned to the floor at 1.3pc.

Mr Draghi warned that central bankers still do not fully understand how the financial system functions and are likely to be caught out by new crises as markets run ahead of them. “Our mainstream macroeconomic models still have little to say about the non-linear propagation of shocks. Policy actions undertaken in the last 10 years in monetary policy and in regulation have made the world more resilient. But we should continue preparing for new challenges,” he said.

Mr Draghi gave a brutally honest account of central bank failings before the Lehman crisis, admitting that the orthodoxies of the day bore little relation to reality. There was too much trust in the dogma of “rational expectations” and a chronic neglect of how capital markets really work. Financial “friction” was largely ignored.

“There was a notable absence of a role for banking and finance in these models. The pre-crisis paradigm in macroeconomics predicted neither the onset nor the severity of the crisis in any meaningful fashion. Unconditional trust in the self-repairing capacities of financial markets, or simple neglect, had led to lax supervision in the years preceding the crisis,” he said.

Banks are now much safer with higher capital buffers. The average Tier 1 equity ratio has risen to 13.5pc from 7pc in 2008. The authorities are using a range of new tools to contain bubbles, chiefly through loan-to-value caps in the housing markets.

Critics retort that QE itself has created massive distortions. Some 40pc of all eurozone government bonds still have a negative yield. Extraction will be painful. The ECB has little margin for manoeuvre. It is running out of bonds to buy given a 33pc cap on the share of sovereign debt issues bought from each country. There will be a shortage of German, Portuguese, Dutch and Spanish bonds by early next year. If the ECB kept purchasing Italian bonds in large volumes beyond that point, it would be accused of relying on QE to shore up semi-solvent states.

The imperative for Mr Draghi is to keep the programme alive through the Italian elections next year, hoping that the global economic expansion lasts long enough to put the problem to bed. Once QE tapers away, the Italian government will be on its own. That will be the next test of the euro experiment.