Last week we saw the EUR/USD stumble following the ECB interest rate decision, statement, and press conference with ECB President Trichet in which he disappointed market expectations and was less hawkish than anticipated.
For the most part, the statement saw inflation risks balanced, but that the ECB would be watching for any second-round effects and would act if necessary. These comments were echoed yesterday by ECB governing council member (and the President of Luxembourg's Central Bank) Yves Mersch though the headline that stuck out was his call for hiking rates to control second-round effects.
From Bloomberg: ECB Will Act on Second-Round Effects, Mersch Says
At the beginning of March you'll have our first forecast in 2011 and if it's true that what we see at the moment is only a temporary increase with a retreat at the end of the year below 2 percent, there's no danger, Mersch said in Luxembourg late yesterday. However, there would have to be a rigorous intervention by the monetary authorities if across the second- round effects there's the risk that this increase transforms into a plateau.
ECB President Jean-Claude Trichet last week signaled no immediate plans to raise interest rates even though the bank expects inflation to stay above its 2 percent limit for longer than it predicted just three weeks earlier. Annual price gains in the euro area have accelerated to 2.4 percent, the fastest in more than two years and the central bank will publish new economic and inflation forecasts at its next policy setting meeting next month.
While raising rates in it of itself will not stem the major cause of recent inflation which is mainly being driven by external factors like oil and other commodity prices, it would show that the ECB is committed to price stability and could reduce the demands for higher wages by workers.
Some other interesting bits from Mersch's comments was that he says the ECB should raise rates even before exiting other measures undertaken by the ECB like unlimited lending to banks and buying of periphery sovereign debt.
Can Mersch's comments re-ignite the EUR/USD buying we had seen prior to the ECB decision or did it just help the pair correct its earlier 4 session slide?
I don't believe this changes the underlying dynamics too much and the forecast for a rate hike by the ECB is still for the autumn of 2011. That is still closer than when the Fed is likely to move and so the expectations around interest rate differentials continues to benefit the EUR in the medium term.
With not too much on the fundamental docket - except for the rate hike by China overnight - the EUR was higher on stronger equities in the previous US session that carried over to Asia. European stocks were flat for the most part and we started to see a move towards USD yet again at the start of today's NY session. If we have a shift towards risk aversion due to the China news, then the EUR/USD has the chance to retest its lows just above 1.35 in the short term.