Currency traders may have to decide on Thursday whether to believe European Central Bank President Mario Draghi or their own convictions.
The euro has soared 18 percent against the dollar in the last eleven months, 7 percent in the last two, as markets have bet that the ECB is on the road to ending its bond purchase program, effectively following the Federal Reserve into tighter interest rates.
With the European economies finally performing better than they have for almost a decade, and inflation quiescent, the question facing the ECB is straightforward. Will an official acknowledgement of the end of the deflation threat and the extraordinary liquidity provisions of the asset program fuel a run higher in the euro?
Despite its ascent over the last year and an almost 20 percent move in the terms of trade for the Eurozone, the united currency is still far from its May 2014 high versus the dollar of 1.3992 let alone its pre-crash peak of 1.6038 in July 2008.
After the December 14th ECB meeting Mr. Draghi denied that the bank was considering breaking the link between the purchase program and inflation, "...we didn't discuss cutting the link. That was not discussed."
If the link is dissolved the asset purchases will not depend on the inflation outlook, presumably freeing the bank governors to end the program even if inflation does not accelerate toward the bank's ostensible 2 percent target.
Complicating the situation is the ECB's own minutes of that December meeting released on January 11th which clearly imply a discussion: "...how to transition gradually from the present conditionality focused on APP to a broader concept of forward guidance comprising various dimensions of the monetary policy stance." The "present conditionality" is the lack of inflation.
Traders may be forgiven for taking the bank's action in reducing its monthly bond purchase amount from 60 billion euros to 30 billion euros at the December meeting as a firmer indication of future policy than Mr Draghi's denial.
With the strengthening euro set to inflict more dis-inflationary pressure on the EMU economy, the ECB's decision has become whether to continue an anti-deflationary asset purchase program which, while no longer needed, has become a background monetary condition that the central bank fears to remove lest it stirs up the very deflationary forces it was designed to prevent.
Chief Market Strategist
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