Russia- Ukraine conflict has proven a massive inflationary shock for Europe, in particular, given hefty dependence on imports of Russian energy.

Currencies tend to move significantly when unanticipated shocks occur– like Russia’s invasion of Ukraine. This has proven a massive inflationary shock for Europe, in particular, given hefty dependence on imports of Russian energy. In fact, it is probably the biggest inflationary shock that’s been faced since EMU came into being back in 1999. There were big inflationary shocks before EMU started; the most notable being German reunification in 1990. But the policy response today could not be any different from then and that probably explains why the euro is so weak now.

The German reunification shock to inflation saw the German deutschemark rise substantially in the early 1990s. But the shock to inflation caused by Russia’s incursion into Ukraine this year has seen the deutschemark’s replacement – the euro – fall sharply. The difference comes down to the policy response. Back in 1990, when the West German government decided to offer East Germans the very generous – and very inflationary – conversion of East German Ostmarks at a one-to-one rate for deutschemarks on their wages and savings, the Bundesbank was in charge of monetary policy.

It saw the inflationary consequences of this action and lifted the discount rate from a base of 2.5% in mid-1988 to 8.75% by the middle of 1992. This helped to cap inflation at around 6% and reduce it to 2% by early 1995 but the aggressive monetary action had significant external consequences, not least forcing huge tensions in the Exchange Rate Mechanism (ERM) with the initial expulsion of the UK and Italy in September 1992 followed by the virtual breakup of the whole ERM just under a year later. In short, the Bundesbank showed it meant business in eliminating inflation and the deutschemark responded to this by appreciating significantly.

Fast-forward to today and things seem very different. The strong Bundesbank has been replaced by the tepid ECB and now the euro is paying the price. For while the Bundesbank could hike rates aggressively in response to reunification, and not worry too much about the fallout for other ERM countries, the situation seems very different today. For the ECB has to be much more mindful that aggressive monetary action threatens stability in euro zone countries, particularly those that will see their debt financing costs soar if rates rise sharply.

In short, the hawkish Bundesbank has been diluted and this is probably the first time that this has really come to light since the euro was created. If this is not bad enough for the euro, there’s another factor to consider as well, which is Germany’s economic place within EMU. Back in the 1980s and 90s, Germany was the growth engine of Europe while the Bundesbank’s hawkishness ensured that robust growth did not lead to significant inflation. But today, the German engine has spluttered, if not stopped altogether. Disruptions to global supply chains arising from Covid and now the surge in energy prices have hit industry hard. This can best be seen through the eyes of the trade surplus.

Before Covid struck the monthly trade surplus averaged around EUR20bn per month. Now it is practically zero and at its lowest level in 20 years. In addition to this, Germany is no longer the beacon of low inflation that it was in the pre-EMU days. Inflation in May was 8.7% in harmonised terms which was the fourth highest of the eleven original EMU members. All this means that Germany can hardly be considered the strong man of Europe as it has been labelled before, and it could get far worse if Russia turns off gas supplies.

“The euro zone has essentially lost its low-inflation anchor and this is leaving the euro to drift. So far, that drift has taken it down to near parity against the dollar and there’s little sign that this drift is about to stop even as the ECB lines up a token 25-bps rate hike this month”, said Mr. Steve Barrow, Head of Standard Bank G10 Strategy.