The euro has hit parity with the dollar, falling to its lowest level in 20 years and even skirting just below a one-to-one exchange rate with the U.S. currency at times this week.

It’s a psychological barrier in the markets. But psychology is important, and the euro’s slide underlines the foreboding in the 19 European countries using the currency as they struggle with an energy crisis caused by Russia’s war in Ukraine.

Here’s why the euro’s slide is happening and what impact it could have:

WHAT DOES EURO AND DOLLAR PARITY MEAN?

It means the European and American currencies are worth the same amount.

A currency’s exchange rate can be a verdict on economic prospects, and Europe’s have been fading. Expectations that the economy would see a rebound after turning the corner from the COVID-19 pandemic are being replaced by recession predictions.

More than anything, higher energy prices and record inflation are to blame. Europe is far more dependent on Russian oil and natural gas than the U.S. to keep industry humming and generate electricity. Fears that the war in Ukraine will lead to a loss of Russian oil on global markets have pushed oil prices higher. And Russia has been cutting back natural gas supplies to the European Union, which EU leaders described as retaliation for sanctions and weapons deliveries to Ukraine.

Energy prices have driven euro-area inflation to a record 8.6% in June, making everything from groceries to utility bills more expensive. They also have raised fears about governments rationing natural gas to industries like steel, glassmaking and agriculture if Russia further reduces or shuts off the gas taps completely.

The sense of doom increased when the major Nord Stream 1 pipeline from Russia to Germany closed Monday for scheduled maintenance, raising fears the Kremlin won’t restart deliveries this month.

“What’s the fall in the Euro saying? It’s becoming increasingly clear that the Euro zone is heading into recession,” Robin Brooks, chief economist at the Institute of International Finance banking trade group, tweeted Tuesday.

WHEN WAS THE LAST TIME THE EURO WAS EQUAL TO THE DOLLAR?

The euro hasn’t been valued below $1 since July 15, 2002. While constantly changing, it has dropped just under a $1 at times this week.

The European currency hit its all-time high of $1.18 shortly after its launch on Jan. 1, 1999, but then began a long slide, falling through the $1 mark in February 2000 and hitting a record low of 82.30 cents in October 2000. It rose above parity in 2002 as large trade deficits and accounting scandals on Wall Street weighed on the dollar.

Then as now, what appears to be a euro story is also in many ways a dollar story. That’s because the U.S. dollar is still the world’s dominant currency for trade and central bank reserves. And the dollar has been hitting 20-year highs against the currencies of its major trading partners, not just the euro.

The dollar is also benefiting from its status as a safe haven for investors in times of uncertainty.

WHY IS THE EURO FALLING?

Many analysts attribute the euro’s slide to expectations for rapid interest rate increases by the U.S. Federal Reserve to combat 40-year highs in inflation, which hit an annual 9.1% on Wednesday.

As the Fed raises interest rates, the rates on interest-bearing investments tend to rise as well. If the Fed raises rates more than the European Central Bank, higher interest returns will attract investor money from euros into dollar-denominated investments. Those investors will have to sell euros and buy dollars to buy those holdings. That drives the euro down and the dollar up.

The ECB has announced it will raise interest rates next week and add another increase in September. But if the economy sinks into recession, that could halt the ECB’s series of rate increases. Meanwhile, the U.S. economy looks more robust, meaning the Fed could go on tightening — and widen the rate gap.

WHO WINS?

American tourists in Europe will find cheaper hotel and restaurant bills and admission tickets. The weaker euro could make European export goods more competitive on price in the United States. The U.S. and the EU are major trade partners, so the exchange rate shift will get noticed.

In the U.S., a stronger dollar means lower prices on imported goods — from cars and computers to toys and medical equipment — which could help moderate inflation.

“The parity makes it easy for us, and a lot more money goes a lot further now, so we can do a lot more on our trip,” said John Muldoon, who was visiting Rome this week from Delaware.

Olivia Navarret, another Rome tourist from Pennsylvania, said the exchange rate meant a shirt she bought was less expensive.

“It’s cheaper to come here and buy stuff,” she said. “So it’s better to come here, I guess, and spend money here than spend money in the U.S.”

WHO LOSES?

American companies that do a lot of business in Europe will see the revenue from those businesses shrink when and if they bring those earnings back to the U.S. If euro earnings remain in Europe to cover costs there, the exchange rate becomes less of an issue.

A key worry for the U.S. is that a stronger dollar makes U.S.-made products more expensive in overseas markets, widening the trade deficit and reducing economic output, while giving foreign products a price edge in the United States.

A weaker euro can be a headache for the European Central Bank because it can mean higher prices for imported goods, particularly oil, which is priced in dollars. The ECB is already being pulled in different directions: It is set to raise interest rates, the typical medicine for inflation, but higher rates also can slow economic growth.

Find your latest news here at the Hemet & San Jacinto Chronicle

The post EXPLAINER: What’s the impact of euro parity with the dollar? appeared first on The Hemet & San Jacinto Chronicle.

Policy & regulation

There’s a widespread belief that the exorbitant quantity of money the Federal Reserve is pouring into the U.S. economy must eventually mean the return of high inflation. After all, if there’s lots more money but no more stuff to buy, prices must rise, mustn’t they? So the prospect of Judy Shelton – known for her support of the gold standard – joining the Fed’s Board of Governors is raising the hopes of those who want the Fed to be stripped of its money creation powers.

But the Fed’s mandate is price stability. And, as I shall explain, if the Fed can’t vary the quantity of money in circulation in response to economic circumstances, it can’t stabilize the price of a dollar.

What is the “price” of a dollar? Some people like to express the dollar’s price in terms of gold – though as the dollar hasn’t been backed by gold since 1971, this is perhaps a bad attack of nostalgia. For them, the dollar’s price is anything but stable and the Fed is fatally undermining it.

Goldbugs think the rise in the dollar price of gold over the last century means the dollar is worthless (despite me arguing about it with them for hours). I have had similar arguments with people who think that massive rises in the stock market/bond market/real estate/bitcoin mean the dollar is hyperinflating. But as the dollar is not backed by assets, the rising price of assets tells us absolutely nothing about the price of a dollar.

For ordinary U.S. people and businesses, the price of a dollar is its purchasing power. The dollar’s domestic purchasing power is the quantity of U.S. goods and services U.S. residents can purchase with their own currency. The rate at which the dollar’s purchasing power changes is known as the “inflation rate.”

If people reject a currency in favor of gold or another currency, its purchasing power falls to zero. This is known as “hyperinflation.” It has never happened to the U.S. dollar.

For foreigners, the price of a dollar is its exchange rate versus their own currency. The exchange rate is the quantity of another currency that one dollar can purchase. This in turn determines not only the quantity of externally produced goods and services that U.S. residents can purchase with dollars, but also the quantity of U.S.-produced goods and services that foreigners can purchase with their own currencies. We can therefore regard the exchange rate as measuring the dollar’s purchasing power outside the U.S.

A fall in the exchange rate means one dollar purchases fewer foreign-made goods and services. The rate at which the exchange rate falls is thus the external equivalent of the domestic inflation rate.

Exchange rate collapse destroys the external purchasing power of the currency, just as hyperinflation destroys its domestic purchasing power. Indeed, the two are often seen together. If the country has large amounts of debt denominated in foreign currencies, exchange rate collapse can mean it becomes unable to service these debts.

Furthermore, if the country is dependent on imports, a sudden exchange rate fall can mean it can’t pay for imports. All too often, the government’s response to these disasters is to print enormous amounts of its own currency in the hope of exchanging it for the foreign currency it needs. This fuels the exchange rate collapse and triggers domestic hyperinflation.

In the past, central banks and governments regarded the exchange rate as the most important price. They thought countries must “earn their way” in the world by exporting goods and services to other countries, and they knew controlling the exchange rate would help them to export. They also feared that if a country allowed its exchange rate to float against other currencies it would collapse, resulting in hyperinflation. So they pegged their currencies to gold or other assets, or even to each other.

“Fear of floating” determined monetary policy long after the end of the gold standard. Indeed, for many developing countries it still does. As recently as the 1980s, the Fed was actively managing the dollar’s exchange rate, aided by other central banks.

But after the failure of the Louvre Accord in 1989, the Fed switched to managing the dollar’s domestic purchasing power instead of the exchange rate. Along with most major central banks, it set a target of 2% per annum consumer price inflation and allowed the exchange rate to float.

Since then, the Fed has managed inflation by adjusting the interest rate it charges banks to borrow dollars. Bank lending creates purchasing power. Increasing banks’ borrowing costs encourages them to charge more for loans to individuals and businesses, which damps demand for loans and thus reduces bank lending. When bank lending falls, the rate at which purchasing power increases also falls. In other words, less bank lending means lower consumer price inflation.

Of course, U.S. banks create dollars when they lend. But the Fed doesn’t directly control the quantity of dollars they create. And it doesn’t restrict its own money creation either. It creates reserves in response to demand from banks, and provides liquidity to financial markets in response to signals from market participants. Contrary to popular opinion, this is intended not to allow inflation to run out of control but to maintain it at around the Fed’s 2% inflation target.

To understand why the Fed can’t meet its price stability mandate by directly controlling the quantity of dollars in circulation, it’s helpful to look at bitcoin’s behavior. Bitcoin’s algorithms control its quantity, not its price. The quantity of bitcoin in circulation increases at a constant rate and is ultimately limited to 21 million (even though this won’t be reached in the lifetime of anyone alive today).

The result of controlling the quantity of bitcoin rather than its price is price instability. Bitcoin’s price is subject to wild swings as demand for it fluctuates, while its quantity does not. This roller-coaster ride doesn’t really matter for bitcoin, because almost no one is buying their weekly shopping with it or hodling their life savings in it. But for the millions of people whose livelihoods depend on the dollar, price swings of the kind all too often seen on the bitcoin charts would be disastrous.

As we saw in September last year and March this year, international demand for dollars heads for the moon at times of crisis. So if the Fed wants the price of dollars to remain stable, it has no choice but to accommodate that demand by creating lots more dollars. This would still be true if it were targeting the exchange rate, by the way. International dollar shortages cause the dollar’s exchange rate to rise.

If the Fed adopted some kind of algorithm that kept the rate of money creation constant, or linked the dollar to gold or some other asset, the result would be renewed instability both in the dollar’s external value and its domestic purchasing power, not on the upside (exchange rate collapse and hyperinflation really are not a serious risk) but on the downside. We know from the 1930s that when the Fed is prevented by a rule or a gold standard from creating enough money to ease a crisis, the result is debt deflation and severe economic depression.

Let’s not go there again.

-Frances Coppola

Find your latest news here at the Hemet & San Jacinto Chronicle

Search: Bitcoin-Like Scarcity

The post Why Bitcoin-Like Scarcity Would Be a Disaster for the Dollar appeared first on The Hemet & San Jacinto Chronicle.