THIS summer, the euro should have less sand kicked in its face. At the end of March, Europe's single currency, once dubbed the “euro-rouble”, was still an 87-cent weakling against the American dollar. As the dollar has atrophied, however, the euro has looked relatively less skinny. On June 26th, with the dollar knocked by the news of accounting shenanigans at WorldCom, the euro jumped to within one cent of parity (see chart), a level it last reached in February 2000.
In trade-weighted terms, the euro's rise has been rather less impressive: about 6% since the end of March, compared with 13.5% against the dollar. It is still a shadow of its worth when it was launched, at $1.17, in January 1999; and it is also worth much less than were its constituent currencies earlier in the 1990s. Still, the euro's latest climb will surely cheer Wim Duisenberg, president of the European Central Bank (ECB), who has often argued that the euro is undervalued. After the ECB's monthly rate-setting meeting on June 6th, Mr Duisenberg said that the currency's appreciation (at that time, to 94.5 cents) was “very welcome”, because it would hold down inflationary pressures and expectations.
Despite the euro's rise, Mr Duisenberg was still worried about inflationary trouble ahead. In May, euro-area inflation was 2%, which is exactly the central bank's ceiling for its goal for price stability. However, he also said that core inflation, which excludes relatively volatile prices of energy and unprocessed food, was “stubbornly high”. Figures published last week put it at 2.6%, the highest in more than six years. Some wage increases were “a cause for concern”.
Several economists took Mr Duisenberg's remarks to be a signal that interest rates, 3.25% since last November, might soon be increased, perhaps at the next meeting on July 4th. This now looks highly unlikely, if only because a rising euro should do much of the work of higher rates. It reduces inflation directly, by making imports cheaper, and it reduces demand for euro-area tradable goods, by increasing their prices relative to those of goods from elsewhere. Michael Dicks, an economist at Lehman Brothers, suggests as a rough guide that a 10% jump in the currency is equivalent to a one-percentage-point increase in interest rates. If that is right, the euro zone has already undergone a significant monetary tightening.
The question is, can it take it? The dollar's fall and the euro's rise represents above all a loss of confidence in America—in effect, investors have become less willing to finance its huge current-account deficit—rather than any bullishness about Europe. If anything, portfolio investment is still leaking out of Europe, not flowing in. Investors have as little faith in euro-area shares as in American ones. In Germany, which, along with a sluggish economy, has had its own stories of accounting jiggery-pokery, the blue-chip Dax 30 stockmarket index dipped below 4,000 on June 26th, for the first time since September.
The euro-area economy as a whole grew by only 1.5% in 2001, quicker even than the American economy. It managed growth of a mere 0.1% in the first quarter of this year (when America rebounded). This was entirely the product of rising net exports: exports fell, but by less than imports. Domestic demand was a big drag on growth.
An appreciating currency is little help to an economy whose recovery is still nascent, especially when it is so dependent on external demand. Lehman's Mr Dicks points out that exports may be less sensitive to price than economists once thought: look how well Britain has coped with the pound's strength since 1996. Nonetheless, he concedes, the euro's rise is still likely to be a burden to exporters.
Besides the effect on trade, the euro area's ability to cope with the dollar's fall depends to a large extent on three things. The first is how far a stronger euro will help domestic demand, by cheapening imports and thus increasing consumers' and firms' purchasing power, offsetting the drag on exports. The second is how much more robust the euro area's economy has become in the second quarter, now drawing to a close. It is thought to have picked up fairly well, although it is hard to be sure. Industrial production has probably grown at a decent rate. Inventories are being restocked after being run down during a poor winter.
On the other hand, retail sales in Germany, the biggest economy in the single-currency zone, have been poor, weighed down by the weak economy and by consumers' well-founded belief that some shopkeepers and restaurateurs have used the introduction of euro notes and coins at the start of the year as an excuse to jack up prices. Germany's retail federation said this week that it expected its members' turnover to fall by 2.75% in 2002 and barely to rise in 2003. In the zone's second-biggest economy, France, consumer spending retreated in May after a healthy April.
One problem in forming a judgment, say some economists, is that euro-area data tend to come out more slowly than in America or Britain, and sometimes different figures point in different directions. “It's like flying a plane with a sextant,” grumbles Thomas Mayer of Goldman Sachs in Frankfurt. In the absence of timely hard data, says Mr Mayer, a lot of recent optimism about the euro area has been based on such indicators as surveys of business confidence. These feed into economists' forecasts, which in turn feed back into surveys. As a result, he thinks, optimism has run ahead of reality, which is less rosy. Maybe reality is catching up: Germany's Ifo index of business sentiment fell, surprisingly if marginally, in June. Indices for Dutch consumer and business confidence, published the same day, were also weaker than expected.
The third factor is harder still to estimate: how far the dollar has yet to fall. Most commentators expect a further slide, which would be worrying enough for the euro area. Some fear a wholesale rout. Mr Duisenberg, who is due to retire from the central bank next July, has spent most of his time in office bemoaning the euro's weakness. The president may yet spend his final year ruing its strength.
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