Euro-Dollar Parity: Causes, Risks, and Monetary Policy Challenges

In the conditions of global disparities, military actions in Ukraine and high risks in the energy market, significant changes are also taking place in the financial markets due to the high volatility of currencies. This week, for the first time in 20 years, the Euro exchange rate reached parity with the US dollar, which proves the same market value of the world’s leading currencies.

The euro fell to USD 0.9998 per dollar, its lowest since December 2002, amid Russia’s invasion of Ukraine, a looming energy crisis in European countries due to sanctions against Russia, widening economic disparities and new challenges for business. These trends signal that the European economy is headed for a deep recession and create new challenges for regulators and businesses.

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Key factors of the price parity of the euro and the dollar in the modern world

The current situation regarding exchange rates is caused by the simultaneous action of a number of macroeconomic, regulatory, political and social factors in the geopolitical space, the consequences of which can be quite large-scale not only for Europe, but also for the world economy in general.

Russia’s escalation towards Ukraine became a powerful impulse that launched a whirlwind of large-scale destruction and disrupted the global logistics of supplies of fuel, raw materials, fertilizers, goods and services. After Russia’s invasion in February, prices of major commodities including oil, natural gas, wheat and fertilizer have soared, pushing up food and energy prices around the world. This led to the highest rates of inflation in decades. As a result of high inflation and the allocation of funds to the needs of the military-industrial complex and the supply of weapons to Ukraine, the monetary policy of the United States has changed. 

With inflation in the United States at its highest level in four decades, the Federal Reserve tightened its monetary policy by raising interest rates significantly. Jerome H. Powell, chairman of the Fed, said at a conference in late June that he expects the key rate to reach 3.5 percent this year. He added that there is a risk that the central bank will go too far in raising rates to cool the US economy, but the bigger risk is that inflation will remain high [2]. Thus, the factors of Russia’s aggression against Ukraine, macroeconomic risks and the corresponding US monetary policy contributed to the strengthening of the value of the dollar as a base currency for the refuge of investors during economic upheavals.

This became the driving force behind the pressure on the euro, which was significantly increased by the need to give up energy resources from Russia. Social, psychological and cultural factors of Europe’s energy dependence on the aggressor country on the eve of election capmania increase the growing risk of recession. In addition, the risk of escalation by Russia of certain EU countries also remains high until the war in Ukraine is stopped.

Recession fears have risen in recent weeks amid growing uncertainty over the bloc’s energy supplies, with Russia threatening to further cut gas flows to Germany and other European countries. 

This week, Russia temporarily suspended the supply of gas through the Nord Stream 1 gas pipeline, which is Europe’s largest piece of gas import infrastructure, transporting about 55 billion cubic meters of gas per year from Russia to Germany via the Baltic Sea.

 This raised fears about the eventual cessation of supplies, the difficulty of preparing for the winter supply of the region and the strengthening of the gas crisis. According to Jeremy Stretch, head of G-10 currency strategy at CIBC Capital Market, “This is a key and obvious psychological level that is very much at stake here.” The analyst added that the prospect of the euro falling below this level is a reflection of growing fears of a recession in the eurozone, which creates new challenges for the European Central Bank as a regulator of the EU financial market.

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Top risks and consequences for the international capital market and financial companies

According to the analysts of the Dutch bank ING, the indicator on the currency markets marked “1.00 is probably the highest psychological level” of pressure on clients of financial companies. The euro’s sharp decline came as the dollar, which for generations had been one of the safest places to store money, strengthened against nearly all the world’s major currencies. This shift means that European companies and consumers will pay more for the goods and services they import, while European exports will immediately become cheaper on international markets.

This will have a significant impact on the carrying business of payment institutions and banks that serve international capital flows. Their balance sheets will take on higher currency risks and financial transactions will become more expensive. This, in turn, will affect the business activity of corporate and individual clients of financial institutions.

Consequently, the sudden shock triggered record inflation in the Eurozone, which reached 8.6% in June, along with a gradual slowdown in economic activity. The combination of both risks has brought back the specter of stagflation, a dangerous mix that stifles growth and keeps goods prohibitively expensive for consumers and businesses.

Note that financial markets and exchange rates are very clear indicators of the economic cycle and the main trends in the development of the world economy. Currencies move like stocks, bonds, crypto currencies or any other asset—investors can buy them directly when they think their value will rise and sell them when they think they will fall. They also reflect global demand for a country’s assets in general, since buying U.S. government bonds or Apple stock requires dollars first, and most global trade is done in dollars.

So, as often happens during an economic crisis, people looking for a safe place to keep their money bought more dollars against other currencies like the euro. However, in recent months, as the war has challenged Europe’s political and financial stability, a host of factors have weighed against the euro and created new challenges for the European Bank to regulate financial risks.

Directions of the monetary policy of the European Central Bank to adjust financial risks

The analysis shows that European policymakers are not taking rapid steps to cool down the economy and introduce “expensive money” monetary policy to combat high inflation, unlike the Federal Reserve System. The risks of a sharp recession also cast doubt on whether the European Central Bank can tighten monetary policy aggressively enough to tame record high inflation without deepening economic pain. That is, the situation with the current exchange rate of the euro will largely depend on the decisions of the European Central Bank. However, it is currently unknown how much interest rates can rise in the Eurozone and how this will affect the behavior of investors in the future. 

Investors can only guess what might happen before the end of the year. But even before the first rate hike, which is expected on July 21, the growing risk of a recession in the eurozone has investors questioning how high the bank can raise rates before it has to pause again. 

The next lever that the European Central Bank should pay attention to is the sovereign bond market. Concerns have been raised about the impact of interest rate hikes and the end of the central bank’s bond-buying programs on the bloc’s most indebted members, which could cause additional financial risks for member countries.

As we can see, this will be another testing time for the Eurozone and its central bank over the next year. At the moment, Brussels is carefully avoiding any clear predictions about an imminent recession and still hopes that the eurozone can be resilient enough to survive the fallout from the war in Ukraine and the energy crisis. However, these trends signal changes in the European economy and create new challenges for regulators, businesses, financial institutions, and citizens.

References

1. Euro reaches parity against the dollar, hits its lowest level against U.S. currency since December 2002. URL: https://www.cnbc.com/2022/07/12/euro-teeters-on-the-brink-of-parity-with-the-us-dollar-on-recession-fears.html
2. Euro Falls to Equal the U.S. Dollar for the First Time in 20 Years. URL: https://www.nytimes.com/2022/07/13/business/euro-dollar-parity.html
3. Euro reaches parity with dollar for the first time in 20 years By Jorge Liboreiro Updated: 12/07/2022. URL: https://www.euronews.com/my-europe/2022/07/12/euro-reaches-parity-with-dollar-for-the-first-time-in-20-years

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