Why is the rise of the euro a problem for the ECB?

Contrary to the consensus at the beginning of the year, the euro has risen sharply against the dollar. This rise limits imported inflation, but the high level of the currency is now worrying the ECB. While US tariffs are already expected to slow growth, the strength of the euro is likely to increase pressure on exports.

Two European Central Bank (ECB) officials last week expressed concern that the rise of the euro could further weaken the still-recovering eurozone economy, while US tariffs of 10% on European exports now seem inevitable.

Since the beginning of the year, the eurodollar has risen 14% and reached its highest level since September 2021.

Investors seem keen to reduce their exposure to the dollar in the face of Donald Trump's unpredictable economic policy. At the same time, Germany's fiscal stimulus and rising military budgets in Europe have boosted the euro's appeal.

"We can manage up to 1.20"

Nevertheless, the currency's rapid rise is beginning to make the ECB uncomfortable. While a strong euro is a sign of market confidence and reduces imported inflation, there is also a downside. A more expensive currency weighs on exports by making them less competitive.

The rise of the euro could therefore end up weighing on growth. This is particularly true given that the eurozone relies heavily on exports. "If you combine a 10% tax (customs duties) with a more than 10% appreciation of the exchange rate, that is enough to impact export momentum," warned Martins Kazaks, governor of the Latvian central bank, on the sidelines of the ECB's annual monetary policy forum in Sintra, Portugal.

European leaders are now preparing for a 10% tax on exports to the US to become a reality. Long opposed to any form of customs duties, Europe now seems ready to accept a compromise: a 10% tax, with certain exemptions for key sectors.

These risks to growth are therefore causing the ECB to worry about the rise of the euro. "We can manage a rise in the euro to $1.20. Beyond that, it will become much more complicated," ECB Vice President Luis de Guindos said last week on Bloomberg TV.

This appreciation of the euro could push the ECB to lower interest rates further. After eight consecutive cuts that brought the deposit rate to 2%, the neutral level, the ECB is expected to pause in July.

However, further adjustments are possible between now and the end of the year. With inflation back on target, the ECB could ease monetary policy slightly. Most strategists still anticipate one or two rate cuts in 2025.

The consensus is always wrong

This movement in the eurodollar certainly took investors by surprise. In the wake of Donald Trump's election last November, the rise of the dollar was fairly widely expected and many imagined a return of the eurodollar to parity. At the beginning of the year, the 1.02 level was reached, before the momentum reversed completely.

The rationale behind this reasoning is that tariffs are inflationary in nature. Higher inflation means higher interest rates and therefore a stronger dollar.

At the end of last year, the central scenario for tariffs was a universal rate of 10%, which was to be largely offset by currency adjustment (the rise of the dollar).

But today, Europe has to contend with a eurodollar that has gained 14% since the beginning of the year and, most likely, 10% tariffs. This is a much less favorable scenario for growth.