After losing virtually all influence over the euro-dollar exchange rate since the beginning of last year, interest rate differences seem to be making a comeback, in the wake of rising oil prices. If renewed sensitivity continues, it could have a profound impact on exchange rates. If the euro-dollar exchange rate pair normalized with respect to its long-term reaction function, the economic conditions currently prevailing in the United States and Europe would imply a euro below parity with the dollar.
Until recently, however, the reaction function did not hold sway. It was weakened by structural deterioration in the outlook for the US economy, and many economists who believed in these models were caught unawares all through last year. With this in mind, let’s examine whether rising oil prices could normalize the situation and push the dollar higher, and as a corollary, the euro lower.
Trends in the financial markets have accelerated in the last few days. After hesitating slightly at the start of 2018, it is increasingly obvious to investors that reflation is around the corner. That belief is based on widespread growth, a surging oil price, the first positive effects of Donald Trump’s tax reform – with giant US companies promising to repatriate profits – and good news on investment and jobs. It is hard to see how that situation could fail to end the phase of latent deflation in the last few years and support expectations – seen throughout 2017 – of inflation getting back to normal. The impact of rising oil prices alone could significantly change the inflation situation, judging by how sensitive inflation is to movements in oil prices. If crude stabilises at $70 per barrel between now and the summer, inflation could rise by more than half a point in the industrialised world, taking it well above the 2% target that it touched only briefly in February 2017.
So what could prevent a significant increase in interest rates? It is very tempting to change our outlook for 2018. How is the interest-rate environment likely to develop?
Like all crises, the present one provides a fertile breeding ground for dogmatic, cookie-cutter statements and clichés that don’t always square with reality. So perhaps the best way to avoid making disastrous decisions on the momentous issues of today is to take a good, hard look at our past. This view was what prompted us to publish the following series of charts, which sum up twenty years of comparative economic history in France and Germany.
Growth, consumption, employment, real estate, debt, demographics, and foreign trade are the themes we have covered here, in the hope of offering the reader greater insight into the forces at work in the euro area’s two leading economies.