The year 2022 witnessed significant turbulence for the euro, with analysts labeling it the “worst year in the euro’s history“. Starting the year at an EUR/USD exchange rate of $1.137, the euro experienced a dramatic fall, breaching parity against the US dollar in July for the first time in two decades, marking a 20-year low. The currency further plummeted to a year-to-date (YTD) low of $0.960 on September 27th, coinciding with the indefinite shutdown of the Nord Stream 1 pipeline. However, following a robust 75 basis-point policy rate hike by the European Central Bank (ECB) on October 27th, the euro demonstrated some recovery, closing the year at an EUR/USD rate of $1.07.
Figure 1 US dollar to euro spot exchange rate
While a global economic slowdown, stemming from the pandemic and the Ukraine crisis, impacted economies worldwide, Europe faced particularly acute effects in 2022. Several key factors converged to trigger the Depreciating Euro 2022, which can be broadly categorized as:
- Europe’s substantial reliance on Russian energy and the ensuing economic deceleration amplified by the Ukraine conflict.
- The growing divergence in monetary policy between the US Federal Reserve (Fed) and the ECB.
- The strengthening of the US dollar as a ‘safe haven’ asset amidst global financial and geopolitical uncertainties.
Russia’s invasion of Ukraine significantly destabilized the global economy, causing disruptions in trade and sharp increases in food and fuel prices. Europe, however, felt these repercussions more intensely than other regions. The European Commission’s Autumn 2022 Economic Forecast projected that most EU member states would slip into recession during the final quarter of the year. This downturn was attributed to soaring inflation, sluggish growth rates, and heightened economic uncertainty (European Commission 2022). Large European economies, such as Germany and Italy, heavily dependent on Russian gas, experienced significantly higher energy-driven inflation compared to the US. European inflation peaked at 10.6% in October, while the US rate stood at 7.2%. Furthermore, research by Bobasu and De Santis (2022) indicated that the Ukraine invasion and the subsequent surge in energy prices substantially amplified uncertainty within the Eurozone. This increased uncertainty negatively impacted GDP and domestic demand across the euro area. With the energy crisis pushing the EU’s terms of trade to historic lows, the euro’s depreciation against the dollar became an almost unavoidable consequence of the geopolitical turmoil.
Some economists also point to the economic slowdown in China as having a greater impact on Europe than the US, further weakening the euro. Daniel Lacalle argued that the Chinese economic downturn exerted downward pressure on the euro area’s trade surplus, hindering the euro’s ability to maintain its strength against the dollar.
Another significant driver of the depreciating euro 2022 was the contrasting approaches taken by the ECB and the Fed in combating inflation. The Federal Reserve adopted a more aggressive, or hawkish, stance, signaling as early as June 2021 its intention to raise interest rates to curb inflation. The Fed initiated rate hikes in March 2022, followed by a series of increasingly rapid increases. Conversely, the ECB maintained its accommodative monetary policy until July 2022, when it implemented its first interest rate increase. This more gradual approach by the ECB resulted in a widening gap in interest rate differentials between the US and the Eurozone, prompting investors to shift capital from European to American assets. Consequently, since the Fed’s initial indication of potential rate hikes in June 2021, the dollar has appreciated by approximately 20% against the euro. Beckworth and Leeper (2022) suggest that the ECB’s cautious approach might be influenced by the high levels of debt in some euro area economies. For historical context, see also von Hagen (1999).
The perception of the US dollar as a safe-haven asset, especially during times of crisis, provided yet another layer of downward pressure on the euro. US assets, particularly Treasury bonds, are generally considered safe havens, attracting investors during periods of global instability. This increased demand for dollar-denominated assets during times of uncertainty naturally strengthens the dollar. The Ukraine crisis exemplified this trend, with the US dollar strengthening for three consecutive sessions immediately following the Russian invasion. Egorov and Mukhin (2021) posit that the US, as the issuer of the world’s dominant global currency, is better shielded from international economic shocks and can benefit from its global currency status in international markets.
While a weak currency might offer some advantages under normal economic conditions, its effectiveness as a stabilization tool during the crises of 2022 was questionable. Conventional economic wisdom suggests that a weaker currency boosts exports. Beck et al. (2022) found that during periods of exchange-rate depreciation, large banks with significant foreign currency asset holdings increase lending to export-oriented firms, leading to higher output growth in regions with a strong presence of smaller banks. However, economists remain divided on the actual sensitivity of exports to exchange rate fluctuations, as noted by Mauro et al. (2017). Ahmed et al. (2015) argue that the rise of global value chains has diminished the responsiveness of manufacturing export volumes to real effective exchange rate changes. In contrast, Tsyrennikov et al. (2015) find limited evidence of a general weakening in the relationship between exchange rates and trade flows over time.
In the context of the 2022 crises, some economists contend that the weak euro failed to act as an effective stabilizer. Supply chain disruptions and sanctions hampered European businesses’ ability to capitalize on price competitiveness and benefit from the lower real effective exchange rate (Colijn and Brzeski 2022). Moreover, a depreciating euro 2022 exacerbated inflationary pressures by making imports more expensive, compounding the already severe inflation problem in Europe. As reported by DW, a weak euro significantly intensifies inflationary pressures within the Eurozone.
The question of whether the ECB should actively intervene to bolster the euro, or whether international coordination is necessary, remains a subject of debate. Lodge and Perez (2021) found that globalization has reduced the exchange rate pass-through (ERPT) to inflation in the EU to approximately 0.3%, down from 0.8% in 1999. This suggests that direct intervention in the foreign exchange market by the ECB might be considered an extreme measure. Conversely, given that a significant portion of cross-border loans and international debt securities are denominated in US dollars, a weakening euro relative to the dollar could make debt repayment considerably more challenging for the private sector, potentially increasing the risk of debt crises (Gopinath and Gourinchas 2022). However, Ethan Ilzetzki of the London School of Economics argues that high-income economies like those in the EU are generally well-hedged against this type of risk, and a strong dollar could even improve the balance sheets of certain institutions.
Experts have also pointed to the additional inflationary pressures stemming from a weak euro as justification for ECB intervention to strengthen the currency. Suggestions have been made for implementing a modern version of the Plaza Accord – an international agreement to coordinate efforts to weaken the dollar, thereby relatively strengthening currencies like the euro.
To gain further insights into expert opinions, the CfM-CEPR panel of experts on the European macroeconomy was surveyed regarding the causes of the euro’s weakness in 2022 and the appropriateness of policy responses should euro weakness persist.
Question 1: What was the main cause for the euro’s decline relative to the US dollar in 2022?
Forty-one panel members participated in this survey question. A majority, 56%, attributed the euro’s weakness in 2022 primarily to monetary policy differentials between the ECB and the Fed. This majority slightly increased to 61% when responses were weighted by the experts’ self-assessed confidence levels. Approximately 29% of the panel believed that real economic factors were the main drivers of the euro’s depreciation.
The prevailing view among panellists was that monetary policy divergence was the dominant factor behind the depreciating euro 2022. Maria Demertzis (Bruegel) noted that “the real exchange rate [was not] different to historical values [in 2022]”, suggesting that “real factors or indeed the war in Ukraine” were not the primary causes. Jagjit Chadha (National Institute of Economic and Social Research) proposed that the ECB’s “less aggressive response to emergent inflationary pressures and concerns about weak growth in the face of high levels of indebtedness may have acted to constrain the policy response.” Morten Ravn (University College London) echoed this sentiment, highlighting “initial doubts about the ECB’s willingness to increase the policy rate in the face of ‘fragmentation risk’ and continuing credit policies.” However, Fabrizio Coricelli (University of Siena and Paris School of Economics) pointed out that “with the tightening in ECB policy in the second half of 2022, the euro has recovered some of the lost ground,” reinforcing the significance of monetary policy differentials.
Around a third of the panel attributed the euro’s decline in 2022 to real economic factors. Several panellists identified the Russia-Ukraine war as a major contributing factor. Omar Licandro (University of Nottingham) and Evi Pappa (European University Institute) emphasized Europe’s “high energy dependence” on Russia, particularly on “Russian fossil fuel imports,” as a significant factor. Jumana Saleheen (Vanguard Asset Management) suggested that differing growth expectations between the US and the euro area played a crucial role. She explained that fears of gas shortages crippling European industry, coupled with a “positive terms of trade shock” for the US, led to expectations of stronger US growth relative to the Eurozone. This, combined with a “strong post-Covid recovery” and “monetary policy differentials,” drove investors towards the dollar. Lukasz Rachel (University College London) also agreed that the US benefited from a “positive terms of trade shock,” but further suggested that “financial factors” may have played a significant role in the euro’s decline, aligning with the views of Itskhoki and Mukhin (2022).
Paul de Grauwe (London School of Economics) offered a contrasting perspective, cautioning against oversimplification and stating that economists simply “did not know” the precise reasons behind the euro-dollar exchange rate movements in 2022. He warns against creating potentially misleading narratives to explain the euro’s decline.
Interestingly, when the same question was posed to Chat GPT, its response highlighted the limitations of current AI models, stating: “I am sorry, my knowledge cut-off date is 2021, so I am unable to provide information on events that occurred after that date. However, there can be many factors that can cause a decline in the value of a currency, such as economic conditions, interest rate changes, political developments, or market sentiment.” This served as a reminder that expert human analysis remains crucial in understanding complex economic events.
Question 2: Should the ECB respond to movements in the euro-dollar exchange rate of the nature observed in 2022?
Forty-one panel members provided responses to this question. A significant majority, 81%, believed that the ECB should not respond to exchange rate fluctuations of the magnitude seen in 2022. Of the 14% who thought the ECB should respond, opinions were equally divided between those advocating for coordinated intervention with other countries and those supporting unilateral action.
The dominant view among the panel was that the ECB’s primary focus should remain on its inflation mandate, rather than directly targeting exchange rate fluctuations. Andrea Ferrero (University of Oxford) succinctly summarized this perspective: “The ECB should continue to focus on its inflation stability mandate and thus respond to exchange rate movements only insofar as inflation is affected.” Ethan Ilzetzki (London School of Economics) argued that given the “Eurozone economies were running large current account deficits”, the exchange rate acted “what it was supposed to,” forcing necessary adjustments in European economies to manage energy imports. Jürgen von Hagen (Universität Bonn) emphasized that the ECB’s core challenge lies in “fend[ing] off political pressures from the member governments” and preserving its independence, rather than managing the exchange rate. Cédric Tille (The Graduate Institute, Geneva) concurred, stating that the ECB should react to the exchange rate only “to the extent that the exchange rate connects to inflation” and that any response should be “an answer to price pressure, not the exchange rate itself.”
A minority of the panel supported ECB intervention in foreign exchange markets, either unilaterally or in coordination with other central banks. Richard Portes (London Business School and CEPR) expressed support for unilateral ECB intervention, but only if “exchange-rate depreciation might increase inflationary pressures or threaten financial stability.” Notably, this condition for intervention was also acknowledged by panellists opposing intervention, such as Cédric Tille and Andrea Ferrero, indicating a general consensus on the circumstances under which ECB intervention might be justifiable, but disagreement on whether the specific circumstances of 2022 warranted such action.
Jorge Braga de Macedo (Nova School of Business and Economics, Lisbon) advocated for ECB intervention, emphasizing the necessity of coordination with other central banks. He highlighted the historical precedent of central bank coordination in the international monetary system since the 1970s and argued that the creation of the euro, coupled with renewed international political tensions and the war in Ukraine, underscored the need for such cooperation. However, he acknowledged that historical coordination mechanisms might be insufficient to address contemporary challenges stemming from shifts in international trade and investment patterns and new security threats.
References
Ahmed, S, M Appendino and M Ruta (2015), “Depreciations without Exports? : Global Value Chains and the Exchange Rate Elasticity of Exports”, World Bank Policy Research Working Papers.
Beck, T, P Bednarek, D te Kaat and N von Westernhagen (2022), “The Real Effects of Exchange Rate Depreciation: The Role of Bank Loan Supply”, CEPR Discussion Paper 17231.
Beckworth, D and E Leeper (2022), “Eric Leeper on the Interactions of Fiscal and Monetary Policy | Mercatus Center”, podcast on www.mercatus.org, 4 April.
Bobasu, A and R De Santis, (2022), “The impact of the Russian invasion of Ukraine on euro area activity via the uncertainty channel”, ECB Economic Bulletin, Issue 4/2022.
Colijn, B and C Brzeski (2022), “Euro Weakness Is No Blessing in Disguise for the Eurozone”, ING Think, 17 August.
Egorov, K and D Mukhin (2021), “Policy implications of dollar pricing”, VoxEU.org, 19 November.
European Commission (2022), “Autumn 2022 Economic Forecast: The EU Economy at a Turning Point”, ec.europa.eu, 11 November.
Gopinath, G and P Gourinchas (2022), “How Countries Should Respond to the Strong Dollar”, IMF Blog, 14 October.
Itskhoki, O and D Mukhin (2022), “Sanctions and the Exchange Rate”, VoxEU.org, 16 May.
Lodge, D and J Perez (2021), “The implications of globalisation for the ECB monetary policy strategy”, Occasional Paper Series, No 263, ECB.
Mauro, F, J de Kerke and V Demian, (2017), “You need an ‘extra moment’ to assess the impact of the exchange rate”, VoxEU.org, 8 December.
Tsyrennikov, V, W Lian, M Poplawski-Ribeiro and D Leigh, (2015), “Exchange rates still matter for trade”, VoxEU.org, 30 October.
Von Hagen, J (1999), “A New Approach to Monetary Policy (1971-8)”, in Deutsche Bundesbank (ed.), Fifty Years of the Deutsche Mark. Central Bank and the Currency in Germany since 1948, New York: Oxford University Press, 1999.
