The year 2022 proved to be an exceptionally volatile period for the euro. Many analysts even went as far as to label it the “worst year in the euro’s history“, as the currency faced significant headwinds throughout the year. Starting at an exchange rate of $1.137 against the US dollar (EUR/USD) at the beginning of the year, the euro dramatically weakened, breaching parity with the dollar in July for the first time in two decades, hitting a 20-year low. The currency’s depreciation culminated in a year-to-date (YTD) low of $0.960 on September 27th, a drop coinciding with the indefinite shutdown of the Nord Stream 1 pipeline. However, following a robust 75 basis-point policy rate increase by the European Central Bank (ECB) on October 27th, the euro experienced a resurgence, climbing back above parity to reach $1.07 against the dollar by the year’s end.
Figure 1 US dollar to euro spot exchange rate
While the global economy in 2022 was broadly impacted by the economic repercussions of the ongoing pandemic and the escalating crisis in Ukraine, Europe experienced a particularly acute intensification of these effects. Experts have pinpointed three primary factors that contributed to the significant depreciation of the euro in 2022, impacting its global standing and purchasing power.
Key Factors Behind the Euro’s 2022 Depreciation
1. Europe’s Energy Dependence and the Ukraine Conflict
Europe’s substantial reliance on Russian energy resources, coupled with the economic repercussions stemming from Russia’s invasion of Ukraine, played a pivotal role in the euro’s downturn. The conflict in Ukraine triggered widespread disruptions in global trade, and significant shocks to both food and fuel prices. These global economic strains disproportionately affected Europe compared to other regions worldwide due to its energy vulnerability.
The European Commission’s Autumn 2022 Economic Forecast painted a concerning picture, predicting that a majority of EU member states would slide into recession during the final quarter of the year. This anticipated recession was attributed to a confluence of factors: persistently high inflation rates, sluggish economic growth, and a pervasive atmosphere of economic uncertainty (European Commission 2022). Large European economies, such as Germany and Italy, heavily dependent on Russian natural gas, faced significantly higher energy-driven inflation compared to other major economies, most notably the United States. Inflation in the Eurozone soared to 10.6% in October, while the US experienced a comparatively lower rate of 7.2%.
Furthermore, research by Bobasu and De Santis (2022) highlighted that the Ukraine invasion and the subsequent surge in energy prices significantly amplified economic uncertainty within the euro area. This heightened uncertainty negatively impacted both GDP and domestic demand across the Eurozone. The energy crisis pushed the EU’s terms of trade to a historic low, making the euro’s depreciation against the dollar an almost unavoidable consequence of the geopolitical turmoil and energy market volatility triggered by the Ukraine conflict.
Adding to these pressures, some economists have suggested that the economic slowdown in China also exerted a greater negative influence on Europe than on the United States, further weakening the euro. Daniel Lacalle, for instance, argued that the Chinese economic deceleration put downward pressure on the euro area’s trade surplus. This diminished trade surplus, in turn, eroded the euro’s capacity to maintain its strength against the appreciating US dollar.
2. Divergence in Monetary Policy: ECB vs. Federal Reserve
Another critical driver of the euro’s depreciation in 2022 was the contrasting approaches adopted by the ECB and the US Federal Reserve (Fed) in tackling rising inflation. The Federal Reserve adopted a more aggressive, or “hawkish,” stance towards inflation, signaling as early as June 2021 its intention to raise interest rates to curb inflationary pressures. The Fed initiated interest rate hikes in March 2022, followed by a series of subsequent, rapid increases.
In stark contrast, the ECB initially maintained a more accommodative, or “loose,” monetary policy. It wasn’t until July 2022 that the ECB implemented its first interest rate increase. This more gradual approach from the ECB in adjusting policy rates resulted in a widening gap in interest rate differentials between the Eurozone and the United States. This interest rate divergence incentivized investors to shift capital from European assets to the more attractive, higher-yielding American assets, further fueling the dollar’s appreciation against the euro. Since the Fed’s initial संकेत in June 2021 about potential rate hikes, the dollar has appreciated by approximately 20% against the euro, reflecting the significant impact of monetary policy divergence.
Beckworth and Leeper (2022) have proposed that the ECB’s relatively cautious stance might be influenced by the substantial levels of debt held by certain Eurozone economies. This concern about sovereign debt sustainability could have constrained the ECB’s ability to adopt a more aggressive interest rate hiking cycle, further contributing to the euro’s weakness. For historical context, see also von Hagen (1999) for a perspective on monetary policy approaches.
3. The US Dollar as a Safe Haven Asset
The perception of the US dollar as a “safe haven” asset, particularly during periods of global crisis and uncertainty, constituted another significant factor weakening the euro. US assets, particularly US Treasury bonds, are widely regarded as safe havens for investors during turbulent times. Consequently, investors tend to flock to these assets during periods of financial and political instability, increasing demand and driving up the dollar’s value.
The Ukraine crisis exemplified this trend, with the US dollar strengthening for three consecutive trading sessions immediately following Russia’s invasion. Egorov and Mukhin (2021) argue that the United States, as the issuer of the world’s dominant global currency, enjoys greater insulation from international economic shocks. Furthermore, the US can leverage its global currency status to extract advantages in international goods and asset markets, benefiting from its unique position in the global financial system. This “safe haven” appeal of the dollar further exacerbated the euro’s depreciation in the face of geopolitical risks.
Implications of a Weaker Euro: A Double-Edged Sword
The impact of a weaker currency is complex and multifaceted. Conventional economic theory suggests that a weaker currency can be beneficial, boosting exports by making them cheaper for foreign buyers. Beck et al. (2022) found evidence supporting this, showing that during periods of exchange-rate depreciation, large banks with significant foreign currency asset holdings increase lending to export-oriented firms. Regions with a higher concentration of small banks also experience stronger output growth in such scenarios.
However, the benefits of a weaker euro in the context of the 2022 crisis were contested. Some economists argued that in the face of persistent supply chain disruptions and the looming threat of sanctions, European businesses were unable to fully capitalize on their improved price competitiveness stemming from the weaker euro. Consequently, the anticipated export-driven boost to the European economy failed to materialize. As Mauro et al. (2017) point out, economists hold differing views on the sensitivity of exports to exchange rate fluctuations. Ahmed et al. (2015) argue that global value chains have diminished the responsiveness of manufacturing exports to real effective exchange rate changes, while Tsyrennikov et al. (2015) present contrasting evidence, suggesting a continued link between exchange rates and trade flows.
Furthermore, a weaker euro significantly exacerbated inflationary pressures within the Eurozone, compounding an already severe problem. As imports became more expensive, the weaker euro directly contributed to higher import costs, feeding into domestic inflation. Colijn and Brzeski (2022) and others highlighted that in the context of 2022, euro weakness was far from a “blessing in disguise” and instead amplified existing economic challenges.
Expert Perspectives: Causes and Policy Responses
To gain deeper insights into the euro’s weakness and potential policy responses, the Centre for Economic Policy Research (CEPR) and the Centre for Macroeconomics (CfM) conducted a survey of leading European macroeconomists. The survey explored expert opinions on the primary causes of the euro’s 2022 decline and the appropriateness of policy interventions by the ECB.
Question 1: What was the main cause for the euro’s decline relative to the US dollar in 2022?
The survey revealed a consensus among the 41 panel members, with a majority (56%) identifying monetary policy differentials between the ECB and the Federal Reserve as the dominant factor behind the euro’s weakness in 2022. This majority slightly increased to 61% when responses were weighted by the experts’ self-assessed confidence levels. Approximately 29% of the panel attributed the euro’s depreciation to real economy factors, primarily linked to the energy crisis and the Ukraine conflict.
Monetary Policy Divergence as the Primary Driver:
A significant portion of the panel emphasized the role of diverging monetary policies. Maria Demertzis (Bruegel) pointed out that the “real exchange rate [was not] different to historical values [in 2022],” suggesting that real factors or the war in Ukraine alone could not fully explain the phenomenon. Jagjit Chadha (National Institute of Economic and Social Research) suggested 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, noting “initial doubts about the ECB’s willingness to increase the policy rate in the face of ‘fragmentation risk’ and continuing credit policies.” Fabrizio Coricelli (University of Siena and Paris School of Economics) highlighted the recovery of the euro after the ECB’s policy tightening in the latter half of 2022, further supporting the view that monetary policy differences were central to the euro’s initial depreciation.
Real Economy Factors as a Significant Contributor:
Around a third of the panel emphasized the impact of real economic factors. Several panelists cited the Russia-Ukraine war as a major cause. Omar Licandro (University of Nottingham) and Evi Pappa (European University Institute) highlighted Europe’s “high energy dependence” on Russia, particularly “Russian fossil fuel imports,” as a significant contributor. Jumana Saleheen (Vanguard Asset Management) pointed to differences in growth expectations between the US and the Eurozone. She argued that fears of energy shortages crippling European industry, coupled with a “positive terms of trade shock” in the US, led investors to anticipate stronger US growth relative to the Eurozone, favoring the dollar. Lukasz Rachel (University College London) also acknowledged the US benefiting from a “positive terms of trade shock” but suggested “financial factors” may have played a more significant role in the euro’s decline, aligning with the perspective of Itskhoki and Mukhin (2022).
A Note of Caution:
Paul de Grauwe (London School of Economics) offered a dissenting perspective, cautioning against oversimplification and emphasizing the inherent uncertainty in explaining exchange rate movements. He warned against “inventing stories that appear to be plausible” to explain the euro’s decline, highlighting the complexity of exchange rate dynamics.
Interestingly, when the same question was posed to Chat GPT, its response was: “I am sorry, my knowledge cut-off date is 2021, so I am unable to provide information on events that occurred after that date.” This response served as a humorous reminder of the limitations of current AI models and the continued value of expert human analysis.
Question 2: Should the ECB respond to movements in the euro-dollar exchange rate of the nature observed in 2022?
A strong majority (81%) of the 41 panel members believed that the ECB should not directly respond to exchange rate fluctuations of the magnitude seen in 2022. Of the 14% who believed the ECB should respond, opinions were evenly split between those advocating for coordinated international intervention and those supporting unilateral action by the ECB.
Focus on Inflation Mandate:
The prevailing view among the panel was that the ECB’s primary focus should remain on its mandate of price stability – controlling inflation. Andrea Ferrero (University of Oxford) succinctly captured this sentiment: “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’s current account deficits, the exchange rate depreciation was a natural and necessary adjustment mechanism, forcing European economies to adapt to the energy crisis. Jürgen von Hagen (Universität Bonn) emphasized that the ECB’s core challenge was maintaining its independence from political pressures and focusing on its primary mandate, rather than directly targeting the exchange rate. Cédric Tille (The Graduate Institute, Geneva) concurred, stating that ECB action should be triggered only when exchange rate movements pose a direct threat to inflation, not as a reaction to the exchange rate itself.
Limited Support for Intervention:
A small minority supported ECB intervention, under specific conditions. Richard Portes (London Business School and CEPR) expressed conditional support for unilateral ECB intervention, but only if exchange rate depreciation threatened to exacerbate inflationary pressures or destabilize financial markets. This view aligned with the conditional stance of panelists who opposed intervention, suggesting a consensus on the circumstances under which intervention might be warranted, but disagreement on whether those circumstances were met in 2022.
Jorge Braga de Macedo (Nova School of Business and Economics, Lisbon) advocated for ECB intervention, but stressed the importance of international coordination with other central banks. He argued that international central bank coordination has been a feature of the global monetary system since the 1970s and remains crucial, particularly in times of geopolitical instability and economic uncertainty. However, he acknowledged that the evolving patterns of international trade and investment, along with new security threats, present challenges to effective international coordination.
Conclusion: Navigating Currency Volatility in a Complex World
The euro’s tumultuous year in 2022 was driven by a complex interplay of factors, primarily the energy crisis triggered by the Ukraine conflict and the diverging monetary policy responses between the ECB and the US Federal Reserve. While a weaker euro presents both potential benefits and significant drawbacks, expert consensus suggests that direct exchange rate targeting by the ECB is generally not advisable. Instead, the focus should remain on maintaining price stability and addressing the underlying economic challenges facing the Eurozone. Navigating currency volatility in an increasingly complex and interconnected global economy requires a nuanced approach, prioritizing sound monetary policy and international cooperation to foster economic resilience.
References
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