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Euro to Dollar Rate Burdened by ECB's Escalating Confrontation of Inflation

The Euro to Dollar rate reversed a short-lived rally on Thursday after European Central Bank President Christine Lagarde made clear the potential costs of an escalating confrontation of inflation, which elicited the monetary union's largest interest rate rise to date in September's decision.

Europe's single currency had climbed briefly above parity early in the ECB's September press conference on Thursday but was quick to reverse its gains after President Lagarde said the ECB's fightback against inflation would further weigh on Europe's economy and may lead unemployment to rise.

"I would like to say this. What I know today is that zero is not the neutral rate and that where we are is not the neutral rate. We are heading in that direction but it takes a frontloading. It will take further hikes in the next several meetings of a magnitude and at a pace that will be determined meeting by meeting and on the basis of the data that we receive," she told reporters following a Governing Council decision to lift all of the ECB's benchmark interest rates by 0.75%.

The ECB's statement and press conference made clear the Governing Council will seek to further dampen economic demand by continuing to lift interest rates in the months ahead as part of an effort to prevent businesses and households from expecting that inflation would remain above the symmetric two percent target over the longer-term.

This was after ECB staff downgraded GDP forecasts and significantly revised up their inflation projections including for 2024, the year at the end of the forecast horizon and a point at which consumer prices are seen still growing at an above-target pace of 2.3%.

While a European recession was not baked into the ECB's September forecasts, it was not ruled out either and President Lagarde did warn the economic outlook would darken further if disrupted energy supplies necessitate more widespread rationing of energy usage.

"That downside scenario differs from the current situation in that it includes in particular a total shutdown of all Russian gas supply. We are almost there but there is still a bit of flow going through the Ukrainian one. But we also foresee rationing across the whole Euro area and no measure of compensation between gas supply and other alternative sources," she told the press conference.

All of this comes with soaring energy and food prices having lifted inflation to 9.1% in August, leading other prices across the economy to also rise and stoking concern among Governing Council members about the risk of a self-sustaining cycle of higher inflation rates becoming established.

"We also have an inflation that spreads across the whole range of products in particular in the services sector where supply factors are less prevalent. So in the face of an inflation that is extremely high, that is of a magnitude and persistence across sectors of that nature, obviously determined action had to be taken," President Lagarde said.

Thursday increase in borrowing costs is the second for the ECB since 2011 and saw rates charged or paid on its main refinancing operations, marginal lending facility and deposit facility lifted to 1.25%, 1.5% and 0.75% respectively.

Derivative markets had stopped short of fully pricing-in this larger step ahead of Thursday's decision, although it did few obvious favours for the Euro-Dollar rate.

"Note that they highlight familiar language (as observed across many CBs) which is 'frontloading' tightening, so essentially borrowing from future rate hikes. The ECB didn't mince words in trying to say they want to 'dampen' demand," says Mazen Issa, a senior FX strategist at TD Securities.

"The strategic outlook remains very challenging for the EUR and the ECB doing 75bp is not going to change that. The macro situation will continue to deteriorate and that is deeply problematic for this pro-cyclical currency staring down a deepening energy crisis," Issa wrote in a note following the decision.

Source: Pound Sterling



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