A Misaligned Euro?

CAMBRIDGE: Caught by rising inflation from oil prices and a soaring dollar, the European Central Bank (ECB) has raised interest rates yet another notch. More is to come. Growth is wonderful; inflation is terrible; a central bank cannot avoid choosing: it must restore price stability even if that means sacrificing growth. This is what lies ahead, unless there is sudden relief from an upturn in the euro. But is it realistic to expect a rally from a currency that has been under siege since its birth?

At its introduction the euro reached impressive heights, like a high-tech IPO. But the IPO soon sunk miserably. Since its introduction, the euro has fallen further from its peak then even the Nasdaq in the high-tech sell-off of earlier this year. Like the Nasdaq’s high-tech high-flyers, the nagging questions about the euro are these: what is its fundamental value? Is there a fundamental misalignment of the euro with other currencies (most notably the dollar) and how long might this last? It is commonly assumed (but nobody takes big bets) that the Nasdaq still carries major downside risks while the euro, sooner or later, must return to normality, whatever that means. Could the opposite happen?

A recent study by the IMF reports on “equilibrium” exchange rates derived from models of long run factors in currency valuations. The equilibrium rates are reported in the accompanying table and so are today’s actual rates. According to these IMF theoretical equilibrium rates, the euro is grossly misaligned: 30% underpriced against the dollar, 18% against the Yen!

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