The SNB has skewered the ECB

• After the SNB's move, the euro's depreciation might accelerate
• What boosts exports makes imports more expensive
• Cost-push inflation and higher unemployment are looming

When the Swiss National Bank unexpectedly decided on to end the three-year policy of placing a 1.20 price ceiling on the level of the Swiss Franc against the euro (EURCHF) yesterday, bearish bets on Europe’s common currency increased.

The immediate trading after the announcement saw the euro fall 3.5% against a basket of 10 developed nations' currency pairs – the largest fall since the euro was launched in 1999.

One can see below how suddenly, technical analysis could be applied to the EURCHF rate. Instead of being a dormant, static number, it became a live currency pair in the forex market.

Source: Action Forex

The SNB’s course of action has served to undermine one of the foundations of the euro. By doing so, it increased the chances that the single European currency will begin to see an accelerated decline.

Now it is being speculated whether the EURUSD can slide to parity within two years (as the euro-as-reserve-currency is currently finding few friends).

Oh Mario…what to do?

This news from the SNB has indeed muddied the waters for the European Central Bank, which for months has been struggling and failing to find a way to stave off the slide into deflation. After all, the December 2014 CPI was minus 0.2%.

Whilst it is hoped that the ECB will announce the details of quantitative easing on January 22, one can almost see Mario Draghi spluttering about "using every tool", but also claiming that with oil prices possibly stabilising or even reversing, and given the currency's slide of the currency it is best to wait until March 7...

Evidently, I am cynical. However, this time I am convinced that Draghi will deliver something of value to the market.

Just pause for a moment. He will be looking over his old comments and he will know that for months, he has been actively urging the leaders of numerous Eurozone nations to implement reforms in their economies.

He will also peer into his economic textbooks and note that from the Eurozone perspective, the good inflation that is required is that of “Demand-Pull”, where the amount of goods and services being demanded creates a price rise and a reason for manufacturers or service suppliers to increase their offerings and hence employment. 

That would then see the long-run aggregate supply curve shift to the right and raise prices through an increase in demand.

Source: Spotlight Ideas

The trouble is that the economic prospects in the Eurozone are not terribly encouraging and whilst the fall in the euro may lead the cost of imported goods to rise, it may also prove that medium-term input costs to Eurozone corporations' value chains start to rise. 

In short, as the euro falls the cost of imported goods starts to rise and this will feed into “Cost-Push” inflation. Fluctuations in the exchange rate can have a powerful effect on inflation in the short and medium-term.

Cost-Push inflation occurs when firms increase prices to maintain or protect profit margins after experiencing a rise in their costs of production. This can be shown by an inward shift of the short run aggregate supply curve which leads to a contraction in aggregate demand and a fall in real output (Y1 to Y2, Y2 < Y1), but an increase in the general price level (P1 to P2, P1 < P2).

 

Source: Spotlight Ideas

This is the nightmare that now confronts Mario Draghi. The markets are demanding QE news, detail and clarity on January 22. However, the delegates from the Bundesbank will point to the inflationary impact of the softer currency. 

Overall, the nightmare is that in the short-term, the fall in the Euro and the impact on input costs sees firms reduce production so prices rise, production falls and unemployment creeps higher. 

As a result, the Eurozone enters “stagflation”; the SNB has just made the ECB’s life more complicated.

By Stephen Pope ---  - Edited by Clemens Bomsdorf