ECB must choose the right moment

SINCE the start of the year, the strength of the euro against the dollar has dominated all market commentary.

Last week the ECB and ECOFIN, the council of Eurozone finance ministers, issued a joint communiqué calling for more stability in the foreign exchange markets.

It was obviously their intent to halt the euro 's appreciation, but it didn't work simply because talk is cheap.

Two weeks ago, ECB president Trichet took his chance at the ECB's monthly press conference to call for greater exchange rate stability and he succeeded, forcing the euro down to 1.23.

Trichet's comments worked because it was the first time he publicly commented on the dollar's fall.

However you cannot indefinitely cry wolf. Last week's ECOFIN/ECB statement simply wasn't phrased harshly enough to discourage currency speculators, so the euro rose again.

That's the problem with the currency market talk is cheap, and at the moment the market has come to the conclusion that the ECB's bark is worse than its bite.

So what can the ECB do to stem the dollar's decline?

Theoretically, they have two options. They can either cut the Eurozone interest rate, or intervene in the currency market, to sell the euro and force down its value.

However, the ECB really don't want to pursue either of these options, because both could cause inflation.

Remember, the ECB is legally mandated to ensure price stability across the Eurozone.

Nowhere in the ECB's charter does it specify that the Bank should stimulate growth, or manage the currency.

If the ECB were to cut interest rates in response to the euro's strength, it might deter speculators from buying the euro, and it might not.

What it almost certainly would do however is push prices higher, because it would make it cheaper to borrow across the continent.

If the ECB were to intervene in the currency markets in response to the euro's strength, that might also deter speculators from buying the euro.

But there's a real risk that it too would push inflation higher.

To conduct foreign exchange intervention, the ECB would simply print more money, and sell it aggressively.

However, by printing more euro, they would increase the amount of cash in circulation, and almost certainly push prices higher.

They could try to counteract this inflation by 'sterilising' the intervention, whereby they would increase the deposit rate on offer for cash on deposit, in an effort to take back some of the cash in circulation.

But it's almost impossible to completely 'sterilise' intervention.

So the simple fact is that the ECB really can do little to halt the euro's rise, without risking higher inflation, which goes against their mandate.

There may well come a stage when they are left with no option but to intervene in the market, but I don't think we will see that outcome until the euro rises comfortably above the $1.30 level.

The views and opinions expressed in this article are those of the author and do not necessarily correspond with those of Ulster Bank or any other member of the RBS Group.