Watch the currency, Mario. Photographer: Jasper Juinen/Bloomberg
Watch the currency, Mario. Photographer: Jasper Juinen/Bloomberg

The European Central Bank is set to venture deeper into uncharted territory next week in its efforts to ensure a healthy economic recovery. To understand the motivations and gauge the likelihood of success, it's important to pay close attention to the euro.

The euro's appreciation over the past couple of years is largely a good sign, reflecting the ECB's success in restoring confidence and stabilizing financial markets. Unfortunately, it has also gone too far due to developments elsewhere that affect currency markets, including in the U.S., Japan and emerging economies. As such, the strength of the euro has become an obstacle to converting Europe’s financial gains into durable economic improvements.

ECB officials have joined government officials in signaling concern about the euro’s overappreciation, and not only because of its effect on competitiveness, growth and jobs. Another worry is that the currency is contributing to "lowflation" -- that is, inflation that has been too low for too long. If people and companies lower their medium-term inflationary expectations in response, the phenomenon could become chronic, increasing the burden of debt, moderating demand and further complicating Europe’s recovery.

The varied concerns help explain the broad range of measures said to be under consideration for the next meeting of the ECB’s Governing Council, including an interest rate cut, stronger forward policy guidance, quantitative easing, credit easing and even selected negative interest rates.

The moves, if implemented, would take the ECB to a very unusual place. In addition, the central bank would be loosening monetary conditions at a time when the Federal Reserve is removing accommodation through the reduction, and likely elimination, of its monthly purchases of securities. Indeed, the Bank of Japan could end up being the only systemically important central bank with a more accommodative monetary policy, if that.

The market's anticipation of the ECB's policy shift has already brought a desirable weakening in the currency: A euro bought just less than $1.36 on May 28, down from $1.39 three weeks earlier.

The currency could move much more sharply, though, if the ECB adopts decisive measures next week. This risk is partly related to carry trades, in which investors borrow money in currencies with low interest rates to buy assets that offer higher yields. The high-yielding bonds of European countries such as Greece, Italy, Portugal and Spain for example, have been a target of such investments. If the ECB's moves cause Europe to switch from being a recipient to a source of borrowing, history suggests that the corresponding currency fluctuations could be quite dramatic.

The ECB will have to watch the currency market closely. Its challenge is to engineer a sufficient devaluation, but one that stops short of undermining financial stability.

To contact the writer of this article: Mohamed A. El-Erian at M.El-Erian@bloomberg.net.

To contact the editor responsible for this article: Mark Whitehouse at mwhitehouse1@bloomberg.net.