Euro 2022: A Year of Volatility and Decline

The year 2022 witnessed significant turbulence for the euro, with analysts labeling it the “worst year in the euro’s history.” The EUR/USD exchange rate, starting at $1.137, plummeted below parity for the first time in two decades in July, reaching a yearly low of $0.960 on September 27th following the Nord Stream 1 pipeline’s indefinite closure. While a late-year recovery pushed the rate back to $1.07 by December, driven by the European Central Bank’s (ECB) 75 basis-point policy hike in October, the year was undeniably challenging for the European currency.

The global economic slowdown triggered by the pandemic and the Ukraine crisis had a disproportionately negative impact on Europe. Three primary factors contributed to the euro’s 2022 depreciation: Europe’s dependence on Russian energy and the subsequent economic fallout from the Ukraine invasion; the widening monetary policy gap between the Federal Reserve (Fed) and the ECB; and the US dollar’s “safe haven” status during periods of uncertainty.

Europe’s reliance on Russian gas resulted in significantly higher energy-driven inflation compared to other economies, particularly the US. Inflation in Europe soared to 10.6% in October, contrasting sharply with the 7.2% rate in the US. The Ukraine invasion further amplified uncertainty in the euro area, negatively impacting GDP and domestic demand.

The European Commission’s Autumn 2022 Economic Forecast predicted a recession for most EU member states in the final quarter of the year, citing high inflation, weak growth, and heightened uncertainty. The energy crisis, pushing the EU’s terms of trade to historic lows, coupled with the euro’s depreciation against the dollar, became unavoidable consequences of the Ukraine conflict. Some economists also argued that the Chinese economic slowdown disproportionately affected Europe compared to the US, further weakening the euro.

The ECB’s comparatively passive approach to inflation, in contrast to the Fed’s more aggressive interest rate hikes, also contributed to the euro’s decline. The Fed’s hawkish stance, signaled in June 2021 and implemented with rate increases starting in March 2022, attracted investors away from European assets and towards American ones. This divergence in monetary policy widened the interest rate differential between the two economies, accelerating the euro’s depreciation against the dollar by approximately 20% since the Fed’s initial announcement.

The US dollar’s perceived safe-haven status further exacerbated the euro’s weakness. During times of crisis, investors often flock to US assets, particularly Treasury bonds, driving up demand and strengthening the dollar. The Ukraine crisis reinforced this trend, with the dollar appreciating for three consecutive sessions following the Russian invasion.

While a weak currency can stimulate exports under normal circumstances, the 2022 scenario presented challenges for Europe. Supply chain disruptions and sanctions hindered European businesses from capitalizing on price competitiveness offered by the weaker euro. Furthermore, the rising cost of imports fueled inflationary pressures, compounding existing economic woes. Debate continues regarding the ECB’s role in managing the euro’s value and the potential benefits of international coordination to address global currency fluctuations.

Expert opinions on the primary cause of the euro’s decline varied, with a majority attributing it to monetary policy differences between the euro area and the US. Some pointed to the stability of the real exchange rate, suggesting that real factors or the war in Ukraine were not the primary drivers. Others emphasized the ECB’s less aggressive response to inflation and concerns about weak growth amid high debt levels. However, the euro’s partial recovery following the ECB’s policy tightening in the latter half of 2022 supports the argument for monetary policy divergence as the main culprit.

A significant majority of experts believed the ECB should prioritize its inflation stability mandate and not directly respond to exchange rate fluctuations. They argued that the exchange rate was functioning as expected, forcing European economies to adjust to higher energy import costs. The focus, they contended, should remain on addressing inflation and maintaining the ECB’s independence from political pressures, with exchange rate intervention only warranted if it directly impacted inflation or threatened financial stability. A minority advocated for intervention, either unilaterally or in coordination with other central banks, citing potential inflationary pressures and financial stability risks associated with a weak euro.