Something interesting happened yesterday. The Euro strengthened after Draghi hinted at easier policy.
Usually when policy eases, a currency will weaken. However, the euro is so fragile now that easier money lifts the currency’s survival odds and outweighs the normally dominant effect of a greater expected money supply. I had wondered what would happen to the EUR/USD rate if, say, the ECB announced a major unsterilized bout of QE, we may have an answer. This may be a rare instance where money printing—to a point—strengthens a currency.
The graph above ties in with Sumner’s new post regarding the ‘irrelevance’ of monetary policy in driving financial markets. Care to guess when Draghi spoke?
This is a good example of why macro econometric models aren’t terrible helpful when one really needs them. What model, be it a (G)VAR or some sort of New/Old Keynesian abomination could yield this sort of counterintuitive result? I wouldn’t know where to begin…
It is also possible that the market took Draghi’s comments not as a sign of easier money (willing to tolerate higher aggregate spending and inflation), but instead that the ECB is willing to backstop the Spanish bond market only if it can sterilize the purchases. I think this is less likely, but would welcome being proven wrong.
Update: Lars Christensen kindly sheds light on the dynamics at work here.