COLUMN-ECB can still frustrate euro surge with 'contingency cut': Mike Dolan

By Mike Dolan

LONDON, Sept 22 (Reuters) - Financial markets think the European Central Bank has found its "happy place" with a policy rate of 2%. An outsize surge in the euro might change that, which means it probably has another cut in its back pocket just in case.

The threat of an ECB "contingency cut" could slow further dollar losses in arguably the world's most pivotal exchange rate even as the Federal Reserve resumes easing, thwarting an overwhelming investor consensus that the dollar will fall even further from its recent four-year low against the euro.

It may well end up being a cat-and-mouse game over the months ahead.

After this month's ECB meeting, interest rate markets seem to conclude that the ECB is done easing in this cycle and will thus not seek to fine-tune rates much more from here.

Euro zone inflation is at 2%, ECB policy rates are at 2% and long-term inflation expectations EUIL5YF5Y=R are within a whisker of 2%, too. With broad agreement that the euro zone economy's "neutral" real rate - the inflation-adjusted rate neither dragging down nor spurring activity or inflation - is still zero, then all seems where it should be.

And yet ECB doves continue to fret about the risk of further disinflationary forces that could see inflation durably undershooting the central bank's 2% target, with the ECB's own inflation forecasts for next year and 2027 below that goal.

Multiple crosswinds are at play, as ever.

When exactly will Germany's giant fiscal boost kick in? How will disruptive U.S. trade policies pan out? What will happen to energy prices amid uncertain geopolitics to Europe's east? Can France dodge a fiscal crisis?

But the most obvious deflationary risk ahead is that the euro will soar as the Fed drops interest rates, perhaps dramatically so if political pressure on the U.S. central bank goes up a gear after Chair Jerome Powell steps down in May.

Even ECB boss Christine Lagarde's statement nodded to this last week by saying further euro gains could pull ECB inflation forecasts down even further.

TO COO OR NOT TO COO?

Late last week, outgoing Bank of Portugal chief Mario Centeno - long a vocal dove on the ECB council - said he believed the next move in interest rates would be down, under the assumption that inflation was heading back below 2%, something the ECB could not tolerate for too long.

Might a euro surge shift that dial sooner rather than later?

"If the euro continues to strengthen, it would add to the downside risks to inflation and GDP," Centeno told Bloomberg. "A rapid appreciation of the euro from its current value has the potential to bring difficulties in the short term. In these circumstances policy must react. That's why remaining agile is important."

To be fair, Centeno's term at the ECB is now up, and his nominated successor Alvaro Santos Pereira claims he is "certainly" not a dove.

But like all ECB members, he says he's committed to the 2% inflation target. And that's a symmetric goal after all.

Other ECB members have recently played down the risk of an inflation undershoot and the impact of the dollar exchange rate alone in that equation.

ECB Vice-President Luis de Guindos last Thursday said the council gave a lot of attention to the euro's nominal effective exchange rate rather than just its level against the dollar.

But this year's developments offer little comfort on that score.

The euro's effective exchange rate index against 41 trading partners is at an all-time high, up 7% since February and up 27% over the past decade. The real effective exchange rate is at its highest in 11 years and up 18% over the past 10 years.

So even though the euro gains of 13% against the dollar this year dominate market chatter, the euro has also gained 10% against China's yuan and 6-7% against both Japan's yen and Britain's pound.

DISTURBING THE 'HAPPY PLACE'

The ECB may want to embrace a stronger euro for other reasons, but a robust currency could squeeze trade and inflation at a tricky time, not least if China seeks to re-route exports to Europe due to its bilateral tariff standoff with Washington.

What's more, the dollar's fall earlier in the year came despite widening Transatlantic interest rate differentials in favour of the U.S.. Now it's trading more in line with those spreads just as Fed rates are tumbling.

Mark Dowding, fixed income chief investment officer for RBC BlueBay Asset Management, reckons he's inclined to revise down euro zone inflation forecasts for next year and is more constructive on German bunds despite rising debt supply, with fiscal deployment seemingly quite slow.

"A stronger euro can act as a deflationary force, especially as euro zone tariffs have been declining, not rising, as is the case across the Atlantic," Dowding wrote.

The exchange rate is not the whole story, of course, and the ECB is always at pains to say it's not targeting the currency per se. But big euro moves could yet disturb the central bank's "happy place".

The opinions expressed here are those of the author, a columnist for Reuters

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