By Mike Dolan

LONDON (Reuters) – The European Central Bank (ECB) may quietly support a weaker euro exchange rate, given the economic challenges ahead.

The euro is possibly too strong considering the anticipated subdued growth and significant trade risks facing the zone next year. This depreciation might even prompt the ECB to consider at least one deeper half-percentage-point interest rate cut during upcoming meetings.

The ECB's final meeting of 2024 is next Thursday, where economists largely anticipate another 25-basis-point rate cut, marking the fourth cut this year.

The prevailing thought is that the ECB has mostly tamed inflation and can revert to a neutral policy rate—around 2%—if inflation aligns with targets. At this point, the ECB would ideally wait for a cyclical recovery while remaining cautious of evolving political and trade risks into 2025.

During a recent European parliament hearing, ECB President Christine Lagarde illustrated this outlook, amidst discussions among policymakers regarding potentially more aggressive rate cuts to counteract a sluggish German-led economy.

If gradualists prevail, this implies a quarter-percentage-point cut at each meeting until mid-2025, aiming to realign the current 3.25% deposit rate to estimated neutrality. Thus, the expected easing of 125 basis points by the ECB stands in contrast to market pricing, which speculates half that from the U.S. Federal Reserve.

Many strategists, however, suggest that this Transatlantic divergence is already reflected in the euro/dollar exchange rate, which has fallen approximately 5% in two months. The euro's indifferent response to political events in Paris reinforces this.

Morgan Stanley raised concerns about potential unintended consequences of the ECB’s cautious approach surrounding next week's rate cut, warning that any indication of unchanged policies could be viewed as a hawkish surprise.

AVOIDING A EURO REBOUND

The ECB has valid reasons to prevent a euro rebound currently, especially since its trade-weighted index remains significantly higher than indicated by its decline against the dollar.

Despite the euro being just 5% shy of parity with the dollar (last seen post-Russia's invasion of Ukraine in 2022), the ECB's nominal euro exchange rate index against major trading partners sits only 1% below the all-time highs recorded in September.

While the inflation-adjusted real effective exchange rate index has declined in recent months, it stands relatively unchanged from a decade ago, despite recent economic shocks.

With the eurozone potentially facing 10%-20% U.S. tariff impacts from President-elect Donald Trump’s administration, a trade dispute with China, and a downturn in Germany (the region's weakest link), currency depreciation could be beneficial.

Even as inflationary pressures from wage growth remain concerning for the ECB, a weaker currency might restore some competitive advantage in today's global trade wars.

With euro consumer price inflation hovering near targets and producer price deflation exceeding 3%, the ECB has considerable room for significant easing. Although trade tariffs might influence prices, ECB Chief Economist Philip Lane emphasizes that the adverse impacts of trade wars could take precedence over temporary price level increases.

The only uncertainty centers on whether a substantial euro decline through dollar parity would disrupt regional confidence, particularly amid shaky domestic politics in Germany and France.

However, weakness in the currency isn't currently a problem for the eurozone economy; arguably, the opposite holds true.

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

*(by Mike Dolan X: @reutersMikeD; Editing by Paul Simao)