BERLIN European Central Bank president Mario Draghi pledged Thursday to keep a close eye on the economic impact of the rise of the euro, a move that surprised many in the markets and sent Europe's single currency skidding lower.
Draghi said the recent appreciation of the euro was a sign of rising confidence in the region but he acknowledged that it could weaken economic growth.
Over recent months, the euro has risen from around the $1.20 mark to trade over $1.35 even though a number of the 17 European Union countries have sunk back into recession.
A rising exchange rate could have a major impact on the eurozone economy. It could raise the price of exports, unappetizing news for many of the region's hard-pressed businesses. That prospect of lower activity could also weigh on prices - as would the lower import costs that the high euro would likely engender.
Several European leaders, notably French President Francois Hollande, have already started to voice their concern. And without explicitly addressing those fears, Draghi indicated there could be a policy response.
"The exchange rate is not a policy target but it is important for growth and price stability," Draghi said in a press briefing after the bank kept its main interest rate unchanged at the record low of 0.75 percent.
"We will want to see if the appreciation will alter our assessment as far as price stability is concerned," he added. "We will closely monitor money market developments."
The euro took a nosedive after those remarks, tumbling from around $1.3550 to just above $1.34.
"Draghi's biggest challenge was to show his magic skills of verbal interventions and to talk down the euro exchange rate," said Carsten Brzeski, senior economist at ING. "He succeeded."
Though the euro has clearly benefited from the region's easing debt crisis, analysts also say a more aggressive Japanese economic policy designed to revitalize that country's moribund economy has indirectly pushed up the value of the single European currency.
The yen has fallen sharply as the Bank of Japan has been given a new 2 percent inflation target that may well see more yen created. Investors have concluded that the yen will continue to fall. The reverse of that is that other currencies will continue to rise, including the euro.
Bundesbank President Jens Wiedmann warned last month about the politicization of the Bank of Japan and of possible unintended consequences to the international monetary system.
"Until now the international monetary system got through the crisis without competitive devaluations and I hope very much it stays that way," he said.
The idea of a currency war raises the specter of the 1930s when countries around the world pursued "tit-for-tat" policies with their exchange rates in order to get an edge. However, the outcome was to decimate global trade, accentuate the depression and sow the seeds for World War II.
Though Draghi sought to downplay talk of a currency war and assigned most of the recent movements in the foreign exchange markets to changes in countries' economic policies, his comments were different to those of his predecessor, Jean-Claude Trichet.
The fall in the value of the euro following Draghi's remarks will likely be greeted by France's Hollande, who on Tuesday suggested that the ECB use its powers to bring the value of the euro down.
"The euro should not fluctuate according to the mood of the markets," he said at the European Parliament. "A monetary zone must have an exchange rate policy. If not, it will be subjected to an exchange rate that does not reflect the real state of the economy."
If inflation, which Draghi said is expected to fall below 2 percent in the months to come, drops by more than anticipated, then it could pave the way for interest rate reductions - one of the main factors that investors assess when deciding which currency to buy.
"Adding the stronger euro to the downside risks for price stability opened the door for new policy action if the euro strengthens further and starts to weigh on the growth and inflation projections," said ING's Brzeski.
Draghi's remarks on the euro came after a cautiously upbeat assessment of the prospects of the eurozone economy. As well as predicting that inflation will likely fall below the target in the coming months, Draghi said economic growth would likely resume thanks to an "accommodative" monetary policy, an improvement in financial market conditions and a pick-up in global demand.
Though Draghi said risks to inflation are "broadly balanced," he noted that risks to growth are "to the downside."