LONDON: The European Central Bank's decision to leave monetary policy unchanged, and its seemingly relaxed attitude to the impact of a strong euro on deflation, may have put the single currency on course to reach its highest levels in nearly three years.
If the euro zone economy shows more signs of recovery in coming months and US data remains patchy, the euro could rise towards $1.45 - a level seen in mid-2011 - before the ECB expresses discomfort with the exchange rate.
ECB President Mario Draghi suggested at a news conference after last Thursday's Governing Council meeting that economic recovery in the euro zone was on track and did not require a shift in monetary policy.
His comments sent the euro to a 2 1/2 year high of $1.3915 and analysts expect the currency to rise initially to $1.40 in coming weeks.
Although one ECB policymaker, Christian Noyer, expressed some unhappiness about the euro on Monday, investors are likely to test the ECB's resolve to keep monetary policy unchanged by adding to long bets on the euro.
"We would not want to go short on the euro and do not rule out a move to $1.40 in the near term given the ECB's stance," said Yujiro Gato, G10 currency strategist at Nomura in London. "But only a move up towards $1.45 would change the ECB's (stance)."
The euro has gained 15 percent against the dollar from 2012 lows as the threat of a euro zone break-up waned and the region's economy has started to pull out of its slump.
However, while a sharply rising currency adds to the risk of deflation in the euro zone, as it lowers prices of imported goods, Draghi said on Thursday that the currency's rise since 2012 lows had pushed down inflation by only 0.4 percentage points.
That has led some analysts to believe the central bank could tolerate the euro strengthening by another 5 percent - to around $1.45 - at which point it would probably be forced to take action to ease policy to boost prices.
"It appears the FX market found Draghi's comments more hawkish than the rates markets did," said Anthony O'Brien, an interest rate strategist at Morgan Stanley.
Draghi's "rule of thumb" comments that "each 10 percent permanent effective exchange rate appreciation lowers inflation by around 40 to 50 basis points," could give the euro a 3-5 percent lift, he said. After that, the ECB would become concerned about the euro's impact on inflation and consider cutting interest rates.
A cut in the deposit rate, now at zero, into negative territory, would have the biggest impact on the euro, analysts say.
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