Why the euro-dollar parity is important

In a year that has seen many economic fireworks go off - exceptionally high inflation, aggressive rate hikes, contracting economies - it is tough for yet another one to stand out. Yet, recently it did. 

The euro has now depreciated against the US dollar enough that each euro equals a dollar, also known as the euro-dollar parity. It could fall even further. 

Why is it important? 

This is the first time it has happened in almost 20 years, which is essentially the entire time period since the euro was first introduced. This means that the euro is the weakest it has ever been. Which in turn has a host of implications for investments and, of course, the economy. 

The good news

For EU investors who have put in money in the US financial markets, returns just got bigger. This is probably a positive even for investors elsewhere, who hold euro denominated international financial assets. And going by forecasts of an even weaker euro, things for this segment can look even sweeter going forward. 

Exporters in the EU have also become more competitive. How China used a weak currency to become the factory for the world is history. There can be significant power in a falling exchange rate to boost the economy, particularly right now. 

The bad news

Which brings us to inflation, which is routinely rising to new multi-decade highs these days, in many big economies. It has sparked off fears of a recession, though the actual numbers are yet to corroborate that. A recession, technically speaking, is two quarters of a shrinking economy. 

But inflation can, and in fact is, slowing down the economy. A weak exchange rate can accelerate this process. According to an ECB study, a 1% decline in the exchange rate increases inflation by 0.1%. Inflation rises with a weak exchange rate because imports become costly, leading to what's called 'imported inflation'. In the past year, the euro has dropped by almost 17% against the dollar. You do the maths. 

Also, if costs rise for producers in the EU, chances are that they would pass them on to consumers. Around half of the UK's imports still come from the EU, potentially impacting its economy too. 

What happens next?

In other words, the euro-dollar parity is everyone's problem. How it plays out depends on policies. A steadily weakening currency can be an opportunity for an export push, which over time can be great for the economy. 

But in the short-term more central bank action is required to stave-off inflation and manage exchange rate weakness. It might have taken its time, but the European Central Bank has joined in with the rest on rate hikes, raising policy rates by 0.5 percentage points. 

How the story evolves remains to be seen. But it is one to look out for.