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Euro weakness predicted as Draghi’s cautious stance is expected to last

  • Warnings sounded over implications for economies and currencies as ECB continues with extremely cautious move towards stimulus exit door

European Central Bank (ECB) President Mario Draghi confirmed expectations on Tuesday in expressing more dovish noises about the path ahead for interest rate normalization while observers cautioned about the implications for the euro zone economy and financial markets.

While acknowledging the trading bloc's "strengthening and broadening recovery," Draghi warned that the exit path from the bank's stimulus programs was still being blocked by a measly inflation showing.

"We are still in a situation of continuing slack, and where a long period of subpar inflation translates into a slower return of inflation to our objective. Inflation dynamics are not yet durable and self-sustaining. So our monetary policy needs to be persistent," Draghi told an audience at the European Central Bank Forum in Sintra, Portugal on Tuesday.

Yet, the bank's tiptoe approach towards withdrawing ongoing stimulus in the form of asset purchases and towards moving interest rates back into positive territory is increasingly rankling among economists and policymakers within the broader region.

"It would be very welcome from my side if they normalized sooner rather than later," Mar Gudmundsson, governor of the Central Bank of Iceland, told CNBC speaking from Sintra on Tuesday.

Singing from the same hymnsheet, Volker Wieland, member of the German Council of Economic Experts, reiterated his call made when speaking to CNBC in April for the ECB to hike rates.

"I think they could do more, I think they should signal and explain how they can unwind this huge asset purchase program," he said, also speaking to CNBC from Sintra on Tuesday, adding that he did not expect much to happen in the short term.

"There may be hints here and there, more hawkish tones maybe in terms of assessing the economy, the recovery we observe in the euro area, but I don't expect at this point any major change in the ECB communication," he conceded, while pointing to some growing issues with the stimulus program.

Looking at the practicalities of asset purchases, Wieland warned that the vast quantities of government bonds being snapped up could soon cause problems with regards to regulatory limits in place – rules that some, such as potentially Bundesberg President Jens Weidmann, could be reluctant to see waived.

Turning to the currency effect, while Wieland acknowledged that the low exchange rate had certainly provided a boost to the economies, it was not ideal for some economies that exports were growing so rapidly.

"For Germany of course, it's not optimal, it's growing above potential. It's maybe overheating," said Wieland, the member of Chancellor Angela Merkel's so-called band of "Wise Men".

Yet given the expectation that Draghi will continue to edge towards normalization at a glacial pace, Kamal Sharma, G-10 FX Strategist, Bank of America Merrill Lynch, told CNBC on Tuesday that he is expecting the euro to encounter more near-term downside.

"Markets look to be under a bit of pressure. U.S. data is turning over, European data is turning over. Against that backdrop and Draghi continuing to push against some of the more hawkish expectations of the market, we suspect that the euro will edge back below $1.10 over the coming months or so," he predicted.

"The ECB is very concerned about one thing that we did see in 2011, where they reacted in some ways prematurely to the improvement in the European economy. I think they're keen to avoid the mistakes and are probably playing it ultra-cautious at the moment," he explained, highlighting the influence of lessons learnt since the financial crisis.

"Ultimately the ECB will need to keep rates accommodative despite the criticisms that are mounting from the Germans," Sharma concluded.

Michele Tantussi | Getty Images | Getty Images News

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