Members of the ECB Shadow Council discuss the impact of the slowing US economy and of financial turbulenzes on the economy of the euro area. Latest comment by: Veronique Riches-Flores
The euro area entered a period of marked slowdown especially in the services area. The PMI index –which has proved to be a very good indicator of activity trend so far- is suggesting an exceptional turn around in the overall tertiary sector. National surveys providing more details show a profound adjustment in financial activities and housing and the beginning of a serious slowdown in services to corporate industry and the retail sector. Eventually all the services activity seem to be significantly affected by the financial crisis, tight lending conditions and the weakening private consumption resulting from higher commodity prices. This suggests a significant easing in employment trend for coming quarters. The manufacturing sector seems less affected so far and still running at relatively high level although on a significant slower trend than some months ago. The slowdown is in place, however, and has every chance to gather momentum in the wake of weakening global environment. Overall, the euro zone economic outlook has deteriorated rapidly. Growth that was seen in the area of potential early summer (2.3%) is now very likely to fall below 1.5% this year according to recent indicators- even if the US economy avoids recession.
Inflation is an issue. Consumer expectations on prices have deteriorated substantially. Wage negotiations in Germany are likely to end on a relatively strong note. Social pressures in France are also likely to pave the way for higher wage growth although certainly less than in Germany. This expected trend in wages does not really weigh on inflation outlook however, this latter being much more dependent from cyclical factors that are going in the direction of closing the door for spiraling inflation risk.
The eurocoin indicator today showed that European growth if likely below trend. The business cycle has peaked, consumption has never really taken off, and the external environment is weakening. In addition, the banking sector is tightening lending standards and stock markets have declined 12 percent since the beginning of the year. Clearly, financial conditions have tightened while growth is slowing. If I thought that interest rates were too low before this happened then I could argue for rates on hold, but I think that rates at 4 were already on the high side. Inflation is right now above 2 percent but monetary policy has to be forward looking and, with expectations firmly anchored, there is room to ease policy if needed. And it is better to ease policy in a preemptive manner.
The outlook for inflation has not really changed over the last months. I would expect inflation to remain above 2 % well into the year. The signs on economy activity are mixed with weaker surveys, but stronger credit growth. Credit growth is in general only a lagging indicator of the cycle, but given that the current problems started in the financial sector one might expect that this time credit might lead the cycle. It is also possible that some of the additional credit that now appears in the ECB statistics might be due to the fact that credits which were previously securitized only now appear on banks balance sheets. But since the scale of securitization has always been limited in Europe it is likely that the most recent ECB statistics reflect genuinely the absence of a credit crunch.
Anybody who claims that the continuing deterioration in the US housing sector constitutes ‘news’ is deluding himself: It is clear that US house prices were at their peak (2006/7) around 20-30 % overvalued. In past cycles an overvaluation was usually followed by an undershooting. Hence a correction of US house prices of around 20-30 seems the minimum to expect. As this process always takes several years it is disingenuous to assert that the discovery that house prices are still falling barely six months after the start of the crisis constitutes ‘news’.
The ongoing weakness in the US housing sector thus does not constitute any ‘news’. It can be expected to go on for several years. The only real news is the emerging consensus in the US that during periods of asset price inflation monetary policy should target consumer prices whereas asset prices justify large cuts when they are falling. Hence my overall conclusion: don't panic!
Printing money is not the solution: Too much credit and money caused the crisis, pumping even more credit and money into the economies won't solve the crisis. The outcome of US monetary seems to be pretty ugly: debasing the Greenback through inflation. There is no point for the euro area to follow the US. The ECB should gear its policy towards reigning in liquidity creation - especially given that money supply growth suggest annual CPI inflation to move towards a range of between 3 to 5% in the years to come.
The euro area entered the new year at a pace of growth below trend, probably around 1.2 percent in annualised terms. The RBS/NTC flash PMI for January showed little forward looking momentum, raising the risk that the euro area could be at a standstill by the middle of the year. The slowdown seems to be the result of three shocks: weaker foreign demand, weaker real disposable income because of higher inflation, and to a lesser extent the credit turmoil. The impact of the credit turmoil seems to be concentrated on financial activity at this stage. Indeed, the impact on the overall economy looks somewhat more limited than I had initially feared, both in terms of borrowing costs (commercial lending rates on short term loans increased by only half the increase in libor rates between August and November). Similarly, lending growth to corporates continues unabated. Business confidence in some euro area countries has also remained surprisingly resilient a possible hint that corporates are not suffering from difficulties to access financing. However, this does not imply that the impact will not materialise. In fact, the ECB lending survey suggests the contrary.
Overall, weaker external demand from both Asia and the US, subdued real income growth and the potential upcoming negative impact from tighter credit conditions suggest that monetary policy should stand ready to counteract these negative shocks. An easing in the policy rate should be considerd in the months ahead should economic conditions continue deteriorating. An early cut could be considered should stock markets enter a vicious downward spiral.
I do not think that the ECB should cut rates at the next meeting, but I think that it should abandon its tightening bias. The slowdown in the US, which according to the Fed is steep, will affect the rest of the world in general and the euro area in particular. The related relief in inflationary pressures may become clear only after some delay - and therefore after some short-term upward pressures are visible - but the potential drag on inflation is probably significant. The ECB's concerns about second-round effects are legitimate but it should address them by being open about its concerns on growth and continue to encourage wage-setters to be forward looking.
The Eurozone real economy has held up better than I expected a couple of months ago. External inflationary pressures are likely to abate, as the slowdown of the global economy lowers real oil and gas prices, but underlying inflation is well above target and it will take a period of below-capacity growth to get it back to target.
The Fed has lost the plot completely and is giving pre-emptive decision making a bad name. I propose that they stop pussy-footing around and instead of merely cutting rates to support the stock market, engage in open market purchases of equity directly. Why not?
There are clear signs that economic growth in the euro area is slowing. Most forecasts signal also a slowing of inflation in the course of the next six months. Given the long time lags of monetary policy the ECB should abandon the remaining tightening bias at the coming meeting and should start preparing markets that the next move might be a reduction of interest rates. On the basis of the current data set I would propose a first cut of 25 bp`s in April followed by a second one in May or June by another 25 bp`s. All experience has shown that the dose of interest rate cuts can be smaller when applied in the early phase of an economic downswing than if waiting with these measures too long.
GDP growth probably moderated to a below-trend pace of 0.3%-0.4% in 4Q 07 and surveys suggest that a similar pace of expansion is continuing early this year. As expected, exports to emerging markets continue to grow rapidly, limiting the slowdown in overall sales abroad, and explaining the relative resilience of business confidence in manufacturing, especially in Germany. By contrast, domestic demand (particularly consumer spending) was very sluggish late last year. While the food-induced inflation spike may have exacerbated the downtrend, consumer spending was moderating before, and the sharp tightening of lending standards plus less dynamic job growth are undermining the hope of a rebound this year. Because of this, risks to growth are increasingly on the downside, even after the downward revision of my baseline GDP growth forecast for 2008 to 1½%-1¾%, and to just about 2% (at the lower end of the estimated range of potential) for 2009.
In my view, the medium-term inflation outlook remains benign, despite the official concerns about a wage acceleration. The current inflation spike remains contained to a narrow list of components and the strength of the euro is limiting import prices generally. More importantly, labor market conditions are turning less favorable, implying a reduced risk that final pay agreement show a significant pick-up. At the same time, the underlying inflation trend is probably hovering around 1½%-1¾%, once some special factors (extraordinary indirect tax hikes, German education fees, etc.) ate excluded; that is, it is not low enough to allow an aggressive policy easing either unless GDP growth falls more dramatically. The likely cyclical productivity slowdown will prompt a (modest) pick-up in unit labor costs even if, as I expect, wage growth remains contained. All in all, it probably pays to continue to put public pressure on wage negotiators at present.
Declining stock prices, cooling real estate markets, tighter credit conditions, slower foreign demand growth, and a higher exchange rate are in my view likely to push GDP growth clearly below potential this year. Business surveys indeed confirm that the cyclical peak is behind us and that the economy is cooling. In this environment I expect inflation to ease from recent highs. Some observers point to the danger of "stagflation" - persistently high inflation coupled with low growth - and therefore caution against rate cuts. I don't agree with this diagnosis. The explanation of the recent run-up of inflation seems to me to be much simpler: it's a late cycle phenomenon.Usually inflation peaks after growth and comes still down when growth already goes up again. Hence, a foward looking monetary policy should look through the present elevated level of inflation and focus on the future downward pressures created by sub-potential growth. Also, when GDP growth slows elevated money and credit growth pose no direct danger for inflation. Credit may be cut and liquidity flow into longer-term investments. In sum, I believe the longer the ECB waits in cutting interest rates the more pronounced and longer the downturn is likely to be.
The sharp ongoing tightening in credit conditions, as clearly shown in the ECB's bank lending survey, suggests that monetary policy will need to be eased in order to lower the risk that unemployment will begin to rise, at a time when the PMI surveys are signalling sub-trend real GDP growth. I have been surprised by how much business and credit conditions have weakened, and we have moved into 2008 without significant signs of improvement. At Barclays Capital, our euro area GDP projection for 08 is lowered to 1.6pc from 1.8pc, and our inflation projections llowered, from 2.5 to 2.4pc for 08, and from 1.8 to 1.7pc for 09.
In my view monetary and credit conditions, taking into account the exchange rate as well as short term interest rates, were already slightly restrictive, before financial market developments of recent months. However, for a central bank to begin to reverse a tightening cycle requires extra confidence.. Hence, before recommending easing I would like to see the January inflation data first to confirm my view that underlying inflation has been still under control at the turn of the year. If that does prove to be the case, which I expect, then I shall probably favour advocating a 25bp rate cut at our end-February Shadow Council meeting.
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