Purchasing Managers Index (PMI) for March showed a significant deterioration in the Eurozone. Having not really shown up in the data before, the shock from Covid-19 would be the biggest since the 2008-2009 crisis. Many countries will be affected and economic policy will need to continue to play its full role in ensuring that we come out of the crisis on a solid footing.
The ECB announced a new series of measures to counter the economic consequences of the Coronavirus pandemic. The Governing Council is seeking to maximize the impact of its actions by opting for targeted measures. It is paying special attention to the risk that monetary and financial conditions could tighten. Despite communication missteps, the ECB has expressed its determination and has called on governments to take concerted action.
Credit impulse in the euro zone stabilised in December 2019 (up 0.3%, as in November) against a background of a slight slowing of real GDP growth in the fourth quarter (1.0% from 1.2% in the third quarter). Outstanding bank lending to the private sector maintained its pace of growth in December (up 3.7% year-on-year). For the second month in a row, growth in lending to NFCs was less than that in lending to consumers. The slowdown in growth in lending to NFCs (where the year-on-year figure fell from 3.8% in October to 3.2% in December) was due mainly to lower investment spending (in France, Germany and most particularly Spain). This was in part offset by strong growth in consumer loans (from 3.5% to 3.7%)
Will the year 2020 be marked by a rebound in eurozone economic growth? More favourable signs seem to be emerging, although they have yet to show up clearly in hard data. In any case, eurozone growth is bound to remain low. In this environment, inflationary pressures will probably fall short of the central bank’s target. Beyond that, the ECB Governing Council will be tackling new issues in 2020. Christine Lagarde announced a strategic review for the Frankfurt-based monetary institution. On the agenda: cryptocurrencies, climate change, technological progress, and inequalities.
The ECB remains cautious in its assessment of the economic situation characterised by risks still tilted to the downside, although less than before thanks to the US-China trade deal. The message is slightly better on underlying inflation where some signs of a moderate increase are noted. Between now and year-end, the strategy review, which has now been launched, will grab a lot of attention, with markets wondering how it could influence monetary policy. The review is also important from the perspective of climate change: will monetary policy operations take it on board as a risk factor or will ambition even be higher?
The most recent economic data in the Eurozone send an encouraging signal. The economic situation remains subdued, and particularly in the manufacturing and export sector, but a start of stabilisation can be expected...
After picking up in October, the credit pulse of non-financial corporates (NFC) in the eurozone dipped again in November. Yet the decline in the private sector’s credit pulse was still very mild, bolstered by the remarkable stability of the credit pulse for households. Recent trends should extend into first-quarter 2020: the banks surveyed expect loan demand from NFC to continue to ease. Inversely, exceptionally low interest rates should continue to boost loan demand from households, mainly for home loans.
Danish monetary policy is closely linked to ECB policy so the recent statement of Denmark’s central bank governor that he expects interest rates to remain around current negative levels in the next five to ten years is not without importance for the eurozone. Forward guidance by ECB implies that policy will only be adjusted when justified by economic conditions. The inability to be clearer in terms of time frame illustrates the complexities of inflation dynamics. Past wage increases will gradually filter through in a pick-up in inflation although low inflation, well-anchored inflation expectations and intense competition in certain sectors may very well moderate this transmission. It thus seems clear that the current policy will remain in place for a considerable time
Eurozone GDP growth is causing concern, but the relative resilience of employment continues to surprise. This trend is nothing new. The negative impact on employment of previous crises has been fairly restrained. Despite considerable difficulties in the sector, manufacturing employment is holding up particularly well. The slowdown in productivity gains could, in the short term at least, help drive the growth in jobs. Slower growth in hours worked and low-skilled jobs: a possible labour hoarding phenomenon is under way in Eurozone companies.
The slowdown in economic activity in the Eurozone and inflation structurally below the target rate have raised the spectre of “Japanification”. This would mean effective growth running below potential, very low interest rates and negative inflation. In Japan, this combination of factors resulted from the bursting of the financial and real estate bubbles of the early 1990s. There is a range of factors that could cause “Japanification”. Faced with the challenges of an ageing population and slowing productivity gains, the Eurozone will need to focus its efforts on boosting its potential growth and its resilience to shocks. Short- and medium-term economic policy choices will therefore be crucial in limiting, as far as possible, the risk of “Japanification”.
The ECB’s monetary policy meeting account illustrates the dilemma it is facing: inflation is subdued and risks to growth are tilted to the downside, yet the financial stability implications of the very accommodative policy need to be closely monitored. These implications are covered in sobering detail in the ECB’s Financial Stability Review. A possible side effect of very low to negative interest rates is that borrowing and spending become more procyclical. Quantitative easing (QE), by modifying the risk structure of investment portfolios (less government bonds and more exposure to assets with a higher risk), will probably increase the sensitivity of portfolio returns to the business cycle.
While many observers have been worried since several months about the health of the manufacturing sector, the activity in services still shows resilience and keeps growing at a pretty decent pace. Nevertheless, the latest economic indicators send a less favourable signal. The Purchasing Managers Index (PMI) for the services sector indeed decreased in November to 51.5 (against 52.2 in October). This level is quite low regarding the historical average. The outlook for economic growth in the coming months, by and large, depends on the resilience of the labour market and the ability to create new jobs.
Automatic fiscal stabilisers help cushion the impact of economic shocks on GDP via changes in government revenues (because of progressive taxes) and expenditures (unemployment insurance). The limited remaining monetary policy leeway in the eurozone is fueling interest in the effectiveness of the automatic stabilisers. European Commission research confirms that, to some degree, automatic stabilisers iron out the impact of negative shocks on GDP. Whether that is enough is another matter. It warrants a debate on the role of discretionary fiscal policy in case of a recession.
The credit impulse has declined in September, moderately for households and much more noticeably for non-financial corporations (NFC). For the latter, the credit impulse has hit its lowest level since the beginning of the asset purchases programme by the ECB at the start of 2015. These movements contrast with the stability of GDP growth in the third quarter in the Eurozone (with a year-on-year rate of 1.2%, like in the second quarter). They almost exclusively involve loans with a maturity of less than one year, which is mainly related to destocking behaviour. For the fourth quarter of 2019, banks interrogated by the ECB anticipate a continued moderation of demand by NFCs and an intensification of demand for housing loans by households.
GDP growth in Q3 2019 has beaten expectations. The growth rate stabilised at +0.2% (q/q) compared to the previous quarter. Economic growth is stable in Spain (+0.4%), in France (+0.3%) and in Italy (+0.1%). For Germany, the data are not published yet. The activity in the manufacturing sector remains subdued while in October, the purchasing managers index (PMI) in the services sector is well below its long term average. Over the coming months, the risk of negative spillovers from manufacturing to services needs to be closely monitored. The evolution of the unemployment rate, which on a historical basis is still relatively low, will be a key factor in the short term.
At its September monetary policy meeting, the European Central Bank delivered a strong message. Through the broad mobilisation of its unconventional monetary policy tools, it aims to fulfil its mandate and reach its inflation target. At the press conference following the meeting, Mario Draghi seized the occasion to reiterate his call on certain eurozone governments to increase their fiscal support. The ECB is entering a long period in which it will have to remain mute, passing on the baton to the member states with comfortable fiscal leeway. This new round of monetary support is welcome considering the economic troubles facing the eurozone, although there are some doubts about its effectiveness.
Credit impulse slightly picked up in August 2019 for non-financial corporations (NFCs), while it was nearly unchanged for households. In spite of the slowdown in the euro area GDP in Q2 2019 (+1.1% yoy in 2019 Q2 vs +1,3% in Q1), exceptionally low lending rates have continued to support loans outstanding, which reached +3.4% year-on-year for households, and +4,3% for non-financial corporations.
In the eurozone, current public debt ratios are much higher than before the Great Recession. A proper assessment of the risk that this entails should also take into account other changes in the economic environment, and in particular, the decline in long-term sovereign rates. This trend has accentuated recently, with long term interest rates in several eurozone countries dropping below zero. But the decline has been at work for a long time and has already produced major effects. On the chart, each point represents a member state. The x axis shows the country’s debt ratio and the y axis the interest charge paid each year on its public debt
The ECB delivered a strong message. The eurozone monetary authorities announced the implementation of a new series of monetary easing measures that went beyond expectations. The Frankfurt-based central bank largely wielded its policy tools by strengthening forward guidance, lowering the deposit rate, easing long-term lending conditions for banks and reactivating net securities purchases. Although the effectiveness of such measures remains uncertain, the ECB’s proactive approach was welcomed. Aware that certain policies could have some perverse effects, the central bankers are now demanding that governments use fiscal policy to pick up the slack for quite some time to come.
Market expectations were elevated but the Governing Council did not disappoint. The comprehensive nature of the package, with the introduction of state-dependent forward guidance, take away the need to envisage additional measures in the foreseeable future. ECB watching has been narrowed to monitoring the gap between inflation and the ECB target. Given certain negative side effects of the current monetary mix, which are acknowledged by the Governing Council, fiscal policy, where leeway is available, is now requested to step up to the plate, so as to foster growth and speed up convergence of inflation to target. The policy baton has been passed.
The latest economic indicators still send a mixed signal. The months pass but nothing seems to change. While GDP growth is declining (+0.2% q/q in Q2 2019 after +0.4% in Q1), activity in manufacturing remains subdued and the Purchasing Managers Index (PMI) of this sector is well below its long-term average. Conversely, the services sector resists and the PMI is globally in line with expectations. In this environment, headline inflation remains pretty far from the 2% target, and surprised to the downside. The core component of the CPI keeps oscillating around only 1% (+0.9% in July).
Private consumption is the biggest component of eurozone GDP: 54% in 2018. It is also more resilient to shocks than GDP. This characteristic is particularly important when activity is slowing. A key driver of household spending is real disposable income, which in turn very much depends on employment growth (wages also play a role obviously). Employment growth has been declining since the second half of 2017, which more or less corresponds to the peak of the eurozone growth. Judging by the employment component of the IHS Markit composite PMI, which is highly correlated with growth in employment, growth of the latter should continue to go down and hence weigh on consumer spending growth.
The Governing Council has tasked Eurosystem committees to examine its monetary policy options. Given the insistence on its determination to act, Thursday’s meeting outcome was basically a pre-announcement of easing in September. Being aware of the importance of maintaining the ECB’s inflation targeting credibility, Mario Draghi was very explicit in expressing his dissatisfaction with current inflation and its outlook, adding that a highly accomodative monetary policy is here to stay for a long period of time.
Despite an increase in June, core inflation in the eurozone remains stubbornly low. The dispersion is significant between countries and between the expenditure components of the price index. Inflation is low for clothing and footwear, furnishings and household equipment, transport and communications. It is higher for housing-related items, restaurants and hotels, miscellaneous goods and services and recreation and culture Non-energy industrial goods price inflation is very low. Should this continue, it would imply that the acceleration of inflation which is the ECB is pursuing by renewed policy easing, has to come from services. However, research shows that it takes more time for services prices to respond to monetary policy and economic activity. Monetary accomodation is here to stay
Since the 3rd quarter of 2017, a year of strong economic growth, non-financial corporations’ margin rate* in the euro area has fallen steadily. In the 1st quarter of 2019 they hit their lowest point since early 2014, at less than 40% of value added. This trend echoes the increase in unit labour costs, which has resulted both from increasing wage growth and slowing labour productivity. Forming part of a wider pattern of slowing growth in the euro area over a number of quarters and with high level of uncertainty, this narrowing of margins reflects the difficulties companies are experiencing in passing higher costs through to prices. Underlying inflation remains particularly inert. If it continues, this narrowing of margins could affect trends in investment