The mystery of the Eurozone slowdown
The global economy entered 2018 apparently locked in a period of strong and synchronized growth, with all of the major geographical blocs breaking free of the constraints that had dogged previous growth spurts since 2010. While that may still be the case, optimism has been dented by a sudden and rather sharp downturn in activity in the Eurozone, a region that had until recently been leading the global expansion.
This started in February and has now become an event of sufficient importance to warrant further investigation, since the causes of such a large setback to growth in a large part of the global economy are not entirely clear.
Last year, the Eurozone surprised economic forecasters in entirely the opposite direction. After a long period in which the ECB had failed to ease monetary conditions in the face of the zero lower bound on interest rates, unconventional monetary easing finally gained traction in 2017. This, combined with global trade expansion, the end of EU fiscal tightening and rising business confidence led to a catch up in spending on capital equipment, housing and consumer durables that drove the sudden rebound in European growth.
According to the Fulcrum activity nowcasts, which identified the surge in growth very early last year, the Eurozone was still growing at a rate of 3.5 percent late in 2017. Each of the largest economies in the bloc was doing well: Germany 4 percent, France 3 percent, Italy 2 percent and Spain 3.5 percent. Economic forecasters and the central bank had become confident that this strong recovery phase would persist throughout 2018. But that has not happened so far.
The latest nowcast results for the Eurozone suggest that activity growth has dropped to only 1.2 percent in early April, with each of the major economies experiencing a sharp decline in growth. Even Germany, which was relatively immune from previous European downturns has recorded a very sharp dip, with growth now down to only around 1 percent.
Overall, the risks to the euro area growth outlook were assessed to have remained broadly balanced. Downside risks continued to relate primarily to global factors, including rising protectionism.
This slowdown has come as a definite surprise to the ECB forecasters, who expected the growth rate to slow only slightly in the course of 2018. The latest ECB Economic Bulletin in March suggested that the annualized GDP growth rate in the first and second quarters of 2018 would be around 2.5 percent and the March Governing Council minutes expressed a high degree of confidence that the forces that had caused the upswing in 2017 would prove long lasting. They argued that the risks around their optimistic growth forecasts were balanced, although they did express some concern about the potential for a negative impact from global trade conflicts.
Why has this downside surprise happened? The fact that activity growth in the US and China have not experienced the same degree of slowdown as the Eurozone suggests that the global economic expansion probably remains broadly intact. Nor has there been any major slowdown in export orders or sentiment that might indicate that the rising euro is mainly to blame for the slowdown.
Some observers think that the bad news stems from temporary special factors, such as extreme weather and the influenza outbreak. Others suggest that the outcome of coalition talks in Germany have dented business confidence.
But I have not seen any really firm evidence in favor of these views. The breadth of the slowdown across Europe, and the fact that survey data and hard economic data have both fallen, suggests that there might be something more important going on. Ben Breitholz of Bianco Research has kindly provided us with the following graph:
Up to now, there has been no compelling fundamental narrative that would account for the Eurozone slowdown. But there are two possible candidates.
The first is that the effects of the ECBs belated shift to quantitative easing in January 2015 have now started to wane. Although this policy change did not involve a large drop in real policy rates, it did succeed in reducing bank lending rates and bond yields throughout the Eurozone, and also restored the provision of bank credit in the troubled economies. It is conceivable that this impetus moved past its maximum effect on the growth rate in 2017. Fulcrum economists estimate that the monetary impetus was adding about 1 percentage point to Eurozone activity growth in mid-2017, and this has now entirely disappeared. Furthermore, forward short rates in the Eurozone began to rise last year as the markets anticipated future ECB normalization of monetary policy.
A second possible explanation is that the growth rate during 2017 was simply too far above the long run growth rate for this situation to be sustainable indefinitely. Supply constraints may have started to bite. The Fulcrum nowcast models had anticipated a gradual return to trend occurring in 2018, and they now seem to interpret the data as being consistent with a much sharper return to trend than was previously expected.
There is probably some truth in the weatherrelated hypothesis, in which case some improvement in growth is likely in the next couple of months. But if either of the two more fundamental explanations — waning monetary policy effects or supply side constraints — proves valid, then the growth rate in the Eurozone will disappoint both market and ECB projections this year. Already, we have seen consensus growth projections stabilizing, after a prolonged period of continuous upgrades.
The ECB will probably give the economy the benefit of the doubt at the next Governing Council meeting on 26 April. It has been very confident that a strong, above trend upswing will continue this year, and will be reluctant to change their assessment based on a couple of months’ data.
The ECB has clearly been intending to end its program of asset purchases well before the end of 2018, but a combination of fading growth and stable inflation could make it increasingly difficult for it to achieve this objective.