The mys­tery of the Eu­ro­zone slow­down

Tehran Times - - ECONOMY - By Gavyn Davies

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.

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