Eurozone: Planning an exit
House View: Q2 2017
- The four-year recovery should continue in 2017, despite political hurdles
- Headline inflation back at target; core still stubbornly low
- ECB in stimulus mode for now, but will be considering exit options
Could 2017 finally be the year that growth in the Eurozone surprises on the upside? The year has begun with a mood of optimism that, despite well-documented political hurdles this year, the cyclical revival that is already four years old and reasonably well-established, could strengthen this year. Although in a region of 19 countries there will inevitably be some areas of economic frailty at any one time, the feel at the start of 2017 is more upbeat than for many years. However, the consensus growth forecast is a relatively modest 1.6% (and 1.5% in 2018). This reflects both political event risk and the fact that the Eurozone has been a serial underachiever on growth since its inception in 2000. GDP has risen by a paltry 1.2% a year on average since then (Figure 1), so it is understandable there is considerable scepticism that the region is suddenly on the launchpad heading for booming growth. There are known headwinds in the form of ageing/demographics and the unhurried pace of structural reform that impact the potential pace of growth. And in the background there are still many rumblings about the glacial rate of progress towards closer integration.
Perhaps some wish for too much. The Eurozone is not a fast-growth region. The trend pace is only about 1% - perhaps even lower – so any GDP increase higher than that should be welcomed for now while there is spare capacity in the area. Estimates vary, but there is still ample room for non-inflationary growth in most of the major countries according to the OECD (Figure 2). The exception is Germany. But even there, the absence of any major inflationary threat (at least so far) is evidence that perhaps structural reforms there have improved the growth/ inflation trade-off. Germany would doubtless argue that other nations should follow this lead more determinedly. Once the Eurozone output gap closes – and that looks possible by the end of this year or early in 2018 – growth will need to slow back to trend to prevent any build up of inflationary pressures.
Although headline inflation has risen back to target, the core rate remains stubbornly low at just 0.9% in February. The ECB expects the two to converge over the next few years, but their forecasts have not always been accurate (Figure 3). Recently, they have rightly stressed that underlying inflation has to rise before they can be comfortable withdrawing the extreme policy stimulus that has prevailed for several years. But they are also right to be considering their exit strategy and sensible to be cautious about advertising such thinking – they have no desire to risk a repeat of the US 2013 “taper tantrum”. Nevertheless, the very fact that the end is in sight is a long-awaited sign that things are really getting better and that the notion of a return to some form of normality is no longer farfetched. And growth should be improving: monetary policy cannot really be any looser and with much less attention being played these days to the need for fiscal consolidation, the policy backdrop could hardly be any more conducive to better growth outcomes. Moreover, the cyclical revival will provide an environment in which it is easier to undertake reforms that will help over the longer-term. The Eurozone has not always taken advantage of such episodes.
One of the more encouraging aspects of the recent revival is that growth has been underpinned by better domestic demand rather than the more traditional driver of net exports (Figure 4). Less promisingly, it seems to have slowed a little in recent months. We expect another increase in GDP of around 1.7% in 2017 (Figure 5). Whatever the exact growth outcome this year, the European recovery looks set to continue. And anything above 1% will allow unemployment to fall further, boosting confidence and adding to the mounting belief that the Eurozone is not destined to struggle and stagnate endlessly. This being Europe, it could yet turn sour, but for now those strong sentiment readings are extremely valuable as they can become self-fulfilling, persuading both businesses and households to borrow and spend. Low interest rates have, of course, helped as well. The muchwatched monthly PMI surveys have gone from strength to strength, with the latest readings consistent with faster growth than seen in 2016. National business surveys paint a similarly upbeat picture.
Meanwhile, consumer confidence levels are a world away from the troughs seen in the Global Financial Crisis and again in 2011/13. If the surveys (business and consumer) prove a reliable guide, then growth should move meaningfully higher in the first half of 2017. So far the hard data has been less impressive and it is fair to ask whether survey balances are overstating prospects. The Eurozone has moved decisively away from stagnation and deflation in recent years and given the very real threat of implosion at one stage and the long history of disappointments, it is quite understandable that optimism has surged once it became apparent that the cliff edge had been avoided. That confidence now needs to feed through into actions and spending over a sustained period. It all looks promising at present, and is moving in the right direction. But some caution is still warranted.
The ECB clearly thinks in a similar way. Prospects for both ongoing growth and rising inflation are good, but until they establish themselves definitively, the ECB is happy to maintain a relaxed approach. Underlying inflation now holds the key to any assessment of likely monetary policy actions and their timing. As long as core inflation ticks slowly higher throughout 2017, we believe that the ECB will try and manage expectations towards a tapering in early 2018 and eventual rate increases.
It is not out of the question that they move the deposit rate up from the present -0.4% before ending QE, since many are uncomfortable with negative rates. If so, their guidance will probably have to change this year. One of the factors that may guide them is wage developments. In the past President Draghi’s predecessors had occasion to worry about the possibility of “wage-price spirals”, partly as a result of Europe’s dysfunctional labour markets. Although there is still plenty of room for improvement, progress has been made. European wage data is notoriously flaky, but a proxy can be constructed by subtracting the growth in hours worked from the growth of the aggregate wage compensation bill. The result is shown in Figure 6. Cyclical movements in wages are easy to discern, but the latest upswing has been very modest. Even if trend productivity growth is only 1%, as we believe, the current subdued pace of wage growth – around 2% – is consistent with a 1% rate of increase of unit labour costs, probably the best measure of underlying inflationary pressure. Unsurprisingly, this is in line with core inflation.
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