While growth remains muted, the spectre of deflation should be avoided as euro-zone policymakers ease monetary policy further, says Stewart Robertson.


The euro-zone recovery was supposed to be picking up speed by now, supported most recently by cheaper oil and cheap money. Instead, growth slowed during 2015, culminating in a disappointing 0.3 per cent in the final three months.

A number of reliable leading indicators have peaked in recent months, suggesting that no improvement in the pacestwaer of expansion is imminent. However, the latest sentiment surveys – released after the European Central Bank (ECB) unveiled its latest stimulus package in March – hint that those declines have at least been arrested.

Expansion disappoints

Growth disappointments in the euro zone have been a regular occurrence since its inception in 2000. Moreover, a large part of the expansion seen in the bloc since 2008 has been highly dependent on the extreme level of monetary stimulus provided by the ECB. We believe the latest package of measures was merited on both growth and deflation fears and should help sustain the recovery. But while it was probably a necessary condition for growth and a return of inflation to target, we are not convinced it is sufficient.

Looking at the composition of euro-zone growth, all components have been weaker recently compared to the historical norm, but domestic demand – and investment in particular – has been particularly weak since early 2015. This would usually reflect subdued business sentiment and uncertainty about the future.

The outlook for the region is better than it was. Policy is set to remain supportive and 1.5 per cent growth* is above most estimates of trend, which will allow unemployment to continue to fall slowly. But a pick-up in annual expansion to two per cent or even three per cent, as some commentators had been hoping, seems fanciful. Jobs growth may remain comparatively sluggish – a net 1.4 million new jobs have been added in the last 12 months – not least because of the impact of labour market reforms in the short term.

Hope amongst the gloom

Lest we get too downbeat on euro-zone prospects, there are some welcome signs. Of these, the most notable is the upward trend in real disposable incomes, now rising at the fastest pace since before the financial crisis in 2008. Granted, it would be strange if they were not rising given how exceptionally low inflation has been over the last year. Nevertheless, the rise in real disposable incomes will still boost sentiment and spending power. Moreover, the longer the trend persists, the greater the chance that euro-zone households might move incrementally from saving towards spending. That really would be a change worth having.

Meanwhile, inflationary pressures are easing again in continental Europe. The collapse in oil prices has been a major factor, but is not the only reason. It is too alarmist to talk about the spectre of deflation re-appearing over the single-currency area, but only just. And the move of headline inflation back into negative territory in February did not help. It fell to -0.2 per cent (from 0.3 per cent) and is likely to stay below zero until June or July. The dip in core inflation from 1.0 per cent to 0.8 per cent was a jolting change after the gentle upward trend that had been in place since March last year. Against this backdrop, it is not surprising the ECB is doing more – its December projections were optimistic on growth and hopelessly optimistic on inflation. Both have been downgraded in March.

Political risk to the fore

The major headwinds facing Europe include the manufacturing downturn, ongoing weakness of world trade, continuing banking worries and political concerns. The last of these is not going to disappear quickly. It relates not only to progress towards closer integration within the euro zone, but also to the upsurge in nationalist political movements. While this is usually characterised as a local problem in the regions affected, any exit from the group would be hugely disruptive for the European Union too. Indeed, it may result in the re-emergence of existential worries about the single currency area. A year ago, Greece was the main concern for financial markets. It is not solved yet.

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* Source: Eurostat