Eurozone: Better all the time
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- The Eurozone’s recovery is ongoing, encouragingly supported more by domestic demand
- The ECB is not yet convinced that inflation is on a sustained upward trend towards 2 per cent
- Greater political stability and renewed efforts at closer integration will help
Activity and sentiment pick up further across the Eurozone…
The Eurozone upswing has gathered strength in 2017, with GDP rising by an upwardly-revised 0.6 per cent in Q1 to stand 1.9 per cent higher than a year ago. In the post-GFC world (32 quarters now), annual growth has only exceeded that rate on five occasions. With leading indicators and survey balances resolutely upbeat, Q2 could even improve on the Q1 reading. If this is right, the Eurozone could rightly be described as experiencing almost boom-like conditions, all the more so since the trend pace is only around 1 per cent. Given the amount of stimulus that has been provided to the region since 2008, it would have been disappointing not to see solid growth, but the Eurozone has been to some dark places over the last decade, so it is heartening to see it enjoy better fortunes (Figure 1).
We highlighted three months ago that there were a number of political hurdles to jump, but here too the news could scarcely have been better so far. President Macron in France was convincingly elected in the run-off against Marine Le Pen and has established a large majority in the subsequent parliamentary election. Moreover, he has done so with a bold reform agenda, and while the proof is always in the pudding in terms of delivery on such goals, the positive momentum for France and the Eurozone integration process more generally – including constructive developments of the critical Franco-German axis – could hardly be any better. So, conditions are ripe for the next steps of the project – Governments must now take advantage of them and deliver. There is still the German election and, possibly, an Italian vote to get through, but anxiety levels about results have understandably subsided.
…but inflation remains subdued, allowing ECB to stay relaxed
In “ordinary” economic circumstances (remember them?), these conditions would warrant at least a discussion of monetary tightening from the present extreme stimulus stance of negative policy interest rates. The justification would be to control the boom and prevent inflation rising alarmingly. But there are good reasons for proceeding cautiously, as the ECB has been keen to point out. The key issue is that after the GFC and the Eurozone’s very own sovereign debt crisis, there is still plenty of room for non-inflationary growth. Even in the cyclically-advanced USA, inflation has been slow to return. In the Eurozone, where deflation was the more likely threat as recently as 2015/16, it has been slower still. Core inflation is still stubbornly low, below 1 per cent, and it is clear that the ECB wants to see a more convincing upward drift before they commit to tighter policy (Figure 2). That will only happen when output gaps are closed. Yes, there are differences between individual countries, but as the ECB regularly reminds us, they set policy for the region overall and on that basis, there is still spare capacity that can be re-absorbed back into productive use by allowing and encouraging above-trend growth. A loose policy stance is therefore still merited. Granted, there would be rumblings if inflation were to appear in some countries that were running hot, but so far that has not been the case. This description of the Eurozone helps to explain and validate the ECB’s relaxed approach to policy. But the punchbowl cannot remain on auto-refill for ever and it is clear that they are preparing their exit strategy. Asset purchases have been pared back already and further tapering is expected later this year or early next. Gradual rate rises will follow as long as the macroeconomic backdrop remains robust (Figure 3).
Eurozone has generated 8mn new jobs since 2013
One of the most welcome aspects of the Eurozone recovery in recent quarters has been that it has been domestic demand rather than net exports that has done most of the work (Figure 4). Consumer spending is “only” growing by around 1.5 per cent a year, but that is perfectly adequate for the Eurozone given its underlying demographics. Developments in the labour market have helped: the Eurozone lost just under 3mn jobs during the GFC (compared with nearly 9mn in the US), regained them by 2011 and then lost almost 4mn during its own crisis. But since the start of 2013 the area has generated nearly 8mn net new jobs (Figure 5). The unemployment rate has fallen from a peak of 12.1 per cent to 9.3 per cent in April this year. Of course this is still “high” by the standards of several other developed nations, but it is moving in the right direction and is doing so without any emergence of wage pressures so far. Estimates of the natural rate of unemployment in the Eurozone vary, but it is hoped that some of the muchvaunted structural reforms in labour markets have brought it down to perhaps 8 per cent or so. If that is right, the region can probably afford another year of 2 per cent plus GDP growth before wage pressures start to emerge. Individual country labour markets have different degrees of tightness, but so far, wages have been well-behaved. Were that to change, the ECB would face a trickier task.
Businesses are happy to borrow and spend
Investment spending, meanwhile, rose by 6 per cent in the year to Q1, the highest since the GFC and in line with other periods when the Eurozone economy was doing well. Unfortunately, investment data across Europe is generally of poor quality so it is difficult to assess exactly which categories of spending are advancing most. Having said that, business and industrial surveys show that construction activity has strengthened noticeably and also that Eurozone companies are very upbeat about future demand (Figure 6). This, combined with very low borrowing costs, is stimulating firms to borrow and invest. Finally, although an element of fiscal restraint is still being encouraged, public sector capital spending (in part related to the ongoing Juncker plan) is probably growing quite strongly. As long as “animal spirits” in the Eurozone remain robust, there is little reason to see this changing much in the near future.
Political worries have diminished; enhanced integration must come next
While it is right to be more optimistic about Eurozone prospects than for many years, some words of caution are still warranted. The thorny tasks of much closer fiscal integration, of full debt-burden sharing and of political unity have yet to be achieved. The path to those ends looks clearer than it has for a long time and most participants seem determined to progress down it. There does appear to be a determination to complete the project, but it has been a painfully slow process and lots remains to be done. It would be surprising if there were not some further bumps along the way.
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