Euroland Growth in the Spotlight

June 9, 2008

Nobody disputes that inflation in Euroland is unacceptable or that short-term prospects for significant improvement are very slim. A wider range of opinions surrounds forecasts about how much economic growth is likely to slow. Officials at the European Central Bank (ECB) are on the optimistic side of the spectrum, cautioning that a steep loss of momentum in 2Q08 is simply a technical reversal of the very strong first quarter (3.2% saar), which was buoyed by special factors. Growth last quarter was led by a 6.6% saar increase in business investment. Net exports made a small but unexpected contribution, and inventory building accounted for 28% of the rise in real GDP. Consumption, up just 0.6% saar, remained disappointing, however.

In the ten years of the euro’s existence, a close correlation between Germany and the whole bloc’s economic growth has been maintained. Euroland performs well when German growth is brisk and vice versa. German industrial orders and output fell by 1.8% m/m and 0.8% m/m in April but still posted decent on-year advances of 4.3% and 4.8%. Exports went up 1.2% seasonally adjusted, reversing declines in February and March; however, a sharp 3.8% drop in foreign orders to 4.3% below the first-quarter level indicates that April’s revival will not be long sustained. Euroland’s current account recorded a deficit in three of the past four reported month equal to roughly 0.75% of GDP. This swing into deficit is not surprising, given the uncompetitive level of the euro for many EMU members and soaring energy import costs. Nevertheless, markets have not come to terms with this deficit. In the June survey of forecasters by the Economist, participants predicted a current account deficit in both 2008 and 2009 amounting to no more than a minuscule 0.1% of GDP. This is just another instance of expectations lagging reality.

If both net exports and private consumption underperform, business spending is likely to lose steam as well. The ECB isn’t bluffing about about a rate hike in July. The real debate is over policy beyond that move. Those arguing that there will be no follow-through moves are counting on a series of negative growth surprises to mellow the Governing Council’s currently hawkish predisposition. For two reasons, I am inclined to believe that there will be at least two increases in ECB rates. First, it’s not this bank’s habit to change stance lightly between the three options of tightening, easing, and wait-and-see. In acting, there is probably enough accumulated evidence for the majority to favor at least two moves. Secondly, when expected inflation is drifting higher, the link erodes between weakening growth and slowing inflation. Slower growth only affects ECB policy if officials conclude that the future trajectory of inflation risks has shifted downward as a result.

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