Euroland Growth Powered Euro's Advance

May 15, 2008

Euroland officials have called euro strength against the dollar excessive and persuaded their G7 colleagues to escalate attention to the problem in last month’s joint statement. Between mid-2007 and the end of March, a three-quarter interval, EUR/USD had climbed 16.6% or 22.7% at an annual rate. During that period, real GDP expanded 1.1% saar in the United States, less than half as much as the pace of 2.4% saar in Euroland. The growth differential in 1Q08 was even wider than in 2H07. Against that background, the Federal funds rate was slashed during the period by 300 bps to 2.25%, whereas Euroland’s benchmark refinancing rate remained steady at 4.0%. Ten-year bond yields fell in both regions but by 101 bps more in the U.S. than in Euroland. In a credit crunch, the advantage goes to economies with a sound balance of payments. Euroland’s current account was near equilibrium, whereas the U.S. current account was in substantial, albeit declining, deficit. Money growth was rapid in both economies, but more acceleration occurred in the U.S. than Euroland. Speed up the quantity of money, and if every other factor is the same, one should expect the value of that money to weaken both in terms of rising inflation and a softer exchange rate. Economic fundamentals favored Euroland by a substantial enough margin to have warranted significant dollar depreciation against the euro.

Economic growth in Euroland varied widely last quarter. Such doubled in France and jumped fivefold in Germany compared to the growth rates in 4Q07. However, growth slowed very sharply in the Netherlands (to 0.2% from 1.1% not annualized) and Spain (to 0.3% from 0.8%) and swung to a contraction of 0.2% from an expansion rate of 0.7% in Portugal. Italian growth has yet to be reported, but signs are that such was quite weak. The momentum of growth on the whole and including in Germany moreover slowed noticeably toward the latter part of the quarter. Industrial production in the euro area climbed 3.0% saar in 1Q but slid 0.2% m/m in March. French consumer spending, which rose 2.5% in both 2006 and 2007, edged just 0.1% higher last quarter. An index of Euroland’s economic climate compiled by the German IFO Institute fell in 2Q08 to 76.3 from 81.4 last quarter. The G7 protest against dollar weakness was synchonized to a point of inflection in comparisons between the U.S. and Euroland economies. Euroland may still retain an absolute advantage, but such is not as wide as it had been earlier.



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