Euroland Growth

June 5, 2008

The euro area’s PMI scores are no longer comfortably above the 50 breakeven point between expansion and contraction. The composite index for both manufacturing and services was at 51.1 in May compared to 57.5 last July before the financial market crunch, and it averaged 51.5 in April-May, down from a mean score of 52.1 in 1Q08. Between May 2007 and May 2008, the services index dropped 6.7 points to 50.6, while the manufacturing PMI fell by 4.4 points to 50.6. Smaller on-year point declines were registered by Germany of 3.7 and 2.5, respectively, and larger drops of 12.9 points and 9.5 points occurred in Spain. The Italian indices decreased 8.4 and 7.0 points. Retail sales in the Bloc were already 1.3% lower in April than their 1Q mean. Sales had previously declined in both 4Q07 and 1Q08. Business spending has been solid by contrast, accounting for half of all growth in 1Q08. In the year to 1Q08, exports and investment expanded by 5.4% and 3.6%, but government spending and personal consumption went up just 1.4% and 1.2%. On-year growth rates in Greece (3.6%), Germany (2.6%) and Spain (2.7%) were faster than in Euroland as a whole. Growth of 2.2% in France and 2.1% in the Benelux was close to the regional mean, while Portugal’s 0.9% and Italy’s 0.2% pace lagged significantly behind.

ECB officials are not scared about growth prospects. They are counting on solid capacity usage and sustained profits to keep driving investment, an improved labor market to power consumption and robust emerging market demand to keep exports on an uptrend of at least as steep as that of imports. With CPI inflation at 3.6% in the year to May and not expected to fall below 3% before 2009 and to below 2% until sometime in 2010, sub-trend, but positive economic growth is not only acceptable but appropriate. Central bank officials have under-estimated inflation for quite a while and seem wary of the possibility that inflation will continue to exceed forecast. As they have noted for more than a year, risks to inflation lie clearly to the upside, which means both that inflation is still cresting and that it is more apt to surpass than under-shoot baseline projections. Upstream producer prices in April were already 1.5% higher than their 1Q average level after having accelerated from 2.6% at a seasonally adjusted annual rate in 3Q07 to 6.8% saar in 4Q08 and 8.0% saar in 1Q08.

Private-sector economists are by and large more pessimistic than the ECB staff about growth prospects. They could be right. The ratio of upside data surprises to downside data surprises has been falling. But the ECB’s critics also might prove wrong. The central bank was far more optimistic than consensus in 4Q05 when the first interest rate increase was undertaken, and officials drew considerable complaint at that time for acting so soon. President Trichet has reminded everyone repeatedly who had the better forecasts back then. That experience seems to have endowed ECB officials with confidence to follow their instincts and not to listen to the doomsayers.



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