ECB Understated Growth Slowdown

September 29, 2008

The ECB Governing Council meets this Thursday.  Officials have not hinted that a rate cut might be made, so such a move would be a huge surprise to a market that expects to be forewarned ahead of ECB policy changes.   A statement released after policymakers met on September 4th avoided panic, calling the slowdown “an episode of weak activity,” arguing that resilient emerging market demand will remain a source of support, warning of a possible sharp jump in unit labor costs, reiterating the preponderant upside risks to price stability, and reminding everyone that the bank’s primary mission is the preservation of stable prices in the medium term.  During Q&A, it emerged that officials had not even considered cutting interest rates, and that continues to be a message conveyed through comments by various officials.  New forecast ranges released after the September 4th meeting centered GDP growth on 1.4% in 2008 and 1.2% in 2009 and CPI inflation on 3.5% in 2008 and 2.6% in 2009.  These projections show a greater deviation of inflation from target than growth from its trend potential.

The slowdown was picking up pace even before today’s rescues of Fortis and Hypo Real Estate.  One foretaste of the deterioration in business sentiment was provided last week by Belgian data.  Being the most trade-dependent of Euroland members, Belgium is a good regional bellwether.  Business sentiment in Belgium plunged to a reading of -14.4 from an average score of -6.75 in July-August and -3.75 in May-June.  The manufacturing component was -15.8 after -5.6 in August and zero in May, and the trade component fell 11 points to -18.7 from -7.7.  Euroland sentiment indices released today confirm the Belgian experience to be fairly widespread.  Overall economic sentiment had a reading of 88.7, which was an 82-month low, and averaged 88.9 in 3Q08, down from 96.5 in 2Q07, 109.3 in 3Q07 and a quarterly high of 111.6 in 2Q07.  Consumer confidence (-19) and industrial sentiment (-12) were each 18 points worse than readings in May 2007.  Service sector sentiment, which captures almost three-quarters of activity, had a score of zero, down from +8 in May and +18 in September 2007.  The price components, reflecting the one-year ahead expectations of consumers and businesses, each dropped five points between August and September.

More evidence of just how rapidly business conditions are deteriorating will emerge before the Governing Council meets Thursday, including unemployment, retail sales and finalized PMI-manufacturing statistics.  The flash CPI report will confirm a drop in inflation but will not include an estimate for the core items.  Unions are still demanding catch-up wage increases to offset the commodity-induced squeeze on their members’ purchasing power.  ECB officials can build a case for segregating actions that address money market strains from stabilization-oriented monetary policy.  Even if they verbally acknowledge that the economy has slowed faster than expected and may become more prolonged than assumed earlier, ECB authorities will be criticized for an approach that has been less anticipatory than the Fed’s stance.  Because labor market rigidities make Euroland’s economy more inflation-prone than America’s, there was until now no other way for the central bank to play the conflicting impulses of slower economic activity and a spike in inflation to well above target.

It remains to be seen how forceful officials concede that the danger to inflation has diminished.  Any mea culpa admission regarding an earlier understatement of risks to growth would have less impact on rate expectations if not accompanied by a spelled-out connection between the recession and reduced upside price risks.  I suspect that market players will be disappointed by the ECB.  For some, nothing less than a surprise rate reduction will seem reasonableThe flashpoint of any disappointment will be the euro, and that is unlikely to bother ECB officials, who again on September 4th expressed gratitude for verbal intervention by U.S. officials to support the dollar after it hit a record low of 1.6038 per euro in mid-July.   



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