The eurozone does not seem to be exposed to the risk of recession. It does not make subprime loans. Only Spain and Ireland have been hit by the downturn in house prices. Unemployment continues to ebb, ensuring some resilience in terms of consumption, and corporate balance sheets are generally healthy. Yet it is difficult to imagine that such a severe slowdown in the world’s largest economy would not have an impact on the eurozone, whose economic cycle peaked over a year ago. Furthermore, the current financial shock cannot be considered a purely American phenomenon, even though it originated there, since the consequences of the subprime crisis have spread across borders. The shock is no longer specific, but has become symmetric. The message from economic indicators is very clear. The European Commission’s economic sentiment index has plunged by 10 points compared to the May 2007 level. It fell to 103.4 in December and on to 101.7 in January, the lowest score since mid 2001. The downturn has hit both industry (down 6 points from the July peak) and consumers (-12 in January vs –9 in December, compared to a historical average of –11). Manufacturing PMI is still in expansion territory, but has fallen sharply (to 52.8 from 56.3 in December). The services PMI has followed similar trends, dropping to 50.6 from 53.5. The composite PMI naturally kept pace, dropping from 54.7 in early fall to 51.8 in January. This is in line with a quarterly growth rate of 0.3% (see chart 1). The ECB’s bank lending survey for January showed a tightening of lending conditions. The proportion of banks indicating tighter lending conditions rose from 21 last fall to 24 for loans to SME; from 38 to 39 for large corporations (the proportion indicating a strong tightening rose from 2 to 10); from 10 to 15 for home loans and from 5 to 7 for consumer loans. Unsurprisingly, there also has been a net tightening of financing conditions for M&A operations (from 32 to 47). All in all, 18% of these establishments attributed the tightening movement to the financial turmoil, and 45% indicated that the crisis would lead to a further tightening in the months ahead (39% in Q4) for the same reason. It is even more alarming, however, that the downturn in economic prospects was also mentioned just as frequently, and that if the economy deteriorated, it would lead to even wider spreads. So far, quantitative rationing has hardly come into play: lending to companies increased 14% in November, reflecting in part the impact of the commercial paper crisis. Inflation has surged, rising to 3.2% in January, the highest level in 14 years, from 3.1% at the end of 2007, and is now well above the ECB’s target rate. Under this environment, the ECB is bound to maintain its wait-and-see approach to key rates. Jean Claude Trichet stated that, “particularly in demanding times of significant market turbulence…it is the responsibility of the central bank to solidly anchor inflation expectations.” Unsurprisingly, the ECB opted for the status quo at its meeting on 7 February. Undoubtedly, concerns about second-round effects(1), the decline in unemployment, and a capacity utilisation rate still in line with the historical average are all factors that when combined justify this decision. For the moment, the ECB is forecasting 2% GDP growth and 2.5% price inflation (median figures for its forecast range). With the foreseeable economic slowdown and tighter financing conditions, which should curb the increase in lending aggregates, the monetary authorities are expected to change their tune. The first results can already be seen in the opening statement at the press conference after the Governing council meeting on 7 February, which emphasised that recent economic data confirmed the presence of downside risks for the economy. The shift should be confirmed in March when the ECB publishes its new growth outlook. Even so, the status quo should prevail in the short term. The current levels of PMI and the jobless rate are not in line with those observed when previous rate cuts were made (see charts 2 and 3,). Moreover, the ECB tends to give more importance to retrospective hard data (production, etc.) than to survey data. After a quarter or two of growth below potential, as we are forecasting, the ECB is likely to begin easing monetary policy. A model of the central bank’s response function shows that in the light of inflation and economic conditions, the refi rate is currently neutral. The expected slowdown would make the current monetary stance inappropriate.(2) It seems unrealistic to expect monetary policies to be “coordinated” (i.e. for the ECB to follow closely in the Fed’s wake, regardless of the eurozone’s internal conditions). As was the case at the start of the decade, the eurozone’s policy mix is once again marked by inertia, especially relative to the United States (see chart 4). Nonetheless, we expect the refi rate to be cut by next spring. It is crucial to avoid a drop-off in European growth. The European economy lacks flexibility. As we could see in the early 2000s, it takes a long time for Europe to restore growth. Moreover, several of the big eurozone countries have very little manoeuvring room in terms of budget policy (Spain is the only exception). The situation in Europe differs completely from the one in the United States, where the deficit accounted for only 1.2% of GDP last year.
(1) Average wage demands in Germany have doubled compared to those of previous years. (2) Our response function links the real refi rate to the equilibrium level of real interest rates; the spread between observed inflation and the ECB’s target; and the output gap.