European business confidence in free fall: Thank you, Mr. Trichet?

The global downturn has now hit Europe with its full force. Today, not only PMIs fell across the euro-zone. Also the German ifo-index took a bad hit, experiencing the largest one-month-drop since the recession of 2001. Both the expectations as well as the current conditions index dropped sharply. The expectations component is now not far away from levels seen during the last recessions.

Suddenly, even the German economy does not look as resilient any more as it was long claimed by some observers (see my post here on false complacency concerning the strong euro). Nevertheless, Germany still looks strong compared to the rest of Europe: According to the PMI surveys, the German manufacturing sector is merely stagnating while the sector in most of the rest of Europe already is in recession.

The deterioration has come quite suddenly: Only in April it still looked as if Europe could dodge a recession even if the US economy would experience one. Now, the European economy looks even more vulnerable than the US where the manufacturing sector might be flirting with recession but according to the ISM survey is still growing marginally.

While it is certainly overdone to shift all the blame for this sharp downturn on this side of the Atlantic on the ECB, one has to note that the sharp (and in a global context idiosyncratic) turn to the worse coincided with Jean-Claude Trichet’s announcement at the beginning of June that it would increase interest rates. Immediately following the press conference, interest rates in Europe over all maturities shot up, leaving them now clearly higher than at the beginning of June (look at the instructive yield curves from before and after the June press conference below). Even though inflation in the US is clearly higher than in Europe, the dollar still under depreciation pressure, and budget deficits in the US being much larger than in Europe, European 10-year bonds now yield about 50 basis points more than US treasuries.


Figure 1: Upward shift of yield curve due to ECB press conference on June 5, 2008

By coincidence or causation, June was also the month in which the German ifo dropped sharply while it had kept up well during the time before. Of course, the high oil price might also played a role, but the strong euro and the increase in the interest rate certainly have not helped. Interestingly, both from order intake as well as from the details of the ifo index we see that companies see the domestic situation as a problem, not so much the global situation.

Moreover, there are some indications that the current monetary tightening is translating very quickly to the real economy. Banks have been quick to pass increases in interest rates to their customers. At the end of May, ING Diba, one of the largest direct mortgage banks in Germany, offered 5-year mortgages for 4.75 percent and the 10-year mortgage for 4.90 percent. Now the interest rates stand at 5.30 percent both for the 5- and 10-year mortgage. Judging from experience, such a sharp increase will certainly hit the construction sector.

So it might just be that the latest interest rate hike and the rhetorics which came with it were the proverbial straw which broke the euro-area’s economy’s back. For ECB critics, it certainly now is easy to make this case. Prepare for some more ECB bashing by the public going forward, especially if the US economy in the end weathers the crisis better than the euro-area.

The post has been co-posted at Eurozone Watch.

8 Responses to "European business confidence in free fall: Thank you, Mr. Trichet?"

  1. Flanders   July 25, 2008 at 2:06 am

    "Now, the European economy looks even more vulnerable than the US." I really don’t get this. The US was already in a recession in the summer of 2007 IF inflation was properly taking into account. Even now, the US economy is not in a recession based on real GDP data. That’s just joke !!!

  2. Flanders   July 25, 2008 at 2:11 am

    "Especially if the US economy in the end weathers the crisis better than the euro-area." Only in the government statistics, the US economy will weather this crisis better.

  3. Berlin Taxi driver   July 25, 2008 at 12:40 pm

    The UK economy is in recession, not the European in general. Stick to the facts and talk about your Anglo bubble economy, without blaming Trichet

  4. Guest   July 25, 2008 at 1:46 pm

    As a fellow European citizen, I’m totally behind Jean Claude Trichet, the ECB president.Not only he has shown that the ECB is really credible in fighting inflation but is acting too.One had to stop, ridiculous banks behaviour in the past few years, lending to almost anybody for housing purchase, and putting lots of families on very heavy debt burden. If banks don’t take their responsabilities, one has to put them back in line. The ECB is doing it.The US, has in the past 6 months destroyed the free market pillars by being forced/(put in their knee) by wallStreet/banks to be rescued otherwise the whole U.S. financial system would have collapsed. Now Moral hazard or not, the "the survival of the fittest" has become "too big to fail"… the dinosaurs such as Fannie Mae or Freddy Mac, won’t be instinct and no new leadership will be found, trying to keep the U.S. financial the same way it was before the crise will eventually bring its demise…Coming back to the ECB, inflation is a real treat, you feel it in the street, one has to stop before it goes out of hand…and this…in order to safeguard the poorest, elderly, retired and youngest of the society.

  5. Guest   July 25, 2008 at 5:02 pm

    It’s a real mystery to me in what way hiking interest rates should either improve purchasing power or provide an incentive for capital investment in order to create more employment, productivity, and income generation. These are the only variables that matter in an economy. None of them is on Trichet’s radar. I can’t say I’m surprised at what’s happening in the eurozone and it can only get worse.

  6. Guest   July 26, 2008 at 12:45 pm

    look at economical history, particularly in 1979, 1989 or 1999 where monetary policy mistakes lead to an economy disaster…

  7. Guest   July 27, 2008 at 12:21 am

    I am curious? What is actual relative impact of an increase in mortgage rates in Germany vs an increase in the return on savings? What of an increase in inflation vs. increase in interest rates?

  8. Archinvestor   August 6, 2008 at 2:04 am

    @ Berlin Taxi driver,what do you think of the Fatherland posting a -1% GDP growth ? I’d love to have your opinion…