I expect the US economy to broadly stagnate in the current and next couple of quarters, with the construction recession deepening and consumer spending slowing in response to higher energy prices and much tighter credit conditions for most households. Slower US consumption growth will likely feed into a slower output growth in much of the rest of the world. In the euro area, I expect GDP growth to slow below the trend rate. Banks are tightening lending conditions for corporations and housholds, which will dampen consumer spending and corporate investment. The latter will also be negatively affected by the strength of the euro, which is eating into exporters profits and will induce them to cut capex. Also, the inevitable rise in overall inflation due to higher oil prices and food prices will dent consumer spending. Against his backdrop, and with funding pressures in the money markets rising, I continue to advocate a 25 bp rate cut.
How should the ECB deal with the soaring euro? If the ECB follows my advice to cut interest rates, this would in my view mark the peak for the euro. However, the ECB does not appear to be willing to cut rates anytime soon. Therefore, I would recommend outright interventions in the currency markets if the euro continues to rise, to make clear that EUR/USD is not a one-way street. Contrary to conventional wisdom, even unilateral sterilized fx interventions can be effective in the presence of a large number of momentum traders in the currency markets, provided the intervention is well timed.
Rising oil prices, cooling real estate markets, tightening credit conditions, and a rising exchange rate are likely to push growth clearly below potential next year. In this environment, any "second round effects" of higher headline inflation on wages will only raise unemployment and weaken the economy further. Hence, a forward looking monetary policy needs to look trough near-term increases in inflation and cut rates in time to avoid recession. Some observers may argue that a recession may be needed to purge the economy of past excesses. However, when there is a considerable risk that recession leads to debt deflation borrowing advice from the liquidationist school of the early 1930s is a dangerous undertaking.
I am sceptical of the idea that the euro area is decoupling from the US economy. Asia is not contributing significantly to euro area exports growth and thus can not mitigate the slowdown in US demand for euro area goods. Observers tend to focus solely on growth rates and omit the size of export shares, which can be very misleading. For example, German export growth to China and OPEC countries are running at double digit rates, but their share of total German exports is still small at just 3% and 2.3%. Also the correlation between German exports to the US and to Asia in the past 15 years has been increasing steadily. The correlation between euro area exports growth and Asian domestic demand has also declined steadily since 2005 to reach its lowest level since 1997 in Q2 this year. Since 2005, Asian domestic demand has decoupled from global trade flows, but also from euro area exports growth. The contribution from Asian domestic demand to euro area exports growth has in fact declined to its lowest in 10 years.
Turning from trade to financial linkages: The five largest euro area economies had at the end of Q1 2007 2.1 trillion euros of outstanding claims in the US economy via the banking sector. This excludes the Eur500-600bn of conduits in the euro area. These numbers highlight the risks of contagion through cross border banking sector activities. According to NTC, financial services activity in Europe contracted for the first time since 9/11. The further decline in the RBS/NTC services PMI for the euro area suggests that activity in the euro area banking sector is failing to recover, a key risk for the broader economy in the coming risk.
On the FDI side, BIS estimates show that European subsidiaries based in the US have a turnover which is five times that of European exports to the US. Slowing domestic demand in the US has thus the potential to impact European firms via their subsidiaries which in turn would have repercussions in terms of hiring and investment plans.
In this context, it is difficult to forecast euro area growth to be at potential next year. Indeed, adding the additional headwinds from the currency and energy prices and one can easily come up with a growth forecast near 1.5% for 2008.
The US slowdown, the financial crisis, the strong euro and the high oil pricehave led to a deterioration of overall conditions for the EMU economy. Therefore we have lowered our growth forecast for 2008 from 2.1 % to 1.8 %.
Because the exchange rate development is one important ingredient in this cocktail of unfavorable factors, ECB president Trichet was right to use increasingly hawkish rhetoric on the euro. This “verbal intervention” should be intensified but in my opinion it will only bring the desired effect in conjunction with abandoning the monetary policy tightening bias. I do not believe that there is any scope for an interest rate hike for the time being, indeed a rate cut might become necessary if things turn out worse.
Direct ECB intervention in the foreign exchange market to weaken the euro does not appear to be a sensible option for the time being. Intervention could only bring temporary relief for the dollar, it cannot prevent a devaluation over the long run. Asian countries are presently experiencing just this. There is strong upward pressure on their currencies despite massive interventions in the last couple of years. They should let the market work and allow appreciation vis-a-vis the dollar, even if this means capital losses due to lower reserve valuation. At the end of the day a real adjustment in trade and capital flows is needed to boost the medium-term outlook for the dollar. Continuously pumping up the reserve stocks in this “Bretton Woods II” environment is not sustainable in the long run.
The main news over the last months has been the increase in oil prices and the persistence of the problems in the credit sector. I expect the latter to persist, but as long as there is no systemic crisis, this gradual emergence of the costs of the excesses of the past credit cycle must be let to run its course. Headline inflation is likely to stay above 2 % for some time, but should come down on its own provided oil prices do not increase without limits. Hence there is no pressing need to move rates for this reason.
So we face an oil shock and, at the same time, a lingering credit market crisis. All bad news and yet, no easy wayout. Thanks to the strong euro, the oil shock is moderate, but then the euro is strong...
We know that an oil shock must be met with a policy designed to root out increases in inflation expectations. This means a restrictive stance. This time, however, the stance is made restrictive through a combination of euro appreciation and credit crunch. The question is whether this combination is too restrictive and should be met with an interest rate cut. This is a very difficult question, one for which we don't have much help from historical evidence and that our models will not be able to answer with any degree of precision because the credit crunch is a new event. Given how little we know, I would just sit and wait, if only to avoid making a decision that I would come to regret. It is not a very satisfying position, I agree, but I do not see how to suggest a rate cut, and a rate increase is clearly ruled out given the fragility of financial markets.
Monetary expansion signals that euro area inflation keeps drifting up and could reach 4% y/y in the course of 2008. I don't see any room for cutting interest rates without pushing up inflation further.
Surveys (PMIs) confirm the expectation that GDP growth probably will slow below trend in 4Q and, given the renewed tensions in money markets and the appreciation of the euro, chances are that growth will remain modest also early next year. The key question is whether this “soft patch” will extend into subsequent quarters. On that the jury still is out. Although emerging markets would indeed suffer if the U.S. were to slow significantly, I still believe that they (and global growth) can hold up relatively well, even though no longer above its long-term average, if the U.S. economy just muddles through at a 1.5%-2% pace next year. On the domestic side, there is a tension between the damage inflicted in the near term by the ongoing financial crisis and relatively favorable macro-economic fundamentals. At this stage, I still prefer to stress that risks to euro-area GDP growth are on the downside – and that they may eventually require a rate cut – and not to downgrade the base-case scenario of GDP growth in 2008 clearly below 2% -- which would certainly justify a rate cut.
The medium-term inflation outlook appears benign, notwithstanding current upward pressures from non-core items. Past (and repeated) similar episodes show that these upward pressures are unlikely to translate into inflation expectations and wages, especially as the economy slows somewhat. Moreover, the strong euro is offsetting that impact even in the near term. However, until there are good grounds for a major downgrading of the GDP growth outlook, it makes sense to avoid rate cuts as long as inflation remains well above 2% -- which will likely be the case until 2Q 08 – to avoid igniting inflation expectations.
The fears I had last month, which in my view argued for a preemptive rate cut, are materializing. The credit crunch is intensifying, financial conditions are tightening further and the longer this process continues the more damage it will do to the real economy. Economic growth is already slowing down, and there is no reason why financial conditions should be as high as they are at the moment and continue to be for the next several months. Yes, headline inflation is higher than 2 percent at the moment, but as far as I know the mandate is price stability over the medium term. Monetary policy must look forward, and it is clear in my mind that the probability weighted forecast of growth and inflation suggest that some offsetting of the sharp tightening of financial conditions is in order. If the weakening intensifies, it will be a welcome preemptive rate cut. If the economic outlook turns out to be brighter than expected, monetary policy can easily reverse course and hike rates again. With inflation expectations well anchored, there is room to act now.
José Luis Escrivá
In the short term, inflation has contributed to accentuating the ECB dilemma. HICP is expected to rebound around 3% at the end of the year, mainly derived from commodity and food prices, but they should not affect the long-term outlook.The rebound in inflation in 2008 should not deter the ECB from cutting interest rates as downside risks to growth are growing and inflation expectations remain anchored. In fact, in 2001, the cumulative risks on activity lead the ECB to initiate a decrease in official rates, despite inflation far above the target, credit to private sector growing above 8% and a very weak euro.
Downside risks on activity have increased. Our Indicator of Activity (IA-BBVA) declined in October for the fourth consecutive month. The decline was somewhat larger in the real component than in the expectations component. It confirms that activity is clearly in a decelerating mode, pointing to weaker growth in the coming quarters. Most recent data, such as the PMI in the service sector having decreased 2 points in November, have surprised on the downside and growth is expected to be well below potential in 2008. In the current context, the combination of euro appreciation, tightening financial conditions and bad news in the financial landscape coming from the US and, more recently the UK, accentuate the balance of risks on growth on the downside.
Moreover, the situation of the financial markets remains quite volatile and fragile and it is likely to stay that way over the near future. Additional tensions have arisen this week, along with some news from additional losses in the banking sector (US, UK and, more recently, Japan). The markets seems to give a non-negligible probability to a credit crunch scenario, as can be deducted from the high volatility and the significant decrease along the yield curve, mainly in the 2- year bonds.
There is clearly a dilemma for the ECB, since their is both an inflationary shock (the oil price increase) and a demand shock (the US slowdown). In these circumstances, the ECB would need two policy instruments. One possibility, mentioned by some ECB Shadow Council members, would be to use oral and/or effective intervention in the foreign exchange market, in order to curb the exchange rate without changing the interest rate that could continue to focus on inflation risks. To have a sizeable and lasting impact, however, foreign exchange interventions would need to come with the ECB abandonning any upward bias for the interest rate, and possibly adopting a downward one; additionally, it has been shown in the literature that interventions are more powerful when the market has already started to correct itself, which is not the case now (but could happen in the coming weeks). In brief, I think that the idea of interventions should be considered seriously, but this will not solve the dilemma for the next governing council.