Shadow ECB Council Council discusses the prospects for the economy of the Euro area

In preparation of their meeting on 3 May 2011, members of the Shadow ECB Council give their opinion on whether high energy prices, rising rates and the strong Euro might halt the economic upswing in the euro zone.

Janet Henry: “There is no need for the ECB Council to raise rates at the next meeting
By my calculations, the squeeze on real incomes from the rise in commodity prices in the first half of 2011 will be roughly on par with that in the first half of 2008 and which drove the euro zone consumer into recession. And while there are a number of reasons why the euro zone consumer is on a sounder footing now, I fully expect the higher commodity prices to feed through into softer consumer spending in the second half of 2011 with higher market interest rates having an additional, but smaller, impact. This implies growth will remain dependent on exports and export-driven investment spending. The euro at current levels will also detract modestly from growth but is not a major headwind as long as the global economy remains supportive. A major risk is that the commodity price shock takes a much bigger toll on global growth than the consensus currently envisages. This would alter my central forecast from one of slightly sub-trend growth for the eurozone later this year to one of a real risk of renewed contraction. With interest rates still at emergency levels, the growth rate currently a little above potential and inflation set to remain close to 3% for much of the rest of this year, there is a case for a slow gradual normalisation of interest rates in order to contain inflation expectations. But there is no need to raise rates at this meeting and the ECB needs to stand ready to pause the normalisation process if the global outlook deteriorates more significantly in the coming year.

Janet Henry is Chief European Economist of HSBC


Elga Bartsch: “High energy prices, rising rates and a stronger Euro will weight on euro zone growth in 2012

In my view, a combination of elevated commodity prices, rising ECB interest rates and a stronger currency will take a toll on the growth outlook in the euro area. These headwinds will likely show more materially in the quarterly growth dynamics in late 2011, early 2012. As a result, we will likely see a slowdown in growth next year. We have recently lowered our forecast for 2012 GDP growth from 1.7% to 1.2% as a result of a new set of assumptions on the three aforementioned factors. For this year, we are still forecasting GDP growth to average an above-par 1.7%. The May meeting would offer an opportunity for the ECB to hint at any coming changes to its staff projections. While we don’t think that these three factors are sufficient to derail the upswing, we do believe that the change in the pace of growth is likely to have important repercussions on financial markets. In the context of the euro area, it will likely also affect how the markets and policy makers view the sovereign debt crisis in the periphery. Notwithstanding this coming moderation in growth (back to the trend rate), the ECB should probably continue with its gradual tightening campaign for now. At some point in the future, though, it might want to consider a pause in the tightening campaign. This pause should be considered once the ‘emergency element’ in the ECB policy rate has been removed – which we believe to be the case at around 2%.

Elga Bartsch is Chief European Economist of Morgan Stanley


Jacques Cailloux: “ECB should be prepared to pause and restart its purchase programme
The euro area has been experiencing a moderate upswing over the past three quarters. The nature of the upswing has been very similar to previous ones with the export sector doing the heavy lifting. Exports have been strong in both the core and in the periphery. However, domestic demand has been disappointing especially in Germany where hopes of the awakening of the consumer have failed to materialise. Domestic demand in the periphery meanwhile is depressed by the current deleveraging process. In all, GDP growth has been disappointing in light of the unprecedented rebound in exports. This suggests the ECB should remain very cautious in its tightening cycle as the region remains exposed to any weakening in foreign demand or any idiosyncratic shock in the region. In fact, there is already evidence that most of the acceleration in global activity is behind us and the periphery situation is deteriorating at an unprecedented pace, two reasons which explained my reluctance to support a rate hike. I remain firmly in that camp: the ECB should be prepared to pause and restart its purchase programme before it is too late.

Jacques Cailloux is Chief European Economist of Royal Bank of Scotland


Marco Annunziata: The relentless rise in commodity prices is a cause for concern
The relentless rise in commodity prices, especially fuel and food, is a cause for concern. In the US, where gasoline prices are reaching the record highs of summer 2008, the negative impact on consumer confidence is already visible. In Europe the percentage move is muted by the stronger Euro and the higher incidence of taxes, and if prices remain at current level, I believe the recovery will continue to prove resilient. There is of course a significant tail risk: were turmoil to spread to a large oil producer like Saudi Arabia, it could trigger a large and disruptive further rise in prices. In that case the ECB could and should react. But for the time being, the recovery justifies some normalization in monetary policy. And since the turmoil in the middle east could well be protracted, monetary policy cannot be kept on hold indefinitely. The rise in interest rates could have a negative impact on some countries, especially via the mortgage market, and this impact should be monitored. But even in those cases, ultra-low levels represent an emergency support which must gradually be phased out. Governments should meanwhile take the necessary steps to bolster the sovereign debt market and financial markets. But for now the ECB would be right in pursuing additional cautious normalization of monetary policy.

Marco Annunziata is Chief Economist of General Electric


Andrew Bosomworth: Europe’s Periphery Poses a Greater Threat to the Upswing
The increasingly likelihood of default in Greece poses a bigger threat to the Eurozone’s upswing than energy prices or the euro’s strength. The IMF assumes Greece will borrow €40 billion from capital markets next year; funds needed to finance the budget deficit and redeem €33 billion worth of government bonds maturing in 2012. This assumption is increasingly unrealistic. Capital flight is continuing, yields on short-term Greek government bonds have risen to 25% and the market has effectively given a vote of no confidence in the country’s EU-IMF program. In calibrating its monetary policy stance and advising its fiscal partners, it is incumbent of the ECB to now recognize that liquidity solutions invariably fix solvency problems. The current approach needs to be recast in a way that makes it more likely to address Greece’s solvency problem, restore medium term growth and limit eroding the integrity of European and multinational institutions. The approach to the country's debt must mix liquidity with solvency, preferably through a voluntary and orderly debt structuring. This poses a dilemma for monetary policy. On the one hand, the ECB’s current policy rate is consistent neither with anchoring inflation expectations nor with the strength of economic growth in the vast majority of the Eurozone. On the other hand, European financial companies will incur capital losses in the event of partial non-repayment of Greek government bonds. When it occurs, the default will disrupt both the supply of and demand for capital, posing a risk for economic growth. How can the ECB navigate this dilemma? So long as the sovereign debt restructuring event has not occurred, the ECB should continue gradually normalizing the policy rate, taking into consideration both the inflationary impact of rising commodity prices and deflationary impact of the euro’s strength. Because further rate hikes are discounted in the market, a gradual normalization of policy will not disrupt the transmission mechanism. Refraining from normalizing the policy rate and temporarily tolerating higher Eurozone inflation so as to support the EU-IMF loan programs in Greece and Ireland risks undoing the ECB’s reputation of maintaining price stability, which is so critical for anchoring inflation expectations. Monetary policy for the Eurozone cannot be held hostage to some countries’ insolvency problems. These are the responsibility of fiscal authorities. To mitigate tail risks, the ECB should continue providing ample liquidity to banks. But it should make access to this liquidity for so-called addicted banks conditional on executing realistic restructuring and wind-down plans. In the event the ECB anticipates that a Member State will restructure its debt, a change in the ECB’s policy normalization strategy will be warranted – but not beforehand.

Andrew Bosomworth is Senior Portfolio Manager at Pimco

Marie Diron: “The risks ahead are very large and could easily tip the Eurozone back in recession”
I think that it is premature to raise rates. Every week brings new developments showing that the debt crisis is far from resolved. The risks ahead are very large and could easily tip the Eurozone back in recession. In the current environment, it is difficult to see how a restructuring of Greek (and other sovereigns) debt could be achieved in an orderly fashion. At the same time, the debt dynamics are such that debt repayments cannot be honoured on current terms. Whatever the ultimate outcome, there is a signficant risk of turmoil in financial markets that could engulf core as well as peripheral countries. The ECB cannot afford to add to these risks by tightening monetary policy now. The price to pay may be temporarily elevated inflation in core countries. But it would be preferable to raising rates too early and face considerable damage to the ECB credibility if it had to reverse this decision later.

Marie Diron is Senior Economist at Oxford Economics

José Alzola: “There is no justification for further monetary tightening for now”
Financial conditions are significantly tighter than six/nine months ago because of three factors: (1) Term Euribor rates have risen by nearly 1% since last June, as the ECB has withdrawn excess liquidity and started to hike the policy rate; (2) Medium- and long-term rates have risen significantly in recent months in the periphery and, to a certain degree, also for the entire Euro area, due to the sovereign crises; and (3) The trade-weighted euro has appreciated by 8% since last June, reflecting divergent monetary policies between the Euro area and other major central banks. With the usual, but variable, lag, this tightening of financial conditions is bound to slow GDP growth meaningfully later this year and in 2012, unless unexpectedly global growth picks up again. At the same time, the significant commodity-driven divergence that has opened up between headline inflation and domestic inflation indicators (more than 1%), in the absence, as is currently the case, of an inflationary psychology, represents a major drag on real income, which will further limit the ability of domestic spending to join exports in the recovery.

All in all, the outlook for a sub-par economic recovery remains unaltered (because of powerful structural headwinds on domestic spending), and the above-mentioned developments suggest that risks to this outlook may be moving to the downside. In the absence of a discernible increase in long-term inflation expectations and of second-round effects, there is no justification for further monetary tightening for now. The policy stance remains somewhat accommodative but not excessively so (although the policy rate remains historically very low, short-term money market rates and long-term yields deflated by domestic inflation measures are clearly in positive territory).

José Alzola is Senior Economist at The Observatory Group


Thomas Mayer: “Despite some headwinds, a gradual normalisation of interest rates is still warranted”

Although higher oil prices and the strong euro are creating headwinds, the economic outlook for the euro area remains favourable. This, and above-target inflation that is likely to continue for an extended period of time, warrant a gradual normalisation of interest rates. To avoid an overshoot of rate expectations I favour unchanged rates for this month. But in the absence of new negative shocks I would envisage another refi rate hike in the not too distant future.

Thomas Mayer is Chief Economist of Deutsche Bank


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