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2017-10-05Macro `n Cheese

Indecent talk

In this week's piece Roger delves into a nascent discussion on whether the Euro Area is finally out of the doldrums

Over the past few months, a multitude of forecasters have been forced to revise the Euro Area outlook in a considerably more positive direction, prompting the usual calls for a swift and imminent tightening of monetary policy from market pundits. And, undoubtedly, GDP has developed faster than potential GDP (1¼% y/y according to EU-commission) more or less since 2014. It has also been growing on par with the dynamic US economy (yes, that was a tad sarcastic).

The caveat with the improved performance of the Euro Area economy has of course been the double-dip recessions in conjunction with the global financial crisis, which have set a very low starting point for the recovery.

Macrobond Document

Chart 1: The Euroland double-dip recessions are finally over and done with


A surprisingly normal upswing

Nonetheless, when putting the most recent Euroland recovery into context, a rather normal cyclical pattern emerges with a long drawn out recovery phase that has continued well past the five-year window applied below. Keep in mind, though, that the current recovery has to be seen in conjunction with developments after the 2008-recession, “joined at the hip” (between the 13th and 14th quarter in the graph below) as they are.


Macrobond Document

Graph 2: The Euroland seismic twin recessions


From that perspective, economic developments in the Euro Area have of course been a sombre read for most analysts and policy makers. As I, and many others before me, have pointed out, the GFC did indeed herald a global “new normal” with, for example, GDP- and productivity growth being much weaker than what pre-crisis trends suggested. Unfortunately, the Euro Area does not seem to be an exception to that albeit, possibly, an interesting variation.


Macrobond Document

Graph 3: Who needs monetary policy normalization?


Now, the decent, current GDP-growth, and a supposedly lower trend growth, have lead many market commentators, and even some from within the ECB:s governing council, to believe that the Euro Area is on the verge of a sustained upturn in inflation. As evidence they confer higher headline inflation, but also a recent “jump” in core inflation.


What’s up with the ECB normalization talk?

Macrobond Document

Graph 4: Inflation is not as benevolent as ECB (and market) hawks want it to be


Indeed, we might discern some nascent upward trend in core inflation, but controlling for the effect of a pronounced summer upturn in prices on “packaged holidays” and “transportation services”, there is little to indicate that core inflation is on a sustainable upward trend. Importantly, core inflation is still close to historical lows.


Macrobond Document

Graph 5: A principal component analysis of available wage inflation data


Euro Area developments are easy to interpret

As for the possible building of upstream cost pressures, I see little to no reason whatsoever to be worried. In addition, when using my favourite “all-in-one-graph” (below) we can see that in the Euro Area, labour markets are still reeling. Given the size of the gap, it should come as no surprise that wage growth is historically low and suggests that it will take some time to reach inflationary levels. Furthermore, and interestingly, if we look at productivity developments, the Euro Area actually compares favourably to most other (advanced) economies. Sure enough, and similarly to other economies, productivity levels fell back in conjunction with the GFC. However, productivity growth has not deteriorated as much. Most other advanced economies (e.g. the US) have experienced a drop in both levels and slope.

Macrobond Document
Macrobond Document

Graph 6: Not much of a productivity conundrum in the Euro Area. More of a demand deficiency


So while an investment/productivity growth spurt would certainly be welcome, what the Euro Area is in dire need of is, simply put, stronger demand. Hence, the current discussion on ECB monetary policy normalisation comes across not only as premature, but counter-productive and even dangerous if it continues to lead to a tightening of Euro Area financial conditions.


Macrobond Document

Graph 7: Composition of Euro Area demand

Note: The discrepancy between GDP and the sum of the components is explained by inventories and changes in, e.g., relative prices when aggregating GDP. (No, it is of course not completely ‘kosher’, but the graph is mainly for illustrative purposes anyways.)


The recent and surprising improvement in the Euro Area is mainly about improved global demand and not much else (other than possibly a monetary policy induced strengthening of construction investments).

Thus, in my opinion and if anything, economic policy in general and fiscal policy in particular should instead seize this opportunity to expand, exploiting a chance to finally strengthen inflation expectations and perhaps infusing a whiff of those animal spirits to stave off large deflationary risks stemming from a massive under-utilization of labor.

However, that probably entails not just releasing the Euro Area, but all of EU, from the shackles of once well-meaning but now detrimental fiscal rules. There are good arguments for continuing to run large (or even larger) fiscal deficits. Large, but well defined, infra structure investments and educational/vocational training programs directly financed by a permanent increase of the monetary base would be very close to a euro-tic fantasy of mine (pun, but no offense, intended).

On a more serious note, I believe that a failure of fiscal policy to act, will only risk cementing a low-flationary environment and the much too low inflation expectations. I won’t even mention what would happen to debt sustainability should such a scenario materialize. Or did I just..?


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