No swift turnaround in euro zone

June 4, 2009

MacroScope is pleased to post the following from guest blogger Sarah Hewin. Sarah is senior economist at Standard Chartered Bank and here outlines why she sees no swift turnaround in the euro zone economy.

Overnight indexed swap rates –- which I prefer to Libor, given high liquidity premia — are indicating a tightening of monetary conditions from Q1 next year. But I expect policy rates to stay low through 2010.

True, there have been some signs that the worst of the euro zone recession is past -– rising PMI indicators, improving expectations, a pick-up in exports and orders. Nevertheless, the turnaround in sentiment has been relatively recent (mostly in the last month or so, compared with clear signs of a U.S. improvement since early in the year) and remains choppy, with German businesses still downbeat, particularly on the current situation.

It has come as shock to euro zone policymakers that their recession has been deeper than the profligate Anglo-Saxons. Euro zone GDP is down 4.8 percent from its peak, so far, compared with a fall of 3.2 percent in the U.S. and 4.1 percent in the UK. Worse, the inventory overhang in the euro zone has been slow to correct. Yesterday’s GDP figures showed the drag from inventories at just -0.5 percent since the recession started, significantly less than in the U.S, and UK, which suggests a further de-stocking hit to euro zone GDP in Q209. The downturn in euro zone employment is also accelerating and the recent recovery in consumer sentiment has stalled.

Euro strength poses an additional deflationary risk. My colleagues and I see the euro averaging stronger than $1.50 in H209, an appreciation since Q109 which would nullify the most recent 50bps cuts in the refi.

After its July 2008 policy error the ECB has been swift to tackle the liquidity crisis, with considerable balance sheet expansion. The upcoming covered bond purchase programme should give an additional, albeit minor, boost, though the ECB’s Bundesbank legacy means that euro zone policymakers will move cautiously on any policy which smacks of printing money. But inflation looks set to turn negative from next month, and rising spare capacity is likely to ensure that core inflation stays low even once the temporary impact of energy price cuts fades.

Meanwhile, money supply data and lending surveys show that credit is still tightening (by contrast, there are hints of a turnaround in credit availability in some parts of the UK economy). Finally, Germany’s recent vote in support of a “debt brake”, which could trigger a fiscal crackdown soon after the September elections, risks hobbling any eventual recovery in the euro zone’s largest economy.

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