Euro-zone update

The European Central Bank has cut its key policy lending rate to only 5 bps, it’s progressing its planned schemes for asset purchases and targeted lending to banks and has hinted that it could increase its balance sheet by around €1 Trillion, taking it back to its early 2012 size.

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  • The European Central Bank has cut its key policy lending rate to only 5 bps, it’s progressing its planned schemes for asset purchases and targeted lending to banks and has hinted that it could increase its balance sheet by around €1 Trillion, taking it back to its early 2012 size and implying lots of central bank activity.
  • These central bank decisions reflect weak recent outcomes for Euro-zone activity and inflation. Euro-zone GDP stagnated in the second quarter – a disappointing result for a region that has lagged in the global recovery and where GDP remains around 3% below its early 2008 level. The extent of the slowdown in mid-2014 is exaggerated by a drop from particularly strong first quarter growth in Germany but there’s concern that the Euro-zone faces deeper structural problems.
  • There’s growing belief that the Euro-zone needs higher demand and that private sector de-leveraging and government austerity have put too much of a drag on spending, which has flowed into weak output. The ECB Governor has warned that the high jobless rate will persist unless demand is boosted and the IMF believes that “insufficient aggregate demand” weighs on the economy.
  • With CPI inflation falling to 0.3% yoy in August, well below the central bank target, there’s concern that the Euro-zone could fall into a Japanese-style deflation. With inflation expectations falling, minimal growth in money supply, falling private sector credit, little sign of pricing pressure anywhere, an 11½% jobless rate holding down wage growth and significant unused capacity limiting business pricing power, deflationary risks are obvious.
  • Market stress over sovereign debt in the Euro-zone periphery has abated but its economies still have profound economic problems related to very high unemployment (27% in Greece, 25% in Spain), big debt burdens and a lack of investment that will cramp their long-term growth. The Italian economy is performing very poorly, there are worries over France and the Bundesbank has marked down the German growth outlook. We expect Euro-zone growth of only 0.7% this year and 1.1% next year, not enough to cut unemployment or help stabilise the high debt/GDP ratio of 95%.

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