ECB’s likely policy dilemma
More hikes to go but might carry economic bitel.
Group Research - Econs, Radhika Rao26 Jun 2023
  • Confidence indices are turning mixed after a positive start to the year
  • Inflation squeeze is partly offset by a strong labour market and fiscal support
  • Price pressures are easing albeit gradually
  • ECB is not done with its rate hike cycle as yet, as inflation is viewed as a dominant concern
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Excerpt from the recent DBS CIO Insights

Economic momentum softens

Revised GDP data for the Eurozone confirmed that high energy prices, uncertainty with simmering geopolitical tensions and sticky inflation hurt the economy. Germany dragged the Eurozone economy into a technical recession in the early part of the year (1Q23 and 4Q22 -0.1% qoq).

On an aggregate basis, labour conditions are still supportive, with the unemployment rate at a record low of 6.5%, and wage growth as well as negotiated wage growth remaining strong in 4Q22. Minimum wages are up in large member countries, with Spain’s up by 3% in 1H23 vs the year before and Germany’s up a fifth. Job vacancies are still elevated, even if off highs. Gross disposable incomes rose sharply last year, but inflation outpaced incomes, hurting real purchasing power – see chart.

Wage increments are built on past inflation, so we reckon income growth could witness further increase over this quarter and next. Consumer and business confidence indices are, however, softening. Indices held up in 1Q23 but are coming under pressure in 2Q, as signaled by the drop in May Zew expectations. Price trends are expected to decelerate over the next 12 months but confidence to make major purchases is waning (see chart). Wholesale and retail sales index - seasonally adjusted - has moderated from 16%yoy in mid-2022 to 3% in May23 as high inflation and tightening measures bite.

Amongst the other growth drivers, May-Jun PMIs saw business growth stall as the manufacturing downturn deepened, whilst also reflecting a shift in demand towards services from goods. Export orders have also fallen broadly, also likely reflecting the underwhelming reopening momentum out of China. This is backed by a drop in industrial output to 2H21 lows. Low energy costs are helping to contain input costs, but the aggregate capacity utilisation rate has slipped as inventory accumulation slows. Concurrently intermediate, and capital goods imports are on the decline, partly due to base effects.

Even as part of last year’s uncertainty has eased, including supply chain woes, buoyant gas/ oil prices, and negative terms of trade dynamics, relief from these factors is now offset by tighter financial conditions after aggressive rate hikes by the ECB (over 400bp), sticky core inflation and a still difficult geopolitical backdrop. These two-way forces are likely to skew the trend towards moderation in growth this year. An interplay of better-faring services and terms of trade relief are likely to surface as key counterweights to sluggish industrial activity and lagged impact of aggressive rate hikes, keeping GDP growth at 0.6% yoy, with downside risks, vs 3.5% in 2022. Output in most of the core 4 countries are back at pre-pandemic levels (see chart). Service oriented economies like Spain and Italy are expected to fare better than manufacturing-dependent Germany.

ECB and inflation dynamics

The European Central Bank (ECB) Governing Council raised key benchmark rates to the highest level in two decades in June. The main refi rate was increased by 25bp to 4% and the deposit facility rate to 3.5%, taking cumulative hikes in this cycle to 400bp, the fastest on record. As planned, reinvestments of bond purchases made under the Asset Purchase Program (APP) are set to cease from July.

This hike was backed by an upward revision in inflation across the projected timeline, and growth down a shade. Staff now expects inflation to be near the target only after two years, with the headline at 5.4% in 2023 (core 5.1%), 3% in 2024 (core 3%) and 2.2% in 2025 (core 2.3%). Growth is seen at 0.9% this year and 1.5-1.6% over the next two years, with the weak start to the year raising the likelihood that further downward revisions are likely in the next round.

Inflation has slowed from an average of 10%yoy in 4Q22 to ~6.5% in Apr-May23, but still well above the target. The path of energy inflation is also distorted by last year’s measures to protect against high prices. Core inflation was elevated at 5.3-5.5% in Apr-May correcting more slowly than the headline. Markets-based inflationary expectations (5Y5Y swaps) as well as ECB’s survey (see chart) show that forward-looking views on inflation are yet to return to the target.

Add to this, wage negotiations fuel concerns over ‘underlying inflation’, including in Germany where the public sector recently secured a rise for 2024 after agreeing to a few tranches of tax-free payments this year, in addition to one-off increases last year to compensate for pressure on purchasing power. Even as supply-side pressures ebb, corporate profits were rising as higher costs were being passed to selling prices, adding to domestic price pressures. Even after factoring in a further correction in inflation during the year owing to base effects, its average is still likely to be high at 5.6% vs 8.4% in 2022, underscoring hawkish rhetoric from the central bank.

Sharp rate hikes are already taking an economic bite, as seen in the twice-yearly Survey on the Access to Finance of Enterprises (SAFE), while Euro area firms continue to witness an increase in turnover, rising interest costs, besides labour and production, are weighing on their profitability especially SMEs. Firms’ perception of financing conditions continued to show deterioration, with the latest level being the highest since the start of the survey in 2009. The quarterly Bank Lending survey also (see chart below) reported a substantial net tightening in credit standards for loans to firms and house purchases, with demand for loans decreasing sharply due to higher rates, lower fixed investment and weakening housing markets.

Policy guidance in June maintained its data-dependency but there were clear signs that the Governing Council is keen to have an upper hand in this inflation fight. ECB President Lagarde signalled that a follow-up hike in July is highly likely, and we reckon that a move in September (55% probability) can’t be ruled out either, barring financial sector distress.

Risks are that the hike cycle might go too far, particularly as transmission and impact of a tightening cycle show a lag. This is compounded by the bloc’s high reliance on the banking sector, where funding costs are on a steady rise, part of which has been transmitted to the lending rates. Here in lies the policy dilemma facing the central bank.

Concurrently, the central bank has also been reducing its balance sheet through quantitative tightening, after it peaked at 68% of GDP in Mar22. These asset purchases helped to keep sovereign costs low. With an aggressive tightening cycle underway, the ECB introduced the TPI (Transmission Protection Instrument) in Jul22 to allow authorities to buy bonds of national governments if bond yields rose excessively. While the instrument has not been used as yet, it has helped to cap Italy-German yields (a proxy for weak risk uptake) under check.

Lastly, Eurozone debt to GDP ratios continued to decline, heading to pre-Covid levels, helped by a sharp increase in the GDP deflators. With inflation now on the decline, these ratios are likely to fall at a slower pace this year, while the European Commission urges member countries to pare spending (towards energy support in particular) and consider fresh sources of revenues, for instance, higher corporate tax and wealth taxes. Fiscal and debt thresholds have been relaxed but are likely to be reinstated by 2024-2025.

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Radhika Rao

Senior Economist – Eurozone, India, Indonesia
[email protected]


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