The slowdown in the eurozone economy, which started early in 2018 after a booming 2017, has now become rather troubling. Italy has recorded two successive quarters of negative growth, France slipped towards stagnation in December owing to the gilets jaunes protests and, most worrying of all, Germany seems to have avoided a “technical” recession only by a decimal point or two in the final quarter of last year.
The German situation is highly unusual. Normally immune to the confidence and credit shocks that have plagued other eurozone economies, Germany has apparently needed tighter, not easier, monetary policy for several years. But, in recent months, the slowdown in Germany has been much greater than would have been expected, given the behaviour of the rest of the European economy.
Why has this happened? And does the surprising weakness in Europe’s strongest economy suggest that the ECB should now be easing monetary policy for the entire eurozone?
The central bank has been very clear that the main drag on the economy since mid 2018 has come from contractionary foreign shocks. One factor has been the tightening in global financial conditions which followed increases in US policy rates. This tightening will now be reversed, given the sudden and substantial pivot towards more dovish policy guidance by the Federal Open Market Committee this month.
In addition, there has been a downward shock from foreign trade, triggered by the impact of deleveraging on the Chinese economy, and also the widespread effects of US-China trade wars on business confidence. These adverse foreign trade developments persuaded the ECB to tilt the risks around its global growth outlook from balanced to downwards-biased in its latest meeting.
“The slowdown has surprised us. What we have to understand is the persistence of this shock to eurozone growth. I would say: today the jury’s still out.
A lot of it is trade. A lot of it comes from the outside.”
Benoit Coeure, ECB Board Member, 25 January 2019
The ECB is right to blame foreign developments for the slowdown. Domestic demand in the eurozone still looks firm, with consumer spending benefiting from a buoyant labour market and rising real incomes. Meanwhile, the provision of bank loans to businesses and households continues to rise in a healthy fashion.
According to econometric models estimated in Fulcrum (see box below), the slowdown in eurozone growth in the last 12 months has been very close to what would have been expected, given the weakness in the Chinese economy.
However, the downturn in the German economy has been considerably greater than seems consistent with the China factor. This remains the case, even after allowing for the fact that Germany is usually thought to be more sensitive to the economic cycle in China than are other European economies. In fact, German activity growth is a full percentage point lower than it “should” be, based on normal links with China.
The idiosyncratic slowdown in Germany is probably due to a concentration of one-off shocks that have occurred in important industrial sectors. These shocks are unconnected to macro-economic fundamentals and they should automatically reverse fairly soon.
According to some excellent detective work by Greg Fuzesi at JP Morgan, the three sectors affected are as follows:
Taken together, these three separate shocks have probably depressed German annualised growth rates by 1.4 percentage points on average in the second half of 2018. The bounce back will probably be spread between 2019 Q1 and Q2, and should boost German GDP growth by an average of 1.2 per cent over that period.
This catch-up should take the average annualised growth rate in the eurozone’s largest economy to around 2.0-2.5 per cent in the first half of 2019. Recession over!
Provided that the drag from China gets no worse from here, the ECB will probably be able to delete its reference to “downside risks” during the second quarter, thus removing any bias towards further easing in policy (apart from new LTROs to replace expiring liquidity injections around mid year).
With activity rebounding, Bundesbank President Jens Weidmann, a perennial hawk, is likely to repeat his recent call to “normalise” monetary policy without wasting too much time this year. The labour market is tight and wages are clearly accelerating.
Mr Weidmann is still a candidate to succeed Mario Draghi as ECB President. But his support from Chancellor Merkel has apparently waned, and it seems that he is no longer the clear favourite for the top ECB job. With a more dovish new President likely to succeed Mr Draghi, the ECB will see stubbornly low price inflation as a key reason to leave policy rates unchanged until 2020.
German activity growth, measured by Fulcrum nowcasts, has slowed by about 4 percentage points since the final quarter of 2017, while the rest of the Euro Area has slowed by less than 2 percentage points. The drop in Chinese growth has been about 2.5 percentage points…
According to a new Fulcrum BVAR model estimated by Alberto D’Onofrio, Eurozone activity has slowed roughly in line with what would have been expected, given the effects of the major slowdown in China.
However, German growth has slowed a full percentage point more than would be consistent with activity in China. Much of the “unexplained” decline in German growth is due to temporary industrial shocks, which will reverse automatically in coming months…