As political risks diminish in Europe, economic strength continues to grow — which raises the pressure on ECB President Mario Draghi to bring an end to quantitative easing.
We take an optimistic view of the latest political developments in Europe. With Marine Le Pen vanquished by Emmanuel Macron, the risk of accelerated EU disintegration has decreased significantly and attention may turn to the National Assembly elections in June. As we write, the key questions are relatively obvious but hard to answer: What kind of parliamentary configuration will President Macron have to manage? How will the French economy progress under Macron’s untested leadership?
The Franco-German relationship is crucial for the continued development of the European Union, and the diverging economic performances of the two economies have in recent years put this relationship under strain. However, with a significant political uncertainty now gone in France, it is possible to entertain the idea of reforms pushing France onto a stronger economic path, allowing the growth gap with Germany to shrink. In turn, this would permit some key features of European policy to be opened for debate. This will not happen quickly, but it is important to acknowledge that there is upside potential for Europe.
Positive surprises across the eurozone
As we noted last month, the composition of European growth is encouraging. From a higher-than-expected core inflation reading to better industrial production and higher economic confidence, both the “hard” and “soft” data signals have been numerous and substantially positive across Europe. Indeed, Europe has pulled up our surprise measures for developed markets as a whole, as well as our global measure of economic surprises. While surprise indexes measure gaps between expectations and actual data releases, it is important to analyze the expectations as well. It may be that expectations remain low because analysts show a persistently gloomy bias about Europe. Many market observers dismissed the early signs of Europe’s cyclical recovery, and they continue, in our view, to put too much weight on everything that is structurally weak about Europe. While we agree that structure matters, we observe that even basket-case economies have cycles.
With a significant political uncertainty now gone in France, it is possible to entertain the idea of reforms pushing France onto a stronger economic path.
We believe there is a good chance that Europe’s economy is shifting into a higher gear; indeed, it may already have shifted up and is maintaining a new pace. Manufacturing data are consistent with strong growth, confidence has risen in most sectors across the region, and we are finally seeing signs of a recovery in bank lending. Credit to households and non-financial corporations rose by €34 billion in March — its biggest increase in the current cycle — and the ECB’s bank-lending survey saw banks reporting unchanged credit standards amid rising demand for credit.
Economic strength through a hawkish policy lens
At the European Central Bank (ECB), of course, stronger growth lends support to the hawks’ argument that the emergency policy settings of quantitative easing (QE) are no longer appropriate. In this argument, the pace of growth matters, and the ECB should place less emphasis on the output gap. By the time inflation emerges, there is a risk that monetary policy will overreact, given the lags involved in implementation, and this will add to economic volatility.
The second point the hawks like to make is that inflation dispersion across the eurozone has declined. In Spain, for example, headline inflation was negative for almost all of 2014, 2015, and 2016, but the latest data put it at 2.6%. Italy shows a similar story. Of course, this is headline inflation, and commodity price shocks are common across the zone. But core inflation has moved higher in the periphery, even in Greece, where it’s now hovering around zero.
A third argument the hawks like to make is harder to support, but is arguably the most important. German inflation is already at 2.0%, and the average German inflation rate in the first four months of the year has been 1.9%. This is causing widespread nervousness as the last interest-rate increases the ECB made — two hikes in 2011 — took place when German inflation was running over 2.0%. It is true that, in an unusually frank admission by a central bank, senior ECB officials have said those hikes were a mistake. It is also true that the ECB targets inflation for euroland as a whole. But political realities do not always respect reasonableness.
This does not mean the ECB is about to hike rates. In our view, it underscores how serious the conflict within the ECB must be and how it is increasingly difficult for Mario Draghi to manage. The easiest way to placate the hawks is to begin to plan for the end of QE and to introduce ambiguity into the ECB’s outlook, and we expect this to dominate the ECB meeting cycle in the next few months. Again, the risk is that the hawks push the ECB too quickly into tightening mode.