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Thursday, March 8, 2007

The Eurozone - Continuing the Hike

By Claus Vistesen Copenhagen

If there is one thing you can be sure of as an ECB watcher it is that Trichet and co. almost always delievers as expected, a virtue of credibility which of course is very dear to any central banker's heart. Consequently, the ECB today upped the main Eurozone interest rate 0.25 base points to 3.75%. The rate hike comes pretty much as expected but it also comes at time when markets seem a bit more jittery than usual on the back of rising probability of a recession in the US as well as the fact, and in the light of more recent data to be presented below, that the Eurozone's stellar performance in the 4th quarter is now little more than a glimmer in the rear-view mirror.

A Rough Start to 2007

It is of course still difficult to say anything conclusive about the Eurozone's performance going forward in 2007, and especially since the 1st quarter almost certainly will show a marked slowdown on a q-o-q basis relative to Q4 2006. However, especially the initial signs from the Eurozone's biggest economy Germany suggests that the party might well be coming to an end. First of all we of course have the overall drop in European retail sales which was extended in February for the second consecutive month (-1.0% in January). Of course the overall drop masks notable differences across the zone, since for example retail sales continued to grow at a healthy clip in France.

However, in Germany there were notable signs of a strong drop on the back of the rise in the VAT effectuated January 1st 2007. Further evidence for this is to be found in the recent German consumer confidence survey which recorded a marked drop in February. Especially however, the monthly figures are telling in a German context; in December 2006 retail sales grew 2.6% from November but in January figure was a whopping decline of 5.1% which of course indicates that the notion of forward pushing purchases to avoid the tax hike seems evident. Yet, this notion of forward pushing also has an inflation story and part of the reason why the ECB has remained vigilant is precisely because the VAT hike was believed to be inflationary as retailers might pass the increase on to consumers. I have been persistently critical of this analysis and in a recent piece over at AFOE I argue why we should not expect the VAT hike to be inflationary. In terms of data, the recent inflation figures from Germany do seem to support my analysis. So consumer spending does not seem to be about to pick up in Germany which is not exactly a new story, but more worrying perhaps is the January drop in factory orders which was led by a decline in foreign demand. Of course, the January decline needs to be taken with a pinch of salt since there is a rather large discrepancy between the January and December figures. As such, if we level out the December and January figures we have a less substantial decline going into 2007 than the headline numbers suggest. However, German capex needs to be watched very carefully since a lot of it is dependent on foreign capacity and given net exports' high contribution to German growth rates even a slight decline here would be directly transmitted into domestic growth rates since we should not expect private consumption to compensate, and the fiscal environment has become more restrictive.

A Re-acceleration in the Cards?

As I stated initially above, even the most optimistic proponents of the goldilocks recovery also went out of 2007 with a bearish outlook on Q1 2007 an outlook which indeed seems to be moving steadily towards a more realistic appraisal of the whole situation. So should we expect to see going forward? In a recent note over at Morgan Stanley which seeks to test the resilience of the Eurozone to systemic shocks transmitted by any potential significant sell-off in global equity markets the MS analysts cite the underlying economic fundamentals of the Eurozone as being healthy ...

Going forward, we anticipate a re-acceleration of growth in the second half of the year, when the negative impact of fiscal retrenchments starts to fade away. Depending on the resilience of domestic demand, which so far has been more robust than expected, euro area economies seem relatively insulated against external risks.

Now, who am I to say what the difference between goldilocks and 'healthy' is, but I would like to see and hear where this expectation of a re-acceleration of growth in the latter half of 2007 comes from? Another point here is of course my lecture about the errors of looking at the Eurozone as one integrated economy and in terms of the general scenario plotted above by MS. I think we really need to take a long hard look at Germany and Italy, for example, and especially if the ECB continues its rate-hike process much further. Most importantly here we need to think about the exports picture, since exports are very important for e.g. Germany and, as is also noted by MS, a drop in the rate of increase in exports to either China or the US would have a significant impact the Eurozone's largest economy. Finally, MS outlines the ultimate risk scenario which incorporates an administrative clampdown on investment in China, a subprime (systemic) meltdown in the US, and a subsequent large selloff in global equity markets. Such a 'worst case' scenario would of course lead turmoil in the entire global economy and as MS notes would increase the risk for deflation in the Eurozone whilst immediately prompting the ECB to lower rates. However, once again we need to stop looking at the Eurozone as one single homogenous economy and for example home in on Italy and Germany and look at these economies in a world where the ECB continues to raises rates and the US begins to slow - whether moderately or considerably; in short a watered down version of the ultimate doom and gloom scenario... what would this mean for growth and inflation in these two countries? What I am of course focusing on here is consequently not so much whether the ECB should raise or not but more so the issues pertaining to the single interest rate policy itself. Ultimately, I guess you do need a specific call, so given today's comments from Trichet I would put the chance for another hike at 60/40 in favor of a hike. This relative uncertainty should of course be seen in the ligth of the near certainty of today's move and as Munchau argues today at Eurointelligence, the ECB tightening cycle is fast coming to an end and on that I think he is right on cue.