As world growth continues to slow, central banks in Europe face a difficult arbitrage between growth risks and inflation risks, says a report titled “European Economic Forecast: Europe’s Central Banks Weigh Inflation Against The Fallout From The U.S. Slowdown” published by Standard & Poor’s.
“In setting monetary policy across Europe, the region’s central banks continue to wrestle with the risk of a slowdown in economic growth against that of higher inflation,” said Jean-Michel Six, Standard & Poor’s chief economist for Europe. “The downturn in the U.S. economy, the sharp rise in the exchange rates of the British pound sterling and the euro against the U.S. dollar, and the broad easing in housing markets can all potentially curtail growth. At the same time, higher oil and commodity prices (especially food) point to an acceleration in headline inflation across the region.”
In September, Eurozone consumer price inflation moved above the European Central Bank’s (ECB’s) target of “close to, but less than” 2.0% for the first time in just over a year, reaching 2.1% year-on-year. It accelerated further in October, reaching 2.6%. Energy and food prices are the main culprits behind this increase, with oil prices alone contributing 0.2% to the October figure. As oil prices edge closer to their 1979 levels in real terms (around $110 at today’s prices), the upward pressures on headline inflation show no signs of abating.
Will European central banks react to these pressures as they have in the past, by hiking interest rates? That appears unlikely. We expect the Bank of England to keep its leading interest rate on hold until the New Year, and to cut this rate by 50 basis points in the first half of 2008 as a much weaker domestic housing market weighs on consumer demand and overall growth. The ECB, on the other hand, could hike one final time to 4.25% if Eurozone inflation remains above 2.5% by year-end as we expect.
As the report points out, the next 12 months will severely test Europe’s economic fundamentals, particularly as countries in the region fall into two distinct groups. On the one hand are Germany, France, Italy, and the Benelux countries, characterized by low levels of household and corporate debt and well-positioned to be supported by their domestic demand (comprising corporate investment and consumer demand). On the other hand, Spain and the U.K. feature worryingly high levels of corporate and household debt, and so are vulnerable to a more volatile world environment and will likely experience a sharper downturn in 2008.
According to the “decoupling scenario” for the world economy, the slowdown in the U.S. should have limited effects on the rest of the world, thanks to persistent growth in emerging markets. The report argues that this view needs to be qualified.
“Imports from Brazil, Russia, India, and China–also known as the BRICs–have been growing at double-digit rates, albeit slowing in 2007. But in Europe, only Germany has been able to take a real advantage in those markets,” explained Mr. Six. “Germany alone captures 6.4% of the BRICs’ total imports, while France and Italy follow with a meagre 2.0% each.
“Moreover, the BRICs’ demand for German products will no longer be able to offset the negative effects of the sharp slowdown in U.S. imports. Exports to the U.S. represent 8.6% of Germany’s total exports (versus 7.0% for exports to the BRICs), and they fell back 3.1% in the 12 months to June 2007.”
