At face value, the latest euro area GDP data were disappointing. While surveys had signalled an acceleration in growth in the fourth quarter of 2016, economic growth was in fact unchanged at 0.4%Q/Q. That, however, still left full-year growth in 2016 at 1.7%Y/Y, beating the rate in the US for the first time since 2008. And the individual country figures suggest that – just as has been the case ever since the recovery got underway almost four years ago – domestic demand was again the driver. Consumer spending continued to grow thanks to elevated household confidence, higher employment and rising real incomes. Meanwhile, with corporate profits on the up, capacity utilisation the highest since mid-2008 and orders plentiful, private investment is rising too, helped by record low interest rates and easier credit standards. And, particularly in Germany, government spending is also supporting growth.
The economic expansion was widespread at the end of 2016, with activity accelerating in Germany and France and remaining vigorous in Spain. And while GDP growth remained subdued in Italy, and output retreated in Finland and Greece, with no member state in outright recession and none overheating the dispersion in growth rates across the member states has fallen to the lowest levels since the launch of the single currency. That suggests improved convergence in economic conditions, which should support the sustainability of the economic recovery over coming quarters. The expansion looks to have been broad-based across sectors too. Services, which have cumulatively accounted for about three quarters of the growth in output over the past four years, likely provided most support again in Q4. Construction output was also stronger. And while it was surprisingly subdued in December, manufacturing output also made a positive contribution to GDP growth in Q4.
Despite the broadly upbeat growth story, however, inflation remains the principal focus in the euro area. For the second successive month, CPI surprised very significantly on the upside in January, jumping 0.7ppt – the most in more than six years – to 1.8%Y/Y, the highest rate in almost four years. That figure was about ½ppt higher than the ECB forecast published as recently as December. And it’s also arguably consistent with the ECB’s inflation target of “below, but close to, 2%Y/Y”.
The increase in inflation in January was driven most notably by energy prices, which posted their biggest monthly rise in four years, up more than 8%Y/Y. That was a predictable response to recent shifts in the oil price, the effects of which were exacerbated by a spike in electricity prices attributable to adverse weather, particularly in Spain, where headline inflation more than doubled close to 3%Y/Y. Food prices also rose the most in three years, while prices of non-energy industrial goods rose the most in seven months. However, since the rate of increase in service prices eased slightly, core inflation remained unchanged at a still-tepid 0.9%Y/Y.
Headline inflation now looks likely to average about 1.8%Y/Y over the coming few months and more than 1½%Y/Y in 2017, the most since 2012. To match this new reality, when the Governing Council meets early next month, the ECB will need to announce a significant upwards revision to its own inflation forecast for 2017, which currently stands at just 1.3%Y/Y. And its assessment that interest rates might be cut further now looks particularly incongruous and seems likely to be dropped. But having in December pre-set a path for QE in 2017, with assets to be purchased by the ECB at a rate of €60bn per month from April to year-end, the Governing Council will not change its plans.
To provide greater clarity on the ECB’s decision-making, Mario Draghi has set out certain economic conditions that need to be met before the ECB will consider reducing further the rate of asset purchases. In particular, policymakers want to be confident that inflation will be consistent with the ECB’s target over the medium term even if and when stimulus has been removed. And to satisfy that condition they will want to see underlying inflation establish a firm upwards trend, such that it might be expected to settle close to 2%Y/Y and remain there even once the ECB ceases buying assets. With euro area core CPI still less than 1%Y/Y, that condition for tightening has certainly yet to be met.
Indeed, given the current lack of underlying pressure, once the effects of past movements in oil prices wear off, headline inflation might well be weaker in 2018 than in 2017. Nevertheless, in coming months, a gradual upwards trend in euro area core CPI still seems likely to emerge. In some countries – most obviously Germany, but also the Netherlands and Portugal – the unemployment rate has now fallen to levels likely to generate higher labour cost growth over coming quarters. We also expect higher prices of energy to be passed on to consumer prices of other items, particularly services. With the global economic recovery regaining traction, external price pressures might also soon be reflected in higher inflation of non-energy industrial goods. And any renewed depreciation of the euro against the dollar that might follow further tightening of US monetary policy would also be expected to lead to higher prices of imports.
However, even if euro area core inflation takes a convincing upwards shift over the near term, the ECB will not be in any hurry to act, wary of the risks that new adverse shocks might emerge to destabilise the economic recovery. Currently, those shocks seem most likely to come from the political sphere, with fears of a destructive shift towards populist nationalist parties in upcoming elections. But ahead of the first event in the pipeline – the general election in the Netherlands on 15 March – opinion polls suggest that the far-right anti-euro anti-immigration Freedom Party of Geert Wilders has recently lost support. Long and difficult negotiations to form a coalition among three or four parties are nevertheless likely to be required to establish a new government and policy inertia could last for several months.
Over recent weeks, however, investors have become most uneasy about the forthcoming French Presidential election, pushing spreads of French sovereign bonds over their German counterparts to their widest since the euro crisis more than four years ago and pushing spreads of Southern European bonds significantly wider too. Opinion polls strongly suggest that Marine Le Pen of the far-right National Front will qualify for the second round of the French Presidential election, with significant uncertainty as to who – from the left, right or centre – might eventually qualify to compete against her. And, after she reiterated her determination to push for a referendum to withdraw France from the euro and implement policies consistent with large-scale debt default, ultimate victory for her in May would represent an existential threat to the single currency. On balance, opinion polls suggest that Le Pen will not triumph. However, investors and policymakers alike would seem foolish to ignore the risk.
*This article was originally written for and published in Japanese by NNA Europe (http://europe.nna.jp)