Is the Eurozone on the path to recovery?

24 May 2016

By Shadforth Financial Group

The economic recovery in the Eurozone has been progressing at a slower pace than initially expected. The European Central Bank (ECB) has attempted to stimulate the Eurozone economy by using policies that are designed to encourage businesses to borrow money so they can invest. These measures are known collectively as quantitative easing.

As well as reducing the main interest rate, the ECB has also directly purchased corporate bonds. This pushes  the prices of corporate bonds up and thereby reduces the yield, which makes it cheaper for companies issuing bonds to raise money. The ECB recently increased their corporate bond purchases from ¤60 billion to ¤80 billion per month and reduced the deposit interest rate by 10 basis points to -0.4 per cent. By pushing the main interest rate into negative territory the ECB intends to force businesses to spend money rather than save it. The ECB has also decided to purchase non-bank corporate bonds, which had the desired effect of increasing their prices.

The other benefit of quantitative easing is that it helps reduce the value of the Euro, making exports cheaper and more competitive in the global marketplace. The Eurozone is on the right path to recovery but hurdles remain.

Deflation remains a concern

Low oil prices and a weak economic outlook have pushed prices down, causing headline inflation to actually become deflation, with prices in the Eurozone falling
-0.2 per cent during February. The ECB has accordingly revised its forecast for 2016 consumer price inflation down to only 0.1 per cent. This is well below the target  of around 2 per cent over the medium term. It is evident that the short-term outlook has worsened since last quarter and this is reflected in the lower gross domestic product (GDP) forecasts of 1.4 per cent and 1.7 per cent for 2016 and 2017.

It appears that further monetary stimulus is justified whilst the Eurozone faces deflation risk, worsening business and consumer confidence and the uncertainty that currently surrounds the global economy.

ECB likely to do more

The economic recovery in Europe is expected to continue, but at a slower pace than initially forecast. Negative spillover effects from economic issues in China and emerging markets poses a risk to Europe’s economic recovery. If growth is stifled then the ECB still has a number of available options. New unexpected shocks to the economy may see the ECB adopting these options and introducing further monetary policy measures.

These measures could include:

> increasing the amount of monthly asset purchases, which are currently ¤80 billion
> widening the universe of asset purchases
>  lengthening quantitative easing past the intended end date of March 2017.

The ECB could also extend its Long Term Repo Operations or implement a new program with the aim of offering attractive long-term funding conditions to banks. The ECB hopes to further ease private sector credit conditions and stimulate credit creation to justify the monetary policy it is carrying out.

But will further monetary easing work?

The answer to this question rests on how effective further quantitative easing will be and whether financial markets have grown immune to ECB policy measures.
Despite expansionary monetary policy, we are yet to  see inflation at levels the ECB has forecasted. This begs the question as to how low inflation would have been without unprecedented quantitative easing measures,  or whether the ECB money printing scheme is simply failing. It is evident that either economic headwinds  have strengthened or monetary policy is starting to lose its effectiveness as seen in the downward revision to consumer inflation projections for 2016 to 0.1 per cent.

Although monetary policy is having an impact on growth for now, Europe may require structural reforms and healthy fiscal policy to return the economy back to stability. The chart below demonstrates how there is a divergence between inflation and ECB quantitative easing.

Chart 2

Political instability could derail recovery

Geopolitical risks and spillover effects from external factors skew risk to the downside in Europe, particularly if geopolitical risks were to materialise.

All of the focus in the United Kingdom (UK) for example, is on the 23 June referendum regarding the UK’s withdrawal from the European Union (EU). Opinion
polls show that the position between the ‘stay’ and ‘leave’ vote is relatively close, as shown in the chart opposite.

The uncertainty regarding the decision is adding pressure to already volatile markets. This volatility exists despite underlying economic factors, including growth and consumer spending, being relatively strong in the UK.

The long term risks of an EU exit would depend on the post-exit relationship between the UK and EU. Far-reaching negative consequences could eventuate if the relationship is one that restricts trade between non-EU and EU members.

A free trade agreement would most likely be implemented but the trade benefits of staying in the EU outweigh current free trade agreement models. UK growth could be further impacted if the free movement of labour was obstructed, particularly for lower skilled workers.

Chart 2

If the UK withdraws from the EU, it would have a negative effect on global market sentiment. It would raise questions over the implementation of structural reforms and the possibility of a wider EU breakup.

European politics and the uncertainty regarding the outcome of the referendum will continue to skew economic risk to the downside in the Eurozone. The Eurozone is on the road to recovery but the path ahead remains uncertain and strewn with potential difficulties.

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