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Monday June 20, 2005 - 10:41:32 GMT
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The euro economy: will the ECB have to cut interest rates?

Economics Weekly: Economic Research and Analysis

The euro economy, down but not out?
In the last month, the euro area has seen the rejection of the Constitutional Treaty in referendums in France and the Netherlands, two of the founder members, and a continued spate of poor economic data. It is no wonder that the currency has fallen to 10 month lows versus the US dollar and that bond yields are at record lows. Moreover, the likely failure to reach a deal on the EU Budget this week seems to suggest that further political problems lie ahead. Does this mean that interest rates have to be cut? We look at some of the main euro economic indicators, which do seem to argue for a rate cut.

Another EU recession on the cards?
After a recovery to 1.7% growth in 2004, following expansion of just 0.7% in 2003, growth in the eurozone is weakening again. Chart A shows consumer and investment spending growth rates sliding back from modest peaks in 2004. Where the slowdown will end is uncertain, but Italy has already registered two quarters of negative growth so is technically in recession and production and retail sales are close to zero in the three biggest economies in the euro area.

Chart B shows that for the eurozone as a whole, growth in industrial production and retail sales are both falling sharply. What is the driving force behind this recent weaker economic growth trend? International oil prices are still high and have slowed global economic activity, so is clearly one reason why consumers could be cutting back and industrial production is dropping. Weaker growth in the EUís main export market of the US, and some fall in import demand from China in the first quarter of 2005, may also be impacting. Chart C shows that industrial confidence and consumer confidence in the euro area are both falling. Political uncertainty related to recent events on the treaty and the prospect of general elections in Germany may also be hitting confidence.

But fiscal policy is still loose, interest rates have not been raised and the currency is weaker, which should be acting as some counter weight to the negative effects of high oil prices and politics. However, chart D highlights that the euro area is also suffering from high levels of unemployment, which is related to low consumer confidence and hence acting as a big negative factor for domestic demand. The link between unemployment and consumer confidence depicted in the chart is suggesting that consumer spending could weaken even further, as confidence is currently higher than the past pattern suggests. The problem for the ECB is that it believes that unemployment is high because of lack of labour market reform to make it flexible like those of the US and UK rather than because interest rates are too high or the currency has been too strong. But it may not be able to long resist a cut in rates, given how weak economic growth is and that inflation is falling below the 2% target.

ECB may have to lower rates
It is for all these reasons that the financial markets are beginning to bet that eurozone interest rates could be cut. Chart E suggests that with inflation now below the 2% reference level, a rate cut must now be a greater possibility. A cut may help to bolster consumer confidence and prevent the downturn getting worse. But the ECB remains concerned that with fast growth in money supply, see chart F, there is a risk of asset price inflation. Hence, it may wait for price inflation to fall further below target before acting. If inflation does continue to decline, and economic growth remains as weak as recent trends are currently suggesting, then a cut in the repo rate by the end of Q3 is a realistic possibility. This would be even more likely if the exchange rate were to appreciate from current levels. But the ECB is likely to remain cautious, so a ľ% reduction seems more likely than one of Ĺ%.

UK economic indicators
Strong M4 money supply growth was cited by Governor King as one of the reasons to think that economic growth could bounce back later in the year. Release of this data for May on Monday may hence elicit additional financial market interest. We look for a rise of about 1.0% in the month but a fall in the annual rate to 10% from 10.5%. Minutes of the MPC meeting in June, released on Wednesday, could show that one member voted for a rate cut, probably Marian Bell as a final flourish in her last meeting. With oil prices rising again, the May CBI industrial trends survey may show little or no improvement in company expectations about their order books.

Trevor Williams, Chief Economist
[email protected]
Lloyds TSB Bank,
Financial Markets
Faryners House,
25 Monument,
London EC3R 8BQ
0207 283 - 1000

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