Markets impressed but ECB remains cautious

The eurozone emerged from an 18-month long recession in the second quarter of this year when GDP rose by 0.3%, the first increase since the third quarter of 2011. This was a double-dip recession as it followed soon after the very severe recession of 2008-2009.

The recessions have left the eurozone economy in a very weak state. The unemployment rate has climbed to over 12%, while output is 3% below what pertained ahead of the 2008-09 recession.

The GDP data for quarter two are encouraging in that they show a broad-based recovery in activity. All the main components of domestic demand — consumer spending, fixed investment and government expenditure — showed growth, while net exports also contributed to the rise in GDP. Both the manufacturing and services sectors expanded.

Leading indicators of economic activity point to a strengthening in the pace of recovery in the third quarter. The eurozone’s composite PMI, a good leading activity indicator, increased to 50.5 in July and 51.5 in August, its highest in two years and up from an average of 47.8 in quarter two.

Another important lead indicator, the EC’s economic sentiment index, has picked up strongly, hitting 92.5 in July and 95.2 in August, having averaged 89.8 in the second quarter.

The key German Ifo and French INSEE business sentiment indices have also been on a rising trend in recent months. The continued rise in the various leading activity indicators over the summer months suggests that the pick-up is gaining momentum.

One area of concern is the continuing weakness of monetary aggregates. The growth in M3 money supply remained subdued at 2.2% year-on-year in July.

Even more worrying is the continuing contraction in private sector credit. Loans to the private sector shrank further in July, declining 1.9% year-on-year. The pace of contraction has accelerated in recent months as the economy, in particular the corporate sector, continues to deleverage.

Another area of concern is the very high rate of unemployment, which rose above 12% in the opening half of the year. Labour market conditions remain extremely weak in a number of eurozone countries.

Overall, a recovery in activity has commenced and is proving somewhat stronger than expected. It would seem that stronger global growth, a fall in inflation and the accommodative stance of monetary policy are all helping to spur a pick-up in activity.

However, downside risks persist and the recovery is expected to prove moderate as on-going deleveraging in the private sector, further fiscal tightening, tight credit conditions and high unemployment, all act to restrain the pace of growth.

Thus, the ECB sees GDP contracting by 0.4% this year and is forecasting very modest growth of just 1% in 2014.

Indeed, at his monthly press conference ECB president, Mr Draghi, said that he was very, very cautious about the recovery and that the shoots are still very, very green. He repeated reassurances that, with inflation expected to remain at subdued levels in 2014, the very low interest rate environment could be maintained for an extended period of time.

Markets, though, seem to be quite impressed by the strength of recent economic data. They have started to price in rate increases from the second half of next year. The key ten-year German government bond yield has risen from 1.2 % in May to 2% recently.

The ECB’s fear is that the rise in market interest rates could choke off the recovery in activity. It has warned the markets that it could take action to counter unwarranted upward pressure on interest rates, including a further cut in rates.

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