Despite the recent improvement in short-term cyclical indicators, regular readers of our research will not be surprised to learn that we remain long-term EA bears. That is because the “E” in Economic and Monetary Union has been ignored. In the words of former Bank of England Governor, Mervyn King, “the basic problem with a monetary union among differing nation states is strikingly simple. Starting with differences in expected inflation rates — the result of a long history of differences in actual inflation — a single interest rate leads inexorably to divergences in competitiveness.”
Put simply, those countries with higher rates of price and wage inflation experienced a lower real rate of interest. By stimulating demand and driving price and wage inflation even higher, this resulted in a loss of competitiveness. As our chart highlights, in the early years, the main refinancing interest rate was too low for many of the southern member states, now it is too high. Rather than helping to achieve price stability, the monetary union has exacerbated economic divergences and fuelled support for populist parties as discontent with the status quo grows.
Unless competitiveness can be restored, then members of the common currency union must accept the need for indefinite fiscal transfers. However, creditor countries remain reluctant to enact transfers on the scale required and this is unlikely to change anytime soon. Because of that, the future does not bode well for the euro area.
Nevertheless, as we highlight in our latest Global Economic and Markets Outlook, short-term cyclical indicators have been more positive across the euro area and have surprised to the upside. Unemployment, though still painfully high, is falling fast for the majority of the member states and consumers are as confident about their own financial situation as they have been in almost fifteen years. Over the past three months, we have revised up our central projection for euro area growth in 2017 from 0.9% to 1.3%. The move reflects a combination of stronger US growth, a weaker euro and possibly a growing public perception that the authorities have things under control. As aforementioned, the latter is not a view that we share.
With respect to Germany, our view is that its economy will be the best of a bad bunch and continue to outperform the euro area as a whole. That is because the fallout from the crisis has weighed less heavily on German productivity growth than elsewhere. Also, unlike the periphery, Germany did not build up excessive debt in the run up to the financial crisis. While we are forecasting a slowdown in annual GDP growth from 1.8% in 2016 to 1.6% both this year and next (brought about by increased uncertainty following the UK’s decision to leave the EU and higher inflation from stronger oil prices), we are still above consensus.
German Economic Sentiment Indicator
Our German Economic Sentiment Indicator (GESI), part of a suite of propriety indicators created by Fathom, aims to distill the message from the responses to 18 different questions from 5 closely watched surveys into one composite measure. We have used principal component analysis (PCA) and found that the first principal component by itself is able to account for close to 65% of the variation in the underlying data. We have transformed the first principal component so that it has the same mean and the same variance as quarterly German GDP growth. The resulting monthly series is shown alongside quarterly GDP growth in the following chart.
How should we interpret the GESI reading?
The GESI is more persistent than GDP growth. By construction, it has the same mean and variance, but it displays less short-term volatility. In that sense, we might interpret it as a measure of underlying economic activity, rather than a prediction of actual GDP growth. Actual GDP growth is likely to be more volatile in any given quarter than our survey-based GESI. While still early in the quarter, January’s survey data point toward a strong Q1 GDP reading. Survey responses from the manufacturing sector were particularly robust, with expectations of future manufacturing activity, a component of the Ifo survey, also picking up sharply.
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