Investment Research General Market Conditions 22 May 2014 ECB research #1 ECB s growth projection, economic slack and credit supply We expect the ECB to lower its GDP growth projection for 2014 as growth has undershot the ECB s forecast in Q1. The lower projection should also reflect that the appreciation of the effective exchange rate will have a negative impact on economic activity. We think a lower growth projection will be one argument for the ECB to ease in June. This follows as Mr. Draghi has said growth needs to exceed potential in order to close the negative output gap, which weighs on demand and inflation. The negative output gap and the related large amount of slack in the labour market implies that although the unemployment rate has started to decline, wage growth will remain subdued. Consequently, core inflation should stay modest and the ECB will, in our view, not remain complacent again. We expect the ECB to keep its growth forecast for 2015-16 unchanged. This should mainly follow as we believe it will try to tackle the worsening of the transmission mechanism through additional easing. The ECB has put a lot of focus on weak bank lending and mentioned further impairments as one of the contingencies that would warrant a monetary policy response. In light of this, targeted LTROs or ABS purchases cannot be ruled out. In our upcoming papers, we will analyse the ECB s new inflation projection followed by a consideration of ECB members communication and an analysis of likely instruments together with their market impact. ECB research 1. ECB s growth projection, 22 May 2. ECB s inflation projection, 23 May 3. ECB will surprise the markets, 26 May 4. Implications of negative rates, 27 May 5. The end of ECB s easing cycle? 28 May Lower 2014 projection, but ECB to keep 2015-16 unchanged GDP growth lower than the ECB had projected Source: ECB, Danske Bank Markets Source: ECB, Eurostat Analyst Pernille Bomholdt Nielsen +45 45 13 20 21 perni@danskebank.dk Important disclosures and certifications are contained from page 5 of this report. www.danskeresearch.com
GDP growth lower than ECB s projection The ECB has abstained from easing since it cut the refi rate in November 2013 despite euro area inflation has been very low. At the beginning of the year the ECB argued that the low inflation was less dangerous as it was mostly driven by the supply side, while demand was increasing. But its centre of attention has changed and Draghi had a much more dovish tone in April, when he said my biggest fear is actually to some extent reality, and that is the protracted stagnation. In May he strengthened the stance further and the communication was that the ECB will not accept having low inflation for too long although the recovery is gaining ground. The ECB s shift in focus from the modest recovery to the risk of a persistent period of low inflation makes the new inflation projection, which we will analyse tomorrow, most interesting, but the ECB s new growth forecast will also be important for whether the ECB will ease in June. This is particularly true as we expect a downward revision to the 2014 forecast from 1.2% to 1.1%. Our expectation follows as the growth rate of 0.2% q/q in Q1 was weaker than the ECB had projected. Additionally, the revision should reflect that the appreciation of the effective exchange rate of around 10% since mid-2012 will be negative for growth due to a worsening of price competitiveness. OECD s new global model shows that an euro appreciation of around 10% would have a negative impact on growth of 0.7pp in the first year and 1.3pp and 1.7pp in the second and third year, respectively. Hence there is also a downward pressure on the growth forecast in 2015-16. Added to this, the continuous decline in bank lending is negative for the growth outlook and as ECB s projection made in March was based on an assumption of gradually improving credit supply conditions, the forecast could be lowered (see more below). However, we think the ECB will keep its growth forecast for 2015-16 unchanged. This follows as we expect the ECB will try to improve the transmission mechanism through additional easing. In our view, the ECB will be concerned about the weaker than expected growth rate in Q1 together with a lowering of its growth projection because of the current low inflation environment. Draghi said at the ECB meeting in April that we have to have a growth rate in the coming months that is higher than the potential, so as to basically close this output gap which weighs on demand and therefore on price stability. In light of this we think a lower growth projection will be one of the reasons why the ECB will not continue its complacency. At least, the lower forecast makes it harder for the hawks at the ECB to argue that the growth outlook continues to improve although inflation is low. ECB s focus has shifted from positive growth to low inflation Real GDP to exceed its pre-crisis level from end-2015 Source: Macrobond Financial, ECB, Danske Bank Markets Source: Macrobond Financil, Danske Bank Markets 2 22 May 2014 www.danskeresearch.com
Unemployment rate points to slightly higher wage growth...... but the short-term rate might be a better indicator Source: Macrobond Financial, ECB, Danske Bank Markets Source: Macrobond Financial, ECB, Danske Bank Markets Slack in the labour market will weigh on inflation The ECB has started to focus on slack in the euro area economy and in April Draghi said the ECB sees an output gap that is pretty wide and that only gradually closes up towards the end of our medium-term horizon. As described above the problem with the wide output gap is that it keeps wage pressure and hence core inflation low. However, the unemployment rate has slowly started to decline and it could be argued that it will put some upward pressure on wage growth. Even so, Draghi has not paid much attention to the signs of improvement and instead he has highlighted the sizeable unutilised capacity. In our view, there is a lot of slack in the labour market, which implies wage growth should remain subdued although the unemployment rate has slowly started to decline. Thus ECB s projection for wage growth and hence also core inflation looks optimistic. Lower activity rate for prime-age men Source: Macrobond Financial The short-term unemployment rate remains high in the euro area. This is in contrast with the US, where it is below its historical average. In the US the relationship between unemployment and wage growth is better described by the short-term unemployment rate, see How tight is the US labour market. The short-term rate also looks like a good indicator in the euro area, and although it points to higher wage growth it also suggests that it should stay subdued. The share of long-term unemployed has increased significantly since the financial crisis kicked in and it is now historically high. Long-term unemployed workers typically have more trouble finding work and due to that their wage bargaining power is limited. As a result, the increase in long-term unemployed as a share of the total unemployed explains why the total unemployment rate is a worse predictor of wages. The activity rate has increased during the recession, which could reflect a less weak labour market, where people have not given up searching. However, the increase mainly followed as women have entered the labour force and considering the activity rate for men in the prime working age the rate has fallen since 2008. Hence, wage pressure could be kept low as discouraged workers start looking for employment when the recovery gains further momentum. There has been an increase in the share of involuntary part-time employment in the euro area and in particular in the periphery countries. This suggests more slack than indicated by the decline in the unemployment rate in these countries. On a positive note, consumers unemployment expectations have improved and are now below their long-term average. There seems to be a correlation between these expectations and wage growth and the improvement points to higher wage growth. More involuntary part-time workers Source: Macrobond Financial Better unemployment expectations Source: Macrobond Financial, ECB 3 22 May 2014 www.danskeresearch.com
Information about availability of bank loans to the private sector The ECBs growth projection made in March was based on gradually improving credit supply conditions, but bank lending has still not improved and this is another factor which affects the ECB s growth forecast negatively. So far, the ECB has argued there is a lagged relationship between credit flows and the business cycle s recovery, but with the continued lack of improvement the ECB will provide further information and analysis concerning the availability of bank loans to the private sector in early June. The ECB has already considered the decline in loans to non-financial corporations and it finds that net issuance of debt securities and non-mfi loans have more than made up for the contraction observed in MFI lending in the recent quarter. Moreover, the ECB concludes that this does not reflect constrained access to bank funding but rather attractive market conditions as it occurred while the cost of market based funding was exceptionally low. Nevertheless, the net issuance of debt securities by NFCs is concentrated in Germany, France and Italy and it has to a large extent been limited to large firms. Hence, the decline in MFI loans to the private sector and, in particular, to SMEs is still in focus at the ECB. In the ECB s Bank Lending Survey it appears that euro area banks credit standard towards SMEs was eased in Q1 14 for the first time since 2007. On the other hand, SMEs demand for loans continued to decline; hence, the decline in loans to SMEs does not only seem to be due to lack of availability of bank loans. In the ECB s survey of access to finance of SMEs it was also reported that availability of bank loans was less negative. Even though the surveys point to improvement, it still needs to be seen in actual lending figures in order to push the recovery to the next level. Therefore, we think the analysis of the availability of bank loans will be crucial for the growth forecast for 2015-16. However, if the ECB s analysis does not point to improvement, we expect the ECB will try to tackle the worsening of the transmission mechanism through additional easing. According to Draghi, the instrument will in this case be a targeted LTRO or an ABS purchase programme. We will discuss this further in our upcoming papers. External financing among non financial corporations 800 700 600 500 400 300 200 100 0-100 -200 2000 2002 2004 2006 2008 2010 2012 MFI loans to NFCs (adj. for loans sales and securitisation) net issuance of debt securities by NFCs net issuance of quoted shares by NFCs Source: ECB non-mfi loans to NFCs (excl. securitisations and bad bank transfers) total 800 700 600 500 400 300 200 100 0-100 -200 Banks credit standard and demand for loans among SMEs Source: ECB s Bank Lending Survey Conclusion: we expect the ECB to lower its GDP projection for 2014 and this will be one argument for the ECB to ease in June. This mainly follows as growth needs to exceed potential in order to close the negative output gap which weighs on demand and inflation. We think the ECB will keep its 2015-16 forecast unchanged as we expect it to try to tackle the worsening of the transmission mechanism through easing. In our view, bank lending needs to improve to take the recovery to the next level. 4 22 May 2014 www.danskeresearch.com
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