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Widening EMU output gap to keep core inflation in check

Fri, Jul 11 2008, 12:21 GMT
by Alexander Koch

HVB Group

• Growth. Italy is teetering on the brink of recession, Spain’s economy is in free fall, France is ailing, and even Germany can no longer escape the global downward pull: After the strong start into the year, German GDP is expected to have contracted this spring. And the economy will continue to merely plod along over the coming quarters (pages 2-4).

• Inflation. GDP growth persistently below trend EMU-wide will, however, see core inflation moderate again in the mid-term. Our output gap model based on the PMIs is a clear indication (cf. chart). And headline inflation will also come close to the ECB target zone again in mid-2009 (pages 5-6).

• Second-round effects. There are few if any signs of a wage-price spiral. Even though total compensation per employee as well as unit labor costs are clearly pointing north, our calculations show that this is nothing more than the normal (late) cyclical lag of these indicators (p. 7-8).

• Monetary policy. The ECB should, therefore, keep the key interest rate steady well into next year, even though we cannot deny the risk of an additional rate hike by the end of this year. The persisting growth weakness should, however, force the central bank to initiate an easing cycle towards mid-2009.

• Further topics:
  

  – US: Rising unemployment to slow wage growth (page 9).

  – Fed seeks new regulatory powers to ensure financial stability (p. 12).

  – Data outlook: ZEW growth expectations to decline further; inflation continues to accelerate in the US (page 15).

  – Market outlook: Bonds well supported, EUR pretty stable (page 22).

German GDP: Weakening across the board

• After starting the new year on a very strong note, German GDP is expected to correct strongly in the second quarter. This is suggested by our estimates for the components based on the data available so far.

• First and foremost, investment was probably a major drag after a temporary boost in the previous quarter. Private consumption also points south. Support is, in contrast, expected from net exports.

• We think the risks for our forecast of -0.2% q-o-q are clearly to the downside. After the distortions in the first half of the year, sentiment indicators suggest the pace of growth will slow substantially in the further course of the year.

Decoupling remains wishful thinking

The German economy will not decouple from the global downtrend. The latest sentiment indicators have provided impressive proof of this. The strong correction in the ifo business climate index as well as six consecutive declines in new industrial orders suggest that the resilience of German companies is coming to an end. After the economy was still able to post very strong growth at the beginning of the year of 1.5% q-o-q, the outlook for growth in the remainder of the year has deteriorated considerably. The GDP Flash for the second quarter will not be released until August 14, but the hard data is already available for the first two months of the quarter. The final month of a quarter can only have a material impact on the reading for the quarter in the event of very strong fluctuations. For that reason, we look below at the data available so far and draw implications for the individual GDP components and growth for the quarter as a whole.

Correction in construction

Investment in construction was up a massive 4.5% in the first quarter. The main reason for the boost was the favorable weather at the beginning of the year, which had hardly any negative impact on construction activity. After a relatively cold start into the winter in November, temperatures in January and February were well above the long-term average. As a result, construction was able to make a strong contribution to growth. The strong, weather-related distortions did, however, trigger a drastic correction of construction output in the spring (cf. chart in the next column). Accordingly, our model for investment in construction points to a strong q-o-q decline of roughly 5%.

Exports weak – Imports weaker

In May, exports plummeted unexpectedly by 3.2% m-o-m. While the strongest decline since February 2005 was probably amplified by two bridge days and, therefore, the smaller number of working days, even a probably pronounced recovery in June will not prevent a decline in real exports q-oq. Based on the first two months, our model predicts a decline of 0.9%. Despite the weak export dynamic, net exports are not, however, expected to be negative, since imports adjusted for inflation have posted a substantially stronger decline. Our model projects real imports will be down a strong 2.2% for the quarter. Overall, therefore, net exports should have provided growth with tangible support in the second quarter, after slowing GDP growth at the beginning of the year by 0.2 pp.

Comparison of the model forecasts with the actual readings shows that, as a rule, the foreign trade numbers are a reliable predictor. Deviations are, however, possible, since the monthly numbers do not, for example, include exports and imports of services, which account for roughly 13% of total exports.

Inventory rundown probable

After a strong inventory buildup supported growth at the beginning of the year with a high 0.7 pp, the second quarter is expected to bring a moderate inventory rundown. This is suggested by the equation we have developed, which includes exports, imports and retail sales. The higher exports and retail sales, the stronger demand and, therefore, the inventory rundown. In contrast, stronger import growth triggers an inventory buildup since firms use commodities and intermediates from abroad for further processing. Above all the setback for imports therefore argues for a negative contribution to growth from inventories. Despite the good results produced by our model estimate, caution is nevertheless warranted: Inventory movements are always good for a surprise, since they also include residuals that cannot be allocated to the other GDP components.

Consumption again points south

Near-time data for consumer spending is available in the form of retail sales. And after stabilizing at the beginning of the year, they again point clearly south in spring. The latest retail sales numbers including autos and gasoline point to a tangible decline of over 2% q-o-q for the first two months.

Alongside the growing uncertainty about the economic outlook, above all the high level of inflation is eating into household purchasing power. At the moment, this cannot be offset by the still positive development on the labor market. Accordingly, our model for private consumption suggests private consumption will contract in the second quarter, after growth of 0.3% at the beginning of 2008. The deviation between the forecast and the actual numbers in the past shows, however, that the imponderables for the estimate are considerable. The reason: Retail sales including autos and gasoline cover only roughly 40% of total consumption expenditures in Germany.

Forecast risks

In contrast to the GDP components discussed above, models cannot produce adequately reliable forecasts for investment in machinery and equipment and government consumption1. It is, however, possible to make plausibility comments. After the declining-balance depreciation ruling for corporate investments expired at the end of last year, investment in machinery and equipment was again up a surprisingly strong 3.7% q-o-q in the first quarter. A strong correction is, therefore, probable in the spring quarter. Overall, corporate investment plans remain expansionary so far. The increasing weakness of foreign demand and still ailing households do, however, suggest, that investment in machinery and equipment will increase much less in the further course of the year than in the two very strong previous years.

Government consumption was up strongly at the beginning of the year. The improved public-sector budget situation combined with still rising tax revenues also point to a steady uptrend in government consumption for the remainder of the year.

Conclusion and outlook

Overall, the analysis of the data available so far confirms our expectation of a strong correction after the very dynamic start into the year. The strain from private consumption and specifically investment should more than offset the positive contribution from net exports. The risks for our quarterly forecast for real GDP of -0.2% are also clearly skewed to the downside. There is additional uncertainty for our full-year forecast of 2.2% (adjusted) because of an undisputable revision risk for the first quarter. Seasonal adjustments due to the primarily weather-related problems could result in the correction in the second quarter being milder, at the expense of a downward revision of the growth rate for the first quarter. This scenario would have clearly negative repercussions for the prospects of the growth rate for the year, since the GDP dynamic at the beginning of the year has a decisive impact on the growth rate for the full-year. After the distortions in the growth dynamic in the first half of the year, the numbers in the coming quarters should better reflect the underlying macroeconomic trend. The recent clear deterioration in business sentiment and the still ailing consumer confidence do not point to a recession in the second half of the year though. The growth dynamic should, however, be at an appreciably weaker level below potential. We expect a quarterly dynamic of only roughly ¼% (cf. chart).

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Published on  Fri, Jul 11 2008, 13:03 GMT