• Eurozone. GDP growth fell below trend in Q4 2007. At +0.4% q-o-q, the pace of expansion halved when compared to Q3. And there are no signs of a re-acceleration any time soon (pages 3-4 & chart below). The big three EMU countries were hit the hardest, while the smaller ones showed more resilience.

  • Germany and France suffered in the fourth quarter. In each case, GDP growth was only 0.3% q-o-q. In France, the growth slowdown was driven by an inventory rundown. In Germany, in contrast, private consumption shrank substantially.

  • Italy was hit even harder. Although the numbers have not yet been released, GDP might have clearly contracted in the fourth quarter. In 2008, Italy will again bring up the rear in terms of growth among the large countries in the eurozone (pages 5-6).

  • ECB. The ECB cannot ignore the macroeconomic warning signals. Last week, it already pointed to the deteriorating growth outlook. Despite persisting inflationary pressures, growth risks will – as in 2001 – ultimately gain the upper hand soon. We expect the ECB to switch to an easing bias followed by a first rate cut at the end of Q2.

  • Further topics:

    – Weekly Comment: The challenge for the ECB (page 2).

    – German Construction: No renewed bout of weakness (page 7).

    – US Recession – Waiting for Godot (page 10)?

    – Data outlook: EMU PMIs to tend weaker; US leading indicators to remain in negative territory (page 13).

    – Market outlook: Bonds supported; EUR to tend sideways (p. 19).


A challenge for the ECB

The ECB has stepped back from its implausibly hawkish rhetoric of last month, when it insisted that rate hikes were still being considered. The hawkish threats had been so explicit and aggressive, including the warning that the bank might act preemptively to avoid the risk of second round effects on inflation, that the turn-around was difficult to execute. It is an extremely important and positive development, however, that the change in rhetoric was brought about soon and in a decisive manner, which is exactly what the ECB did last week. The uncertainty surrounding the outlook is sufficiently high that the bank needs maximum flexibility, and with last week’s press conference it has secured it: Trichet’s message was that the bank has upgraded its growth concerns but remains ever vigilant against inflation, and stands ready to react to incoming data. This might imply a quick switch to an easing bias and rate cuts, but also a long waitand- see period followed by a resumption of the hiking cycle, depending on the evidence coming from the real economy. The ECB’s change of rhetoric has cleared the air and opened the way for a much more meaningful debate on the most appropriate policy response at the current juncture. The ECB continues to adopt a very different stance from the Fed. The Fed has pulled out all the stops and made it clear that it will ease policy as much as necessary to keep the real economy and the financial system afloat, pushing inflation concerns squarely into the background. In fact, it almost seems to downplay inflation concerns to reassure the markets that they will not stand in the way of further easing. The ECB, on the other hand, repeats that inflation is “the only needle in the compass”, that is the one key anchor of its monetary policy strategy. To some extent, this difference is justified by the different economic situations: the US economy is more fragile, due to the severe downturn in the real estate sector and the marked imbalances including the high indebtedness of the household sector. This has already been reflected in a worsening of growth indicators that suggest the US economy will at best stagnate in the first part of this year, with a significant risk of mild contraction in output in at least one quarter. Growth indicators in the eurozone, by contrast, continue to show more resilience, and while there is no doubt that the eurozone is headed for a slowdown, coincident activity indicators do not yet suggest that the deceleration will be dramatic. Against this background, the ECB cannot but emphasize its vigilance against inflation, especially as the HICP rate of growth has already reached a record 3.2% and, in our forecasts, seem destined to remain at high levels for the next few months. Keep in mind also that the ECB operates in a different “cultural” environment from the Fed, surrounded as it is by central banks which are equally worried about inflation and, in some cases, still in the middle of tightening cycles— as in the case of Sweden and some Emerging European economies.

The first signs of cooling in the eurozone’s growth performance are unmistakable, however, and the risks extremely high and skewed to the downside. The ECB is, we believe, still worried about the potential for further bad news to emerge from the books of European banks as full-year 2007 results are about to be released. In conjunction with this, the ECB’s own bank lending survey is clearly pointing to a tightening of credit conditions. While the risk of a true credit crunch is extremely limited and, as Trichet pointed out, there is little evidence to date that the financial crisis has had a significant impact on the supply of credit, on the other hand the bank lending survey suggests that credit in the euro area is about to become more expensive and harder to come by— and this is bound to have a cooling impact on growth. On balance, it seems that the ECB will need additional supporting information from the real economy before it decides to embark on an easing cycle. Following last week’s press conference, some have argued that the bank might start cutting rates as soon as April. We think this is an unrealistic expectation. While last week’s conference call marked a clear departure from January’s rhetoric, this is in part because the starting point was unrealistically hawkish, and it does not mean that the ECB is ready to follow the Fed’s path. As comments made by Mr. Weber on February 14 clearly show, inflation concerns still feature prominently in the ECB’s thinking. We still believe the first rate cut will come only in June. There is, in our view, a clear risk that the ECB might end up being behind the curve, starting the easing cycle when the eurozone is well on its way to below par growth and while growth in the rest of the world is also decelerating significantly. A monetary easing that comes a bit too late and is implemented a bit too slowly might imply a long period of sub-par growth for the eurozone. At the same time, however, we do recognize that the more aggressive approach adopted by the Fed carries equally significant risks. The financial crisis we are experiencing represents to some extent a muchneeded normalization, and reducing interest rates to excessively low levels could impair this normalization process. This is certainly one consideration in the ECB’s mind: to the extent possible, it might well be appropriate to accept some deceleration in growth to allow the financial system to consolidate and de-leverage. And with the growth outlook somewhat more encouraging in Europe than in the US, a more cautious approach to monetary policy might indeed be more appropriate. Identifying the right calibration of the monetary policy response is far from easy. As we argued at the beginning of this piece, the change of stance by the ECB has brought us back into the grey area where the debate on the most appropriate monetary policy response is most interesting and meaningful.