We are often at our most vulnerable when the tension suddenly drops: after an important exam, at the end of an intense work assignment— the stress disappears, the adrenalin that kept us going drains away, and a simple cold suddenly knocks us out. There is a similar risk for the world economy as Q2 unfolds. Signs of recovery are becoming more widespread and convincing, bringing comfort to investors, households and policymakers after long months of stress and oppressive depression. The positive reaction of market players and, to some extent, consumers is an extremely welcome development that could accelerate the recovery and the normalization of the financial system. Policymakers, however, must not let their guard down. The “green shoots” suggest policy efforts are working—they should be sustained and intensified, as the recovery is still extremely fragile and uncertain.
Against this background, the ECB faces its own stress test tomorrow: under a self-imposed deadline, it will have to decide whether a move to direct asset purchases is warranted. The recent stronger data have increased the risk that the bank will settle for a more prudent approach, not going beyond a 25bp cut in rates and an extension of liquidity operations to twelve months. This would be a mistake. With growth set to contract sharply this year and stagnate next year, the output gap is widening rapidly, and risks of deflation outweigh any risks of inflation at this stage. The war against the financial and economic crisis is not won yet.
The six months following the demise of Lehman have been a tremendously stressful period for all of us: first the threat of a collapse in the global financial system, and then the actual collapse of global output have put everyone under tremendous pressure: investors saw much of their capital wiped out; households suddenly lost their savings and in some cases their jobs; and policymakers faced unprecedented challenges and were forced to take a series of extremely difficult decisions under severe time pressure. At some point the fear of an inevitable new great depression became inescapable as it echoed louder and louder in the global media.
We can only live in terror for so long—at some point either hope or madness set in. Luckily, recent data have started to offer concrete reasons for hope. The green shoots are becoming sufficiently broad-based to suggest that spring is coming and the global economy is turning the corner. Today we saw that the eurozone services PMI for April recorded the largest monthly gain since end-2001, and the UK services PMI also rose significantly in the same month. Both indicators have clearly turned upwards, and the corresponding manufacturing indices are also moving in the same direction.
US NON-MANUFACTURING ISM HAS TURNED AS WELL
The more upbeat tone of European PMI indices echoes the turn in the US nonmanufacturing ISM released yesterday, which also showed a substantial gain in April, confirming the recovery from the nadir of last November.
EUROZONE AND UK SERVICES PMIS: SIGNS OF RECOVERY
Even more convincing signs of recovery have been coming from Asia, with a buoyant upturn in South Korean exports, a decisive move above the 50 threshold of the Chinese manufacturing PMI, and tentative signs of life in India and elsewhere in the region.
These first signs of improvement have been eagerly embraced by investors, and the sharp and sustained rally in equities shows clearly how market participants had tired of the doom and gloom outlook: not even the IMF’s scary revisions to growth projections and writedown estimates have been able to turn the tide.
A resurgence in optimism could be particularly beneficial as it extends to consumers and producers, and in this light I find the recent improvement in US consumer confidence especially encouraging. Stronger consumer confidence could help accelerate a recovery in demand—and now that inventories have been reduced to very low levels in many industries, this could set the stage for a gradual upturn in production.
The recovery, however, is still extremely fragile, and it is imperative that policymakers do not relax and lower their guard yet—the green shoots need to be carefully nurtured if they are to take hold.
The recent signs of improvement suggest that policy efforts are working, but the implication at this stage is that such efforts must be sustained and possibly intensified, not reduced. Policy makers—and investors—should bear in mind that (1) recent activity indicators seem very encouraging relative to the disastrous performance of Q4-08 and Q1-09, but are certainly not strong in absolute terms; (2) the global economy still faces tremendous headwinds, ranging from a still ailing financial sector to rising unemployment.
The ECB tomorrow faces its own stress-test: under a self-imposed deadline, it will have to decide whether the eurozone’s macro outlook warrants the adoption of orthodox quantitative easing with direct purchases of private or public assets. The hawks in the Governing Council will see the most recent data as bolstering the case for a more prudent approach. However, there is still ample evidence of how fragile the eurozone’s recovery prospects are: one of today’s less encouraging data releases showed that in March retail sales had their largest y-o-y drop on record, a painful reminder of how difficult it might be to resuscitate domestic demand in Europe. The further decline in Spanish industrial production also comes as a warning that the European recovery might be both slow and uneven.
EUROZONE RETAIL SALES KEEP TUMBLING
Most importantly, risks of deflation still clearly outweigh any risks of inflation, as ECB’s Nowotny acknowledged yesterday. Producer prices continue their plunge, as we head towards at least a few months of negative headline inflation.
The most recent rumors and indiscretions suggest a stronger likelihood that the ECB might adopt a cautious stance, and there is a clear risk that the bank might not go beyond lowering the Refi by 25bp to 1.0% and extending the maturity of the liquidity operations from six to twelve months. This would be a serious mistake, in my view. It would be a further mistake to “sweeten” the more gradual strategy with a pledge to keep rates low for a prolonged period. To the extent that it sees a risk of inflation rebounding sooner or more sharply than expected, the ECB should retain the flexibility to react as developments warrant. Moreover, a commitment to keep rates low for a prolonged period would seem at odds with the reluctance to push the Refi rate below 1.0%. While a positive level of the Refi rate might be necessary to ensure the correct functioning of money markets, several Governing Council members seem to think that such a level could be well below 1.0%, and have hinted that further rate cuts might eventually be considered. But if the Council is not yet convinced that there is a need to push the policy rate to its technical floor, it must be because it believes the risk of deflation is extremely limited, and if that is the case, a commitment to keep rates low for a prolonged period would seem hard to justify.
