The list of signs of stabilization grows by the day, today with June Eurozone economic confidence. It is still too short, however, to lead the ECB to change its cautious tone later this week. The green shoots are not a positive surprise, they are just confirmation of what most of us expected, and as such they justify relief, but not enthusiasm. In fact, the ECB’s own macroeconomic outlook would justify additional easing, but the turnaround in activity data has shifted the balance of risks: given the still high uncertainty, the ECB now probably sees the risks of policy overshoot as larger than those of a renewed economic downturn. Similarly, the ECB sees risks of deflation as limited, and its priority is to maintain the ability to tighten quickly when needed. Therefore, I expect the ECB will keep policy on hold this month and for the rest of the year. Then it will turn from watching the green shoots to picking the petals off the first daisy, wondering “I tighten, I tighten not…” Meanwhile, in the coming months it will watch anxiously various measures of inflation expectations, because the true test of whether inflation expectations are really anchored is coming now.
Eurozone economic confidence rose for the third consecutive month in June, beating consensus expectations and bringing some additional comfort to ECB officials preparing for Thursday’s monetary policy meeting. With the exception of retail, all sectors reported unchanged or improved sentiment, confirming that the turnaround is broad-based. This, however, will change the ECB’s cautious tone in my view, and for good reasons.
First, saying that the worst is behind us does not mean much when the worst is as bad as what we have seen. As ECB President Trichet has explained, we are seeing evidence that the economy is stabilizing at very low levels after a dramatic plunge—this is reassuring, but hardly cause for unrestrained celebration. Economic confidence, like other indicators, is still deep in recessionary territory, having barely recovered after a deep and prolonged plunge (see chart above).
Second, we need to bear in mind that these signs of stabilization, the by now famous “green shoots”, are just the confirmation of what most of us expected, and not a pleasant surprise. In other words, they are consistent with expectations of a very gradual and weak recovery rather than with V-shaped rebound—indeed upward revisions of growth forecasts by investment banks and international organizations have been limited and mostly cautious.
Based also on these tentative signs of stabilization, the ECB will most likely keep policy on hold this week, holding the Refi rate at 1.0% and declining to step up either its liquidity operations or its asset purchases. Indeed, the ECB will almost certainly re-emphasize that both the covered bonds purchases and the 1-year liquidity operations launched last week are aimed at providing “better” liquidity rather than more liquidity.
