Europe battles rising headwinds

Darren Williams, senior European economist at AllianceBernstein, discusses the implications of this month’s ECB rate rise.

This month’s increase in interest rates was a seminal moment for the European Central Bank (ECB), being the first time that it has started a cycle of monetary tightening ahead of the US Federal Reserve. The rise by 0.25% to 1.25% comes at a time when the euro area is being buffeted by a number of headwinds.

As well as those affecting other economies, such as the aftermath of the Japanese earthquake and the rising oil price, the region also has to contend with a strengthened currency.

Despite these formidable issues, we do not think they will be sufficient to derail a recovery in underlying output growth in the euro area. Nor do we think they will deflect the ECB from raising rates back towards more normal levels from the historic low of 1% reached in May 2009 after the onset of the credit crunch.

Comfortable growth

The euro area has had a good first quarter, with survey data suggesting that economic growth is running comfortably above its pre-crisis trend. Our preferred indicator, the composite purchasing managers’ index (PMI) for manufacturing and services, fell to 57.6 in March from 58.2 in February. But this is still the second-highest reading of the current economic cycle, and is consistent with real gross domestic product (GDP) growth of 0.8% per quarter.

Hard data are limited at this stage of the quarter and are confined mainly to the industrial sector. However, information released confirms the upbeat message from the business surveys. Our monthly GDP model—a composite indicator using industrial production, construction output, retail sales, car registrations and unemployment—suggests economic growth was running at 0.9% in the three months to February, the latest period for which we have a full data-set.

Despite weak conditions in the periphery stemming from aggressive fiscal tightening, we remain positive about the outlook for aggregate euro-area growth. This reflects our belief that the large (and stronger) “core” countries are enjoying fairly normal cyclical upswings, supported by buoyant world-trade growth and very loose monetary conditions (unencumbered by large housing adjustments).

Nonetheless, we doubt the economy will be able to sustain its first-quarter growth rate. It is hard to believe the headwinds that have emerged will not have some impact on the data, even if they are unlikely to derail the recovery.

Oil price rise

One such headwind is the potential supply-chain disruption from the recent tragic events in Japan. However, any impact from this will probably be temporary in nature, with companies likely to make up for any interruptions later in the year. Far more serious, in our view, is the rise in the oil price.

The pressure being exerted by the oil price is particularly apparent if we focus on the European benchmark Brent crude price in euros. Since the beginning of the year, this has increased by over 20% to stand at €86/barrel, just 7% below the record high of €92/barrel reached in July 2008.