17 October 2017
2017 has been full of good news stories for the Eurozone: GDP is growing at double its potential; unemployment is at a post-crisis low; economic sentiment is at multi-year highs; and populist threats in France and the Netherlands passed without major incident. At the headline level, markets are calm, with volatility at historic lows in equity markets and yields supressed by the ECB’s asset purchase programme (see Chart 6). No surprise then that given this stronger environment, the ECB looks set to announce plans for tapering this asset purchase programme, in spite of little tangible evidence of sustained inflation close to the Bank’s 2% target. There is naturally some nervousness about this tapering, given the degree of pain that followed the last financial crisis, which is widely considered to have been exacerbated by the ECB’s initial reticence to enact extraordinary measures.
On top of these scars, as we frequently point out in this column, the headlines obscure the country level data, with differentials tending to emerge between core, like Germany, and periphery, like Italy, Spain and Ireland, in terms of economic structure and vulnerabilities. While the recovery is broad-based, peripheral countries are recovering from much lower troughs than, say, Germany and tend to draw much more scepticism about the durability of economic recovery given their high government debt levels, unemployment and often chaotic politics (see Chart 7). Of course, Germany, the largest economy in the Eurozone, is firing on all cylinders, so why worry about weakness in a few small countries? The IMF has stressed that a key lesson from recent financial crises is that contagion and spillovers are important factors that can rapidly transform idiosyncratic events into systemic crises. This is especially true for the Eurozone, where member states share a common monetary policy but retain fiscal control, albeit somewhat constrained by Eurozone fiscal rules. The ECB’s challenge is to balance policy across these diverging regions while monitoring signs of financial stress. Given this, are there any signs that financial stress is on the rise?
The substantial strengthening of the euro over the past year constitutes a form of monetary tightening in itself, prompting monetary conditions indices to rise. At the country level, there are pockets of potential stress that echo back to the last crisis but on the whole conditions are better than they have been since the crisis began. Irish house prices raised a few eyebrows last week, growing 10.6% on the year, though they remain 30% below pre-crisis highs. In Italy, the latest data indicates that bad loans in Italian financials have fallen to a three-year low but levels remain high and further work remains to be done in the Eurozone more broadly to create a banking union to prevent repeating the mistakes of the past. But, while the focus tends to be on what caused the last crisis – and clearly these issues have not disappeared completely – political uncertainty also warrants monitoring, with the upcoming Italian elections set to test investor nerves. These few clouds in an otherwise blue sky suggest ECB policymakers are best to proceed slowly with normalisation through tapering, waiting to raise rates only after tapering has ended and maintaining flexibility to address financial stress if it returns.