- Euro area inflation has been falling steadily for more than two years and the region as a whole is now worryingly close to outright deflation.
- Until this week, policy makers could at least take comfort from the fact that the economy was in recovery mode.
- Since it emerged from recession early last year, growth across the single currency bloc had always been modest, fluctuating between 0.1% and 0.3% per quarter.
- All that changed on Thursday when Eurostat published its first estimate of GDP in the three months to June showing that activity had stalled.
- With one more justification for inaction removed, the pressure on the ECB to do something must now be intense, if not yet intolerable.
The preliminary estimate of euro area growth in Q2, at 0.0%, was below both our own forecast, of 0.2%, and that of the consensus. Looking into the detail, output in Germany fell by 0.2%. It is unusual for the region's economic powerhouse to underperform the euro area average - it is only the second time that it has happened since the depths of the global financial crisis in 2009. Output in France was unchanged for the second quarter in a row, causing the French government to halve its forecast for growth this year from 1.0% to 0.5%. Even that looks optimistic. With output in Italy falling by 0.2%, it was left to the peripheral economies to prevent contraction across the region as a whole. Output in Portugal rose by 0.6% after falling by 0.6% in Q1, while Spanish GDP grew by 0.6% in Q2 following growth of 0.4% in Q1.
It is notable that the GDP data released this week pre-date the escalation of the crisis in the Ukraine, which saw further sanctions imposed on Russia by the US and the EU at the end of last month. Euro area trade with Russia has increased markedly since the turn of the century. Russia takes more than 4% of total euro area exports, and supplies more than 8% of total euro area imports. A significant reduction in trade with Russia has the potential to hit the single currency bloc hard. We estimate that a reduction of one third in Russia's supply of oil to the euro area could lower growth across the region by between 1% and 1½% in the first year. It is notable that the ZEW survey of European economy watchers reported a sharp drop in the index of economic sentiment from 48.1 in July to 23.7 in August. That was the biggest one-month fall in more than three years. The chances of a meaningful bounceback in growth in Q3 appear bleak.
Final CPI data for July, also published on Thursday, confirmed the flash estimates of 0.4% for headline inflation and 0.8% for core inflation. Four economies are in outright deflation on the headline measure, while all 18 are below the 2% target, and substantially so in most cases.
We have written before about the corrosive impact of low inflation on the balance sheets of over-indebted sovereigns. Let us take Italy as an example. Even if we assume, somewhat generously, that Italian growth returns eventually to its average rate of 1.5% seen in the 30 years running up to the crisis, it would still require an inflation rate in excess of the 2.0% target just to stabilise Italian debt as a proportion of GDP. Italy at present has no growth, no inflation, and of course no currency of its own. Something needs to give and soon if Italy is to continue to finance its vast national debt.
With the euro area now back on the brink of recession, it is worth reminding ourselves that the collapse of Lehman Brothers did not cause the US recession. It was precisely the other way around. According to the Business Cycle Dating Committee of the NBER, the US economy entered recession in January 2008. The collapse of Lehman Brothers came eight months later. Based on IMF data, we estimate that, by the end of last year, non-performing loans across euro area banks amounted to a little over 10% of the region's GDP. But that aggregate figure masks a wide range of outcomes across individual countries. Non-performing loans on the balance sheets of Irish banks are worth more than 50% of that country's annual economic output. With the euro area economy slowing once more, the non-performing loan problem is only going to get bigger. The need for a comprehensive recapitalisation of banks across the single currency bloc has never been more pressing.
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Business relationship disclosure: Alpha Now at Thomson Reuters is a team of expert analysts that are constantly looking at the financial landscape in order to keep you up to date on the latest movements. This article was written by Philip Lachowycz, independent commentator and analyst. We did not receive compensation for this article, and we have no business relationship with any company whose stock is mentioned in this article.