The euro area has shown surprising resilience in the face of the gales sweeping through financial markets, writes Elga Bartsch in Morgan Stanley's latest Global Economic Forum. However, on the back of upward pressures on the money market and credit spreads, Morgan Stanley lowered its GDP growth forecasts for the euro area to just 1.5% for both this year and next (see Morgan Stanley's Euroland Economics: From Soft Rebalancing to Conflict of Interest, March 19, 2008). This is below market consensus, below the ECB’s staff projections and below the official forecasting community.
Despite our below-consensus growth forecast, we see only limited scope for ECB policy-easing in late 2008 and early 2009. If our forecasts for euro area GDP growth averaging 0.2%Q and thus falling significantly below trend between now and next spring are borne out by the data, and if consumer price inflation does indeed ease back towards the ECB comfort zone, we expect a total of 50bp of easing around the turn of the year. However, the markets, which have already re-priced the prospects of near-term ECB easing, are still pricing in more aggressive ECB action than we forecast. From a peak of nearly 80bp only two weeks ago, they are now pricing in 40bp before year-end. In our mind, they still have further re-pricing to do, we think. We expect that more forecasters to push back the timing of what would be the first ECB refi rate cut in this cycle on the back of the recent upside surprise in HICP and wage inflation, the robust money and credit growth and what, potentially, could be another hawkish press conference after the ECB Council meeting on April 10.
Noting the remarkable resilience of euro land activity, Bartsch recognizes a stumbling block between the ECB and rate cuts: the upside surprises on HICP (harmonized index of consumer prices) and wage inflation. HICP inflation surged to 3.5%Y in March, marking a new record for the EMU area, and putting headline inflation way above the ECB's comfort zone. Morgan Stanley believes that this will likely stay above the comfort zone for both this year and next.
As for the credit crunch, though it is difficult to gauge for the non-financial sector, there is as yet no evidence of credit supply being significantly impaired. February saw M3 growth and loans to the private sector holding broadly steady. Euroland inflation tends to be more persistent that in the U.S., Bartsch notes, explaining why the ECB may be moved to act more aggressively:
The introduction of additional six-month refi operations shows that the ECB is determined to ease money market tensions through additional liquidity operations rather than policy rate reductions. The ECB decided to offer supplementary longer-term refinancing operations [LTROs] with a maturity of six months, in addition to further supplementary LTROs with a three-month maturity. The regular monthly LTROs remain unaffected... If signs of an impairment of credit supply to the non-financial sector were to emerge, this would likely induce the ECB to move more aggressively than our current forecasts and its communications would suggest.