I suppose it is only natural for people to worry about the economy after more than five years of hardship. Last week's news that the US economy contracted more than expected in the first quarter brought another set of challenges to our moderately optimistic outlook.
It is, therefore, completely reasonable for the ECB to take action this week and it has very much committed itself to doing that.
Han de Jong Chief Economist
However, I am convinced that the global recovery is on track and will remain on track. This week promises to be hugely interesting as the ECB will announce measures to prevent deflation and remedy problems in the credit mechanism. It is also going to be interesting to see how financial markets will react.
Eurozone economic confidence up in May
The European Commission's index of 'Economic Sentiment' (which combines consumer confidence with confidence in industry, services, retail and construction) showed an improvement for the eurozone in May:102.7, up from 102.0 in April. This is a modest gain, but it is important all the same. The confidence measure had fallen a little in April, giving rise to fears that the eurozone recovery had already run out of steam. May's reading suggests otherwise.
On the negative side, economic sentiment in France weakened. Several less important economic indicators provided a mixed picture in Europe last week, with some up and some down. One indicator that caught my attention was Italian consumer confidence. It rose for the third consecutive month in May and now stands close to the highest level since 2002. It is not clear what that really means, but it would appear to suggest that Italian consumers are comfortable with the new government of prime minister Renzi, something also borne out by the results of their elections for the European Parliament.
The ECB's report on monetary developments in April gave conflicting messages. M3 growth slowed to 0.8% yoy, from 1.0% in March. The April reading was the lowest since 2010. The credit data was actually better. The pace of contraction of credit to the private sector eased a little: -1.8% yoy, against -2.0% in March. Adjusted for sales and securitisations, the contraction eased even more: -1.5% versus -2.0% in the previous month. Loans to non-financial corporations were down 2.7% yoy, but that was better than the -3.1% in March.
The monthly flow data also shows a meaningful improvement. It is, nevertheless, clear that the ECB is concerned about the so-called transmission mechanism, meaning that it is worried that the economy is being or will be starved of credit. This would be a major impediment to a sustained economic recovery. The question is to what extent the credit channel really is damaged. True, outstanding credit to the non-financial corporate sector continues to decline. But I would like to make two points here. First, the credit cycle lags the economic cycle. So credit growth as measured in the statistics turns after the business cycle has turned. That is partly because companies fund their first expansion plans themselves, rather than with bank credit. It is partly also the result of simple arithmetic. Outstanding credit is the net result of repayments over past credit and new credit. When the investment cycle turns very negative, repayments are much larger than new business, pushing overall outstanding credit down. This continues even after new business increases until that new business is larger than the repayments. That simply takes some time. Second, an (admitted, superficial) observation from my side is that the modest improvement in the credit data is consistent with the results of the ECB's bank lending survey. That survey does not suggest there is a major problem with transmission, but that the weak state of the SME sector in many countries is the main hindrance to stronger credit growth.
ECB officials have also expressed increasing concern recently over sustained low inflation. Below-expectation inflation data in Spain and Italy last week underscore these worries. We have long argued that inflation would be lower than the ECB was forecasting and we are also concerned that inflation expectations are not as firmly anchored as the ECB appears to think. However, we do not believe that a period of painful deflation is upon us. Having said that, it is not a risk the ECB can take. Their view seems to be that they must do what they can to prevent deflation taking hold.
It is, therefore, completely reasonable for the ECB to take action this week and it has very much committed itself to doing that. A cut in official interest rates, pushing the deposit rate into negative territory, seems a done deal. What else the ECB comes up with is going to be more interesting. An ABS-purchase programme seems likely. Commentators also talk about a 'funding for lending' programme such as the Bank of England launched some time ago. There are, however, doubts about how effective such a programme could be.
US recovery on track
It is true, US Q1 GDP was revised down to -1.0% qoq annualised, from +0.1%. Does that mean the recovery is in danger? No! In fact, the composition of the revisions made me more confident of the recovery, not less. The biggest change from the originally reported numbers was a sharp downward revision to inventories. These subtracted 1.6% from GDP in Q1, against the original estimate of -0.6%. Very often, a sharply negative contribution from inventories is 'compensated' for in other spending items, but that was not the case this time.
Another meaningful revision was in 'structures' (investment by companies in buildings). In the first estimate of the GDP data, these had shown a modest increase, which seemed odd given the adverse weather conditions in Q1. In the data released last Friday, structures were down by 7.5% qoq, annualised, which looks more like what one would expect. Other components saw very small upward revisions: private consumption and corporate investment in equipment and intellectual property. It looks likely to me that the Q2 GDP data will show a considerably bounce, partly by way of payback for the weak first quarter. Corporate profits were also down quite sharply in Q1 according to the national accounts data. Here, too, one would expect positive payback in Q2. Whether that expectation is correct will become clear when the earnings season starts in July.
Other data released last week continues to paint a picture of sustained recovery in the US. Importantly, jobless claims fell again last week, amounting to 300,000 - the second lowest number since November 2007. This is actually a very low number: During the period 2004-2007 when the US economy was doing well, jobless claims averaged 326,000 per week. The recent data is a sign that the US labour market is continuing its improvement. Durable goods orders data was also encouraging. Total orders rose a relatively modest 0.8% mom in April, but the March data was revised to show a monthly gain of 3.6%, from the earlier reported +2.6%. Non-defence capital goods orders excluding aircraft fell 1.2% mom, but this followed a jump of 4.7% in March. The trend in corporate investment is clearly strengthening.
The preliminary readings on business confidence as produced by Markit showed an improvement for the services sector from 55.0 in April to 58.4 in May. The gauge for services and manufacturing combined jumped from 55.6 to 58.6, the highest on record, although the record only goes back to May 2011. The Chicago PMI, measuring business confidence in the Fed's Chicago district was strong and above expectations in May. All this data is consistent with our view that the economy continues its recovery and that economic growth is, in fact, accelerating.
Personal income and in particular the spending numbers were below expectations. Spending fell 0.1% mom in nominal terms. However, this data can be volatile. Spending had been strong in March and April and the 3-month annualised rise is still 5.4% in nominal terms and 3.8% in real terms. That is not weak. The personal income and spending report also contains the Fed's favourite inflation measure: 'PCE core' (Prices of consumer expenditures excluding food and energy). PCE core was up 0.2% mom, which was the second monthly gain of that magnitude. On a year-on-year basis, inflation accelerated to 1.4%. That is not high and certainly still below the Fed's target, but it represents a rapid rise from the 1.1% registered two months ago. The rise is partly a base effect, but the trend bears watching. It has long been our believe that the Fed is overestimating the slack in the labour market. As a result, we believe that the Fed may have to be more aggressive than the market thinks and than the Fed itself seems to think when it starts tightening. Against that argument, there could be reasons for the Fed to tolerate a pick up in inflation beyond its target for a while if it considers the actual level of unemployment further (below) from its target than inflation. But we believe that is next year's story. Should, however, the trend of rising inflation persist, then the Fed, and the market for that matter, may at some stage have to reconsider its stated position on tightening policy.
Data concerning the rest of the global economy was scarce and inconsequential.
Holiday reading tip: Timothy Geithner, "Stress Test"
Perhaps you will allow me to make a suggestion for some reading material for your holidays. Thomas Piketty's "Capital in the 21st century" is a best seller. I have bought it too. But I find it tough going. So that book is not my tip. Former New York Fed President and US Treasury Secretary Tim Geithner has written a book called "Stress Test". This fascinating book does three things. It provides a look into the life of this interesting man. It also gives an account of decisions taken before and during the crisis. And third, it provides a non-systematic theoretical view on financial crises and how they should be dealt with. I find this book an absolute 'must', though you will need to have the stamina to read more than 500 pages.