Is the EU economic recovery on track?
European economies are unlocking, with some semblance of normality visible in parts of society. After a slow start, Europe is catching up with other major economies such as the UK and US in terms of vaccinations and mobility. This is not the only area where Europe is behind; European policy makers, despite acting decisively, face some scepticism that the growth trajectory in Europe will disappoint relative to the US. Given the prospect of economic scarring and stagnation in a post pandemic world, the question remains ‘is Europe on the right path?’
The significant stimulus policies already in place across the globe, which the Financial Times Martin Wolf has described as “wildly expansionary”, are already large by historical standards. Growth is expected to be strong in the near term, especially as pent-up savings are deployed. Calibrating economic policy to manage the recovery and exit the current emergency measures will be challenging. Central Banks are trying to strike a balance between boosting the recovery while also being mindful of their inflation mandates. Inflation is a major theme. Headline inflation in the US is above 5% YoY, the highest core reading this century. European inflation is also expected to print above 2.5% later this year. One reason for this is due to bottlenecks in global supply chains; it takes time to restart the global economy and to respond to surging post-pandemic demand for certain products.
The US Federal Reserve has embraced flexible average inflation targeting (FAIT) and the ECB’s strategic review also signalled a higher tolerance for inflation. While the last three decades have seen structural disinflation, central bankers may be nervous that they are becoming more tolerant of inflation at a time when these structural forces are being questioned and fiscal policy is historically loose.
In Europe, monetary policy settings remain on full accommodation mode; interest rates remain below zero and the ECB is still conducting Quantitative Easing (QE) via the Pandemic Emergency Purchase Programme (PEPP) – in fact the ECB increased the rate of PEPP purchases in March. Some ECB Board Members are expected to push to phase out pandemic support policies. There is a real debate in both the EU and US as to whether central banks should act pre-emptively to allay inflation and financial stability fears or whether they should remain very accommodating to allow the post pandemic recovery embed further. The Federal Reserve signalled a glance towards the exit at their June meeting.
Meanwhile the fiscal response by governments has also boosted expectations for growth and inflation. In the US spending has been enormous. President Biden has sent $1,400 cheques to every American as well as passing an additional $1.9 trillion stimulus plan in March. The Biden administration has agreed a $1 trillion bipartisan Infrastructure package and is also planning an additional fiscal package on social infrastructure which is under the American Families Plan. While this future package may get watered down and will face major challenge in the Senate by Republicans, the ambition and scale is clear. US Growth is forecast to be above 6% in 2021 and critically US output will be above its pre-pandemic path in 2022.
The Eurozone, in stark contrast, will still be behind its pre-pandemic path and may never regain the prior growth trajectory. The US is already back at its pre pandemic level of growth while Europe remains some 5.5% below the equivalent level. It is clear that the US has acted swiftly and more boldly, however Europe is starting to mobilise and will be releasing funds as the economy picks up later this year. When national fiscal stimulus in Europe is included, the Eurozone and US packages are more comparable.
While there are reasons for optimism, the consequences of getting it wrong are sobering. While America seems determined to get back on its pre-pandemic growth path, Europe’s ambition appears the more conservative one of restoring the pre-pandemic level of GDP. If Europe does not get back on its growth trajectory, it will have permanently higher debt, making it harder to counter future macroeconomic shocks. It is possible that we will have lower inflation and a long lasting shortfall of demand which could see unemployment remain high. The longer factories stay closed and people stay idle, the more economic scarring occurs – lowering potential future growth. These outcomes may increase intra EMU tensions in the future.
The next few months are important for the medium term outlook in Europe. The recently revealed ECB Strategy Review will set the tone for monetary policy in the next five years. September also sees German elections which will provide a clear indication on the appetite for increased fiscal largesse in the EU’s biggest economy. Policy makers will have to decide whether the increase in inflation that is expected later this year is transitory in nature and manage any phased withdrawal of accommodation accordingly. As the pandemic fades, volatility in asset prices may increase. Europe’s recovery can be fully achieved with continued and targeted fiscal stimulus.
Head of Fixed Income
Bank of Ireland Global Markets
This article was published in The Sunday Independent on 1 August 2021