In its monthly policy meeting last week, the European Central Bank (ECB) lowered rates in response to deflationary risks and an appreciating euro. Weak governments and stagnant prices continue to jeopardize Europe’s single quarter of growth (0.3% in Q3), which came only after 6 quarters of recession. Companies, particularly those who report in or transact with euros, should expect currency volatility to increase.
Central banks react when expectations miss on the downside, highlighting the underlying weakness in the recent eurozone economic data that was interpreted by the media as a recovery. FSG is encouraging executives to manage corporate’s expectations of improvement in western Europe in 2014, and keep contingency plans in place for the particularly depressed economies of southern Europe.
What Happened?
The ECB cut its benchmark rate from 0.5% to a new record low of 0.25%. After the news, the euro immediately fell 1.5% against the US Dollar and 0.9% against the GBP before recovering slightly.
The Data, Not the Headlines:
Inflation: The ECB is responding to unexpectedly low price growth. Inflation grew only 0.7% YOY in October compared to 1.1% in September. Inflation, significantly lower than the ECB’s guideline of a 2.0% threshold, creates a large downside risk of deflation; when prices fall, consumers and businesses delay purchases because they expect goods to become even cheaper. Consumption and thus business profits decline, and companies are forced to stall or even lower wages, creating a vicious cycle that undoubtedly would damage economic progress in Europe, a region with only one quarter of meager growth after six quarters of recession.
Appreciating euro: The euro appreciated nearly 5.0% against its peers this year, not least due to Germany’s world-beating current account surplus. A more expensive euro makes it difficult for struggling European countries to regain competitiveness and growth through exports, depressing prices even further.
Unemployment: Unemployment remains at an all-time high of 12.2% and weak growth will not create jobs at a rate fast enough to lower unemployment
Credit: Credit risk and the ongoing adjustment of financial and non-financial sector balance sheets contribute to weak loan demand; loans to households are stagnant at 0.3%, and loans to businesses continue to decrease, down 2.7% YOY in September. From the supply side, banks are burdened by legacy assets that have not been wound down, limiting their ability to create credit.
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