The ECB is increasingly concerned about the Euro area productivity problem

Yesterday I took a look at the state of play in Sweden and life would be a whole lot easier for the Riksbank if the ECB cut interest-rates first. In monetary terms it is kind of a big brother or sister via the exchange-rate between the Euro and the Krona. As I pointed out yesterday there are many similarities and let me start with some cheerleading for ECB policy by Executive Board Member Piero Cipollone.

There is clear evidence that monetary policy restriction is being strongly transmitted to lending conditions in the euro area economy. Since the start of the tightening cycle, bank lending rates to firms and to households for house purchases have gone up by about 370 basis points and 210 basis points respectively. Moreover, annual loan growth over the same period has declined from 6% to 0.2% for firms and from 4.7% to 0.3% for households.

Masterfully done! He wants you to think although like the Riksbank then hits trouble.

The restrictive stance of our monetary policy has contributed to the stagnation of euro area real GDP in the last six quarters. Given that monetary policy operates with a lag, it will continue to exert a negative impact on economic activity, with growth projected to remain anaemic in the first quarter of 2024.

Not looking quite so clever now is it? That is not exactly a magnificent 7 quarters of economic growth including this one. But there is more as he touches on an area we have heard more about this morning.

In particular, private consumption in the euro area has been subdued. Euro area retail sales were broadly unchanged at the start of the year, pointing to continued weak dynamics in spending on goods, and consumer confidence remains below its long-term average .

Retail Sales in Germany

The news this morning was of yet another decline.

WIESBADEN – According to preliminary results from the Federal Statistical Office (Destatis), retail companies in Germany had 1.9% less real (price-adjusted) and 1.8% less nominal (not price-adjusted) sales in February 2024 than in January 2024.

Tucked away in the detail that is relevant for a central banker is that inflation was pretty much non-existent on a monthly basis with nominal and real growth so similar. But the issue for the economy is another weak quarter with the calendar and price adjusted number falling from 111.7 in December to 109.3 in February. Also annually there is a decline.

 In comparison Compared to February 2023, the retail sector recorded a decline in sales of 2.7% in real terms and 0.4% in nominal terms.

So the Retail Sales problem in the Euro areas largest economy is continuing.

Wages

We also find ourselves in familiar territory here as our central banker tells us this.

One important aspect relates to the risk that wage and productivity growth might be inconsistent with the convergence of inflation to our medium-term target of 2%.

This echoes a topic that was discussed by his colleague Dr. Isabel Schnabel on the .19th of February. For workers there is quite a problem.

Real wages are still below their pre-pandemic level – even more so than productivity – while unit profit growth has until recently been high relative to the historical average.

So in essence they have taken the strain whilst the “fat cats” have prospered? Don’t worry as it will be alright on the night.

Profits are now normalising, while the ongoing reversal of negative supply shocks creates additional room for a catch-up in real wages that will contribute to the economic recovery consistent with our staff projections and with a convergence to our inflation target.

There are various issues with this such as if the economy had been “consistent with staff projections” he would not be making this speech as there would have been no inflationary surge. Anyway the German retail sales figures we just looked at tell us this was not in play in February.

Indeed, in the projections, this catch-up is a condition for the increase in private consumption.

Plus aren’t the central bankers telling is to restrict wage rises (ours not theirs)? Yes and no apparently according to Piero.

Let me be clear: wage growth needs to moderate over the medium term for a sustained convergence of inflation to our target. But an excessive focus on short-term wage developments may not take into full consideration the recovery in wages that can – and needs to – take place for the euro area’s currently fragile recovery to gain a stronger footing.

The problem here was highlighted by Dr.Schnabel on the 19th of February.

Between 1995 and 2007, annual growth in GDP per hour surged measurably in the United States, whereas it slowed and diverged in the euro area.

This is actually quite grim for Euro area real wages and thus the economy.

Just as real wage growth cannot be sustained over time if it continuously overshoots productivity growth, output and productivity growth are unlikely to be sustained over time if wages and domestic demand remain permanently depressed. This may lead to a protracted underutilisation of resources, with potential output eventually adjusting downwards to meet depressed demand.

In essence he is in fact looking backwards to the relatively poor economic performance of the Euro area. But that begs the question of how will it get any better? It is unlikely to be improved by something he was boasting about  earlier.

Moreover, annual loan growth over the same period has declined from 6% to 0.2% for firms

Looking at the figures labour productivity in the Euro area started to weaken as 2022 started and went into negative territory in 2023 ending the year at -1.2%. Whereas if we use the United States as a benchmark as Dr. Schnabel did.

Nonfarm business sector labor productivity increased 3.2 percent in the fourth quarter of 2023, the U.S. Bureau of Labor Statistics reported today, as output increased 3.5 percent and hours worked increased 0.3 percent.

So in relative terms a move of the order of 4% in one year.

Also if we switch to economic models as our central bankers love to do there are more problems.

For these reasons, the ECB staff projections foresee that a catch-up of wages in real terms, especially in 2024, is compatible with reaching our target in a timely fashion. Thereafter, the projections expect real wages to continue to moderate, before reaching a level consistent with projected productivity growth and our inflation target in 2026.

The model tells us this.

ECB staff analysis suggests that a 1 percentage point increase in wages pushes up core inflation by around 0.5 percentage points.

Except the real world does not always agree.

This pass-through, however, is subject to substantial uncertainty and takes time to fully materialise.

The latter 5 words are their get out of jail free card.

Comment

As we look ahead we see the ECB reshuffling its theoretical pack so that it is ready to cut interest-rates in the summer.The problem though is that the money supply figures tell us this.

Annual growth rate of narrower monetary aggregate M1, comprising currency in circulation and overnight deposits, was -7.7% in February, compared with -8.6% in January.

So the short-term picture is not bright and whilst the annual fall slowed the aggregate fell by another 14 billion Euros in February. Yet the ECB plans to press harder on the brake later this year as it adds to its QT.

Over the second half of the year, it intends to reduce the PEPP portfolio by €7.5 billion per month on average. The Governing Council intends to discontinue reinvestments under the PEPP at the end of 2024.

Switching to broad money which impacts in around two years we see this.

Annual growth rate of broad monetary aggregate M3 increased to 0.4% in February 2024 from 0.1% in January.

At face value that is not much as if the Euro area economy does not grow it means inflation of 0.4%. Or if hits the inflation target then the economy shrinks by 1.6%. I do not take the numbers that literally but if we look at 2024 so far the aggregate has shrunk by 17 billion Euros. So the economic outlook is for lower inflation and a weak economy that may also contract. Not much of an Easter message from them but let me wish you all a Happy Easter.

Easter Podcast