Euroland: Financial Crisis Killing off Growth

• Since the publication of our September forecast, the financial crisis has hit the Euroland economy. The impact on economic activity is proving dire. Based on historical experience we expect the economy to stall over the coming quarters. We now forecast Euroland GDP to stagnate in 2009 (0.0% GDP growth). Thus we have revised down our 0.7% GDP growth forecast as companies shed inventories and cut down fixed investments in the light of slow domestic and foreign demand and limits to credit. For 2008 we revise down our growth forecast 0.2%-point from 1.3% to 1.1%.
• The global slowdown is having a profound effect on commodity prices. Consequently we have lowered our inflation forecast for 2008 from 3.6% to 3.4% and for 2009 from 2.6% to 2.0%. By mid 2009 inflation is expected to be around 1.5% mainly due to the negative contribution to inflation from energy prices. Thus inflation is on a clearly downward path until mid 2009. From then a gradual pick up is foreseen, albeit inflation is expected to remain below the ECB's target until end 2009.
• Following the globally-coordinated central bank rate cut, we expect the ECB to deliver more rate cuts over the coming months. We are looking for the ECB to cut rates in December 2008 and again in February and April 2009, each time by 25bp, meaning that the ECB policy rate will be 3.00% by summer 2009.
• Uncertainty surrounding our forecasts on growth, inflation and the ECB is unusually high, as much depends on developments in financial markets. Furthermore, historical data in Euroland on how financial sector stress affects the economy is relatively limited, and the size of the impact is highly uncertain.

Euroland growth is being badly hit

The ticking bomb has exploded

The financial turmoil that began in summer 2007 has turned into a full-blown crisis. During the past month the crisis has hit the banking sector in Euroland and a number of governments (for example, Belgium, France, Germany, Ireland, Luxembourg and the Netherlands) have provided solvency support for a number of major financial institutions, raised guarantee limits to creditors or provided explicit guarantees to depositors. Thus one of our major downward risks to growth has materialised. At the same time commodity prices have tumbled, making our low inflation scenario the most likely outcome at the moment. In this paper we try to take stock of the total effect by updating our forecast on the Euroland economy.

Although past financial crises have not always been associated with economic downturns, history has taught us that the resulting downturns have tended to be relatively severe with large output losses. Episodes of banking stress have generally been followed by downturns that are both more severe and prolonged than those that follow crises related purely to the securities or foreign exchange markets, in which the banking system remains largely unaffected.

The remaining part of this paper is organized as follows. First we compare developments in the most important macroeconomic variables (including our forecasts) in the current crisis against the general pattern found in periods of financial stress. We then turn to the mechanisms behind these developments in order to illustrate how the crisis affects our forecasts.

The lessons from history

Every crisis has its own characteristics. Still, it may be informative to take a look at the general behaviour of important macroeconomic variables in periods of financial stress. In the following section we compare data for the current crisis against the general pattern found by the IMF in their recent very extensive analysis of past periods of financial stress (in World Economic Outlook, October 2008). For each variable we have added our new forecast in order to illustrate how it fits into the pattern. Details on the mechanisms behind these developments are left for the following section.

In general, both our new and our September forecast follow the general patterns of GDP growth, private consumption and investments. In our new forecast, year-over-year growth rates are typically lowered versus our September forecast. This is especially true for the next couple of quarters.

One of the special features of our new GDP growth forecast is that companies are expected to shed inventories much faster and to a larger extent than previously expected. A comparable pattern was seen in the Nordic banking crisis in the early 1990s as illustrated by the Finnish example in the chart below.

Revision of our forecast

Since the release of our September forecast we have not had much new statistical evidence on the Euroland economy. Thus the adjustment of our forecast is mainly due to financial market developments during the past month or so and the historic experience we have on how economies react to financial stress. Therefore we are not going to comment on specific new statistical information (although it is of course taken into consideration).

We continue to see a very substantial risk of contraction in Q3 2008, and for Q4 we forecast GDP to contract as companies shed inventories and reduce fixed investments on the back of of slow domestic and foreign demand. Private consumption is expected to remain flat almost throughout the forecast period as the real income effect from the expected decline in inflation is hampered by the levelling off in employment growth. Growth is likely to be very slow into H2 2009 when a slow and gradual pick up is forecast as the US recovers and the financial turmoil abates. Growth is not expected to resume to trend before H2 2010.

For the whole of 2008 we forecast GDP to increase by 1.1%, down 0.2%-point compared to our September forecast. In 2009 we now project GDP to be close to stagnant. This is much lower than our previous forecast of 0.7%.

It should be noted that in the current juncture uncertainty surrounding our revised forecast is much higher than usual. Risk to growth is associated with both the evolution of the financial turmoil and how the crisis impacts the Euroland economy and its most important trading partners.

In the following we focus on a few of the most important channels through which the financial crisis affects the macro economy:

• Tighter lending
• Lower prices on financial assets including houses

The lending channel

Banks' lending standards have been tightened on a broad scale according to the ECB's lending survey.

This is having an effect on:

• private consumption, as an increasing number of consumers are unable to spend their future income
• housing investment, on the back of curbed demand in the housing market
• companies' investments into production equipment

We have very limited statistical evidence of the negative effect on Euroland consumption from a tightening of consumer credit. Usually consumption is driven by developments in real income. However the credit tightening episodes in 2001 and 1992 in the US tell us that consumer credit plays a major role. We expect a similar impact now, albeit more extreme than in 2001 given the greater severity of the current crisis. Together with the wealth effects (albeit rather low in Euroland) stemming from lower prices in the housing and stock markets, this implies that consumption is likely to be much more subdued than one would expect just by looking at the developments in real income. We note that the significant forecast slowdown in employment growth curbs the private consumption effect from the sharp decline in inflation.

Lending seems to play an even more important role in terms of investment growth. Recently lending for housing has contracted considerably and normally this is followed by a slow down in residential investment.

We also note the clear connection between loans on the one hand, and investments in machinery on the other. (Again the statistical evidence in the Euro area is limited. But a relatively clear connection may be established for the US).

So far the financial tensions have not affected bank lending to enterprises significantly. However data only covers up to end August and therefore don't encompass the worst of the financial crisis. Thus, should loans dry out (as we have reason to believe given the tightening in loan standards and the current financial turmoil), a marked slow down in investment seems unavoidable.

The asset price effect on investment

While the wealth effect on consumption is limited, the slowdown on the housing market and the sharp stock market decline are having an effect on investment. In a nutshell, the argument is that new housing and production capital is relatively expensive compared to existing, making it less attractive to make new investments.

Inflation declines sharply

As result of the slowdown in the global economy we also see a sharp decline in inflation as commodity prices decline.

So far, the unfolding of the financial crisis has resulted in a sharp decline in commodity prices. In itself this is having a marked effect on inflation. According to our models and assuming that oil continues to trade at the current prices y/y, inflation is likely decline sharply during autumn and winter 2008/09. By New Year we see inflation just below 3% and by mid 2009 at approximately 1.5% y/y. This is close to our September low inflation scenario, see Global Scenarios - September 2008.

The sharp decline in inflation is stimulating consumer purchasing power and thus private consumption, cf. above.

The precise inflation path depends heavily on developments in commodity markets (and thus global growth). If growth (prospects) turns out more positive than expected e.g. oil prices could rebound more strongly than we assume in our current forecast.

More ECB rate cuts in the pipeline

The ECB took part in a coordinated action (together with the Federal Reserve, the Bank of England, the Swiss National Bank, Riksbanken in Sweden and Bank of Canada) in a 50 bp rate cut. The ECB argued for a coordinated rate cut by stating that the financial crisis has augmented the downside risks to growth and has thus diminished further the upside risks to price stability. Some easing of global monetary conditions is therefore warranted. We expect the ECB to cut rates further from here as the economy continues to weaken. Furthermore, inflation and inflation expectations are coming down. This gives the ECB room to manoeuvre.

We are looking for the ECB to deliver more rate cuts over the coming months. We expect one more cut this year and two in the beginning of 2009 each time by 25bp, meaning that the ECB policy rate will be 3.00% by summer 2009.

The precise timing of the rate cuts is tricky, but we see December 2008 and February and April 2009 as the most likely. In itself the profile for headline inflation will be critical for inflation expectations - not least for households. With actual inflation clearly downward sloping, expectations are falling too and this will help the ECB to cut rates. Furthermore, in December the weak national account figures for Q3 will be under our belt. The forecast weak Q4 2008 national account data are scheduled for April - a swift recovery is not in sight.

The ECB could be tempted to cut rates sooner and more than we project depending on financial market developments. Also we see a further rate cut in June 2009 as a risk to our ECB scenario as growth continues to look weak and inflation has dropped significantly.

Danske Bank
http://www.danskebank.com/danskeresearch

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