Eurozone recovery very weak, risk of deflation

The Eurozone recovery is still extremely weak, GDP during the third quarter of 2013 grew by only 0.1%. Economists say a sharp fall in export growth was mainly to blame.

The economy is predicted to continue growing at a slightly faster, but still very slow pace – at +0.2% during the last quarter of 2013, and then +0.2% again in the first quarter of 2014 and +0.3% in the second quarter.

The CES-ifo Group Munich in Germany says there will be a gradual shift in the Eurozone in growth engines from exports to domestic demand.

However, private consumption growth will be very limited in several member states whose governments have had to pursue tight fiscal policies in an environment of persistent labor-market slack. When unemployment is very high real disposable incomes tend to remain low.

Investment is expected to grow thanks to the gradual increase in economic activity and “the need to renew production capacity after a marked phase of adjustment.”

If the price of oil stabilizes at $110 per barrel and the euro-dollar exchange rate hovers around the 1.36 mark, headline inflation will most likely stay well below the 2% target of the European Central Bank (0.9% in the first quarter of 2014 and 1.1% in the second).

In a communique, CES-ifo adds “The major upside risk to this scenario is a stronger than expected investment growth, led by improved access to credit.”

Key downside risks include:

  • stagnant private consumption.
  • continued labor market weakness.
  • declining external demand in emerging economies.

Is the Eurozone at risk of deflation?

Inflation expectations in the Eurozone, at least during the short- and medium-term are for price increases well below the European Central Bank’s (ECB’s) target of nearly 2%.

Demosthenes Tambakis, fellow and director of studies in economics and finance at Pembroke College, the University of Cambridge, writes in The Economist that the European banking system is in a “fragile state” and most of the Eurozone countries are either going through anemic recoveries or mired in recession.

Tambakis writes “Prolonged weakness of aggregate demand is sustained by banks’ reluctance to deleverage seriously and kick-start healthy credit growth – an agonizingly slow process, given record unemployment at 12.2%, for which European politicians are ultimately responsible.”

The Eurozone has a higher risk of deflation today than it did one year ago, Tambakis adds, partly because “the ECB’s mandate is to maintain price inflation just below 2%, while the Fed’s is symmetric (“2% over time”).”