Europe
End of the Recession, Start of a V-Shaped Recovery?
July 31, 2009

By Elga Bartsch | London

Incoming Activity Data Support Our GDP Caution...

Business surveys continued to improve gradually in July. Yet, they remain below their long-term averages that we would deem consistent with trend growth.  By and large, activity indicators support our cautious near-term GDP forecast profile (see Euroland Economics: Paring on Past Data, Outlook Unchanged, June 19, 2009).  True, there could be a more vigorous bounce in the industrial sector during 2H09.  But this likely reflects temporary factors such as the inventory cycle and the subsidy-fuelled car cycle.  Still, a number of headwinds will weigh on the economy, we think, notably a slowdown in consumer spending on the back of deteriorating labour market conditions and very subdued corporate investment spending.  In addition, it is worth bearing in mind that while the euro area as a whole does not suffer from major imbalances, many of the individual countries still do.  Last but certainly not least, indications of a V-shaped recovery would likely cause policymakers to bring forward the exit from the über-expansionary fiscal and monetary policy at the moment.

...Where We Look for a Stabilisation in GDP Only in 3Q

Feeding our GDP indicator with a fresh set of monthly indicators shows some noticeable improvements in the 2Q estimates, bringing them closer to our official forecasts.

For 2Q, our GDP indicator now yields an estimate of -0.7%Q based on industrial production up to and including May.  This is only a touch below our official forecast of 0.5%Q.  For 3Q, the GDP indicator points to a broadly stable level of activity, also close to our official forecast of a further small 0.1%Q decline.  Hence, our full-year GDP estimates of -4.4% for this year and of +0.5% for next year still seem on track.  The model estimates come with a serious health warning though.  As the models - like most others - underestimated the extent of the downturn by a wide margin, there is a distinct possibility that they could also underestimate the extent of the rebound.

Our Surprise Gap Stays Close to its New Historical Highs

Overall, our take on the July business surveys is optimistic.  Notably, our surprise gap index stayed close to the all-time high in July.  This elevated reading of our preferred reversal indicator for the euro area business cycle shows that an unprecedented margin of companies are positively surprised by how well their business is evolving compared to their (grim) expectations three months ago.  Such a sizeable positive surprise should cause manufacturers to be poised to raise production in the coming months - a conclusion that is also supported by a further rise in output plans.  The elevated reading of the surprise gap implies that it gives a statistically significant signal for a turning point in the euro area business cycle for the third month in a row.  The further recovery in the assessment of current output and a first improvement in order books push our manufacturing production indicator into positive territory for the first time since May 2008.  Our manufacturing indicator, which tracks three-month/three-month growth in the sector, now estimates a small gain in manufacturing output of 0.2%Q for 3Q.  While our business cycle compass is reiterating its verdict that the euro area is moving out of recession, it still only points to a tepid recovery in the months ahead.  Two factors could cause near-term upside surprises: the inventory cycle and the policy-induced boom in the car sector.

Factor 1#: The Inventory Cycle

Contrary to the US, official statistics in the euro area don't provide any ready-made inventory/sales ratios.  A proxy for inventories could be estimated though by using production and sales data (see Inside the Inventory Cycle, February 23, 2009).  Alternatively, more timely business surveys tell us every month whether companies view their inventories as too high, too low or about right.  The business surveys also provide precious insights into how companies will likely go about managing inventories in the near future.  Historically, this assessment of inventories has tracked the order book situation closely.  After order books held broadly steady near their historical lows for several months, they have now started to show the first signs of improvement.

A puzzling discrepancy has emerged between order books and the already considerably improved assessment of inventories.  Historically, the two series have tracked each other very closely.  Not so now.  Not only have companies already become less negative on their inventories over the last six months, but they also consider them to be below the normal level in July in many large countries.  Only in Germany are inventories still viewed as excessive.  For the euro area as a whole, this puts inventories near normal, making further aggressive de-stocking unlikely in the second half of this year.

The noticeable improvement in inventory assessment is good news as it shows some correlation with the inventory contribution to annual GDP growth.  It is worth bearing in mind that for the inventory contribution to GDP growth to become positive in the remainder of this year, it is sufficient that the pace of destocking slows down.  It is not necessary to see some re-stocking to make the inventory growth contribution swing into positive territory.  Given this relatively low hurdle, we indeed expect inventories to start boosting GDP growth in 2H.  Given the sharp turnaround in the new orders/inventory ratio shown in our illustration, we think the inventory cycle could be close to turning around and a lively recovery in industrial production just around the corner.

Factor 2#: The Car Industry

A number of European countries have put in place car scrapping schemes, which seem be taking effect, boosting car registrations, car sales and recently also car production.  As many of the schemes are limited in scope, we think it is important to look at underlying growth dynamics.  We estimate that the impact of the schemes in Europe will be less pronounced than the impact of the car production schedules in the US, where our US economist Dave Greenlaw believes that car production could add as much as six percentage points to annualised 3Q GDP growth, based on current assembly schedules (see US Economics: Pickup in Motor-Vehicle Output Points to Potential Upside for 3Q GDP, July 20, 2009).  In Europe, we see the impact in two areas: consumer spending and industrial production. 

Our consumer spending indicator shows that, so far, car purchases could have added as much as 0.5 percentage points to overall consumer spending in 2Q09, on the back of car registration surging a non-annualised 10%Q between April and June.  Carried-over growth for the current quarter suggests a small positive ramp of 2%Q into the July to September period.  Even though it is conceivable that car registrations show some more momentum over the summer ahead of the incentive schemes running out, so far we only find an impact on consumer spending of around 0.1 percentage points.  Note that not all of these car purchases will have been induced by the car-scrapping schemes.  However, the impact on overall demand will still be noticeable, in our view.

The second area where cars add to the gyrations of the business cycle is industrial production.  Stripping car production out of the recent industrial production dynamics shows that a large part of the recent revival is down to the car sector.  Last winter, when car production was contracting by 19%Q in non-annualised terms, the sector could have shaved as much as 0.6 percentage points off headline GDP growth.  The available production data up to and including May shows that the car industry is already stabilising based on the less volatile three-month/three-month growth rate, thus ceasing to be a drag on overall GDP growth.  Recent monthly dynamics show that without the car industry, manufacturing production would still be falling mildly.

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Europe
Taylor-ing Rates for the Exit
July 31, 2009

By Elga Bartsch | London

Taking a Medium-Term Perspective on ECB Policy Rates

The eventual exit from the ECB's highly expansionary monetary policy stance at present is key to the bond market outlook, notably the shape of the yield curve.  While the exit strategy has many dimensions, given the various unconventional policy measures taken (see EuroTower Insights: A Not So Easy Exit, July 8, 2009), the medium-term policy rate profile is clearly a key factor.  The current market consensus is that monetary policy will leave interest rates low for an extended period of time.  By and large, we concur with this view and expect the ECB to only start raising rates gradually in mid-2010.  Our refi rate target for December 2010 is 1.75%, 75bp above the current level.  In this note, we take a longer-term view and outline how ECB policy rates might evolve based on our medium-term growth and inflation projections over 2011-15 (see Global Forecast Snapshots: The Global Economy in One Place, June 18, 2009) and apply it to a Taylor Rule framework. The resulting rate profile shows a gradual pace of tightening that would bring short rates to 5% by late 2015. We discuss how we arrived at this estimate below.

Using the Taylor Rule Concept ... 

Essentially, the Taylor Rule describes a simple central bank reaction function based on three factors: (1) the long-term equilibrium interest rate, (2) the deviation of inflation from the central bank's target (i.e., the inflation gap) and (3) the gap between actual output and potential output (i.e., the output gap).  In the academic literature, the Taylor Rule comes in many different flavours:  It can be based on coincident data or on a set of forecasts.  It can be based on the latest vintage of macroeconomic data or on the exact data set available to the central bank at the time of the decision (so-called real-time data).  It can potentially also include additional variables such as exchange rates or money supply.  The original idea goes back to Stanford Professor John Taylor, who showed that the policy rate profile in the early Greenspan years is surprisingly well captured by the following simple rule (see Taylor 1993):

[1]    r = r* +0.5(y - y*) + 1.5(i - i*)

where r is the fed funds rate, y current GDP, y* potential output, i inflation, i* the Fed's inflation objective and r* the equilibrium interest rate.

... and Adapting it to the Euro Area Reality

For the euro area, the simple Taylor Rule has not worked very well, for several reasons.  First, the observed policy rate profile in the euro area shows extended deviations from the rate profile implied by the Taylor Rule. Importantly, it tends to show a much smoother profile than implied by the original Taylor Rule described in equation [1].  It seems that the original Taylor Rule does not do justice to the ‘steady hands' policy favoured in Europe.  Second, while the Federal Reserve has a dual inflation-growth mandate, the ECB has been mandated to prioritise inflation in its policy decisions.  Hence, the output gap only matters for ECB policy-making to the extent that it affects inflation.  Importantly, it is not a policy objective by itself.  Third, there is no explicit role for other factors such as monetary aggregates, which implies that the Taylor Rule ignores an important part of the ECB's two-pillar policy strategy.  However, with some appropriate modifications, the Taylor Rule can be adapted to fit the euro area data reasonably well.  Such a modified Taylor policy rule would typically need to have:

•           An element of policy-smoothing;

•           A higher weight on the inflation gap;

•           A lower weight on the output gap;

•           Possibly also include money or exchange rates;  and

•           Have an equilibrium interest rate that can vary over time and, if needed, also allow for a variation in the implicit inflation target.

Allow for Some Monetary Policy Smoothing

Policy smoothing by the central bank implies that the previous period's policy rate becomes a highly significant determinant of the current rate.  Equally, the current rate acts as a key anchor for the future rate.  The observed inertia in policy rates might reflect a preference by policy-makers for a ‘steady hands' approach. Comments by various ECB officials suggest that such considerations indeed play a role in the euro area.  However, inertia could also result from longer-lasting shocks that aren't adequately captured in the estimation technique (see Rudebusch, 2002).  Furthermore, it could also be down to the absence of money in the policy rule (see Scharnagl et al, 2007).  Finally, the observed inertia in euro area policy rates could reflect a high degree of inflation persistence, which would render abrupt changes in the policy rate inappropriate.  For the euro area, inflation persistence is likely to be the dominating factor, we think (see A Dieppe et al, 2004).

Emphasise Inflation, De-Emphasise the Output Gap

In the euro area, the weight attached to the inflation gap should be higher than the 1.5 in the original Taylor Rule, reflecting that price stability is the ECB's primary objective.  Remember though that even for a central bank that weighs inflation and growth equally as objectives of its policy, the weight attached to the inflation gap is three times the size of the weight on the output gap (0.5 in equation [1]).  This is because higher inflation lowers the real interest rate.  As higher inflation pressures require higher real interest rates, the increase in the nominal rate needs to go beyond the rise in inflation.  Hence, inflation dynamics matter much more for the policy profile than growth dynamics.  In fact, the weight attached to the output gap might be dampened in a euro area version of the Taylor Rule.  This lower weight on the output gap could reflect a relatively small sensitivity of euro area inflation to the output gap, a higher degree of uncertainty about the size of the output gap and the fact that stabilising the economy is not a policy objective in itself. Greater uncertainty about the output gap tends to raise the relative relevance of the inflation gap (see Scharnagl et al, 2007).

On the Concept of the Output Gap

Much of the debate about the usefulness of the Taylor Rule for practical policy-making centres on measurement errors for the output gap.  These errors arise because the output gap cannot be observed directly.  Instead, it needs to be inferred indirectly from the behaviour of other variables such as inflation and actual GDP.  As the accompanying chart shows, the estimates can differ substantially, depending on the statistical method used and the time period considered.  In addition, the key variables entering the estimation (notably GDP itself) are revised substantially over time.  With hindsight, the policy conclusions thus can diverge considerably from the ones reached on the basis of the information set available at the time of the decision (see a series of seminal papers on this issue by ECB Council Member Athanasios Orphanides, such as Orphanides, 2001).  A Taylor Rule estimated on the latest available dataset can therefore be misleading, as policy-makers acted on a very different set of information at the time.

Ideally, a Taylor Rule Would Use Central Bank Forecasts

In fact, a monetary policy rule would probably be better formulated based on the central bank's forecasts rather than coincident data outcomes.  Doing so is not always feasible though, if for instance the central bank's forecasts are not publicly available.  While the ECB publishes staff projections, these aren't the forecasts of the Governing Council itself.  Unless there is a reason to believe that the central bank makes systematic forecast errors, it would probably be sufficient to assume that - on average - it anticipated the future correctly and use actual (future) outcomes as a proxy for the forecasts.  The forecast horizon of the central bank has a bearing on relative weights, given inflation and the output gap.  The importance of the inflation gap rises noticeably relative to that of the output gap when the forecast horizon included in the Taylor Rule is rising (see Dieppe et al, 2004).  Put simply, the more forward-looking a central bank, the less importance it will likely attach to the output gap at the time of the policy decision.

A Sighting Shot for the Equilibrium Interest Rate

According to the Taylor Rule, the short rate should be equal to the long-term equilibrium interest rate (i.e., the neutral rate) when the economy is running at full capacity and inflation is at target.  To determine this equilibrium rate is far from trivial, especially in the euro area (see Joachim Fels and Manoj Pradhan, The Nat-EUR-al Rate of Interest, May 2, 2006), for several reasons:  (1) The euro area underwent a major regime shift with the start of monetary union.  Taking simply a long-term average of the actual short rate - which is often done in the literature - is not adequate.  Given the regime shift with the start of monetary union and the jump in credibility associated with it, at least a one-off adjustment in the equilibrium interest rate in the euro area is likely.  (2) Swings in potential output growth over time and shifts in the inflation process, notably the inflation-growth trade-off, can impact the long-run equilibrium interest rate.  As we have argued elsewhere, both factors should play a very important role in the years to come, we think.  Especially potential output growth - the speed-limit for inflation-free growth - varies considerably over time.  (3) Regime shifts in public finances can also have a systematic impact on the equilibrium interest rate.  In the academic literature, estimates of the long-run equilibrium interest rate vary between 3.0% and 3.7%.  The neutral real rate estimated by our colleagues, Joachim Fels and Manoj Pradhan, is around 1% at the moment, yielding a long-term nominal rate of around 2.8% using the ECB inflation norm. 

A Policy Rule ‘Taylored' to the Euro Area ...

One reason for the popularity of the Taylor Rule as a central bank reaction function is the simple rules of thumb that can be gleaned from them.  In general, if current (or expected) inflation rises by one percentage point, euro area short rates would need to go up by around 190-220bp, while a similar increase in resource utilisation measured by the output gap is typically counteracted by a 10-50bp cut in the short rate, according to the academic literature on the topic.  To gauge the shape of the ECB's tightening campaign out to December 2015, we calibrated a Taylor Rule for the euro area, largely based on a study by the Dutch Central Bank (see Adema, 2004) and fed this policy rule with our medium-term growth and inflation projections.  Between 2011 and 2015, we forecast GDP to expand by 1.7% per annum, while we see inflation averaging 2.2% (see Global Forecast Snapshots: The Global Economy in One Place, June 18, 2009). 

... Points to a Gradual Tightening Process ...

According to our modified Taylor Rule for the euro area, the ECB has cut interest rates more aggressively than what the Taylor Rule would prescribe based on the historically observed policy pattern in the first half of this year.  At the same time, the modified Taylor Rule does not see significant ECB rate hikes being required before mid-2011.  This compares to our official forecast of 75bp of ECB rate hikes in 2010.  While we acknowledge the risk that the ECB tightening cycle could start later than we forecast, we don't think that the ECB will wait that long to exit.  Given that interest rates are extremely low now, and given that past tightening campaigns were very gradual, we believe that the ECB will want to start tightening early to ensure that by the time the economy is back at potential, its policy rate is also close to the neutral level.  With a gradual pace of tightening of around 100bp per year, the Taylor Rule takes short rates to around 5.0% in December 2015.  Monetary policy would thus remain supportive to growth until mid-2013. 

... and Needs to Be Interpreted Judiciously

These medium-term projections need to be interpreted with caution, as they are not based on fully specified cyclical forecasts beyond the end of next year. We also share the reservations voiced by ECB policy-makers against the Taylor Rule. That said, we believe that it offers a good, albeit crude framework to model the medium-term interest rate outlook.

Bibliography

Adema, Y. (2004), A Taylor Rule for the Euro Area Based on Quasi Real Time Data, DNB Staff Reports No 114

Dieppe, A. et al (2004) Optimal Policy Rules for the Euro Area: An Analysis Using the Area Wide Model, ECB Working Paper 360.

Gerdesmeier, D. and Roffia, B. (2003). Empirical Estimates of Reaction Functions for the Euro Area, ECB Working Paper 206

Gerlach, S. and Schnabel G. (2000), The Taylor Rule and Interest Rates in EMU, Economics Letters, 67:165-171

Orphanides, A. (2001). Monetary Policy Rules Based on Real Time Data, American Economic Review, 91(4):964-985.

Orphanides, A. and J. Williams (2005), Monetary Policy with Imperfect Knowledge, Finance and Economics Discussion Series, Board of Governors of the Federal Reserve.

Rudebusch G. (2002), Term Structure Evidence on Interest Rate Smoothing and Monetary Policy Inertia, Journal of Monetary Economics (49), 1161-1187

Scharnagl, M., Gerberding C., and Seitz, F. (2007), Simple Interest Rules with a Role for Money, Bundesbank Discussion Paper, 31/2007.

Taylor, J. (1993), Discretion versus Policy Rules in Practice, Carnegie-Rochester Conference Series on Public Policy, 39:195-214.

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