The Eurozone might need a bigger policy toolkit

Thought of the day

by Chief Investment Office 10 Apr 2019

The IMF has cut its global growth outlook for the third time in six months. It lowered its estimate for this year by 0.2 of a percentage point to 3.3%. This would be the slowest rate of growth since 2009. Germany and Italy were revised down by the largest amount, both by 0.8 of a ppt to 0.8% and 0.1% respectively. Separately, the Italian government also downgraded its forecast to 0.1% for this year, compared with a previous estimate of 1.0%.

Slowing growth raises the risk that the Eurozone economy could be headed toward a recession. And as we analyze in a new report, The future of Europe: The Eurozone and the next recession, the available scope for policy response appears limited:

  • The economic recovery since the Eurozone debt crisis has helped contain budgetary imbalances, but fiscal sustainability hasn’t yet been achieved: fiscal space is limited in the periphery, and Germany is reluctant to engage in debt mutualization. The European Central Bank (ECB), rather than governments, is likely to have to act as the key provider of stimulus in the event of a recession.
  • The European Stability Mechanism in its current form would be insufficient to combat a deep recession in Italy and Spain. New powerful fiscal-transfer mechanisms or the creation of Eurobonds seem unlikely given today’s political climate. So the ECB’s Outright Monetary Transactions (OMT) remain the most likely resource to be used to defend the Eurozone’s integrity.
  • With rates still in negative territory, an economic slump in the coming years would likely require the ECB to enact creative policy solutions, including bold measures not part of today’s toolkit. These could include cutting the policy rate below the –1% effective lower bound, pursuing helicopter money policies or revising the inflation target. But such options entail risks, placing considerable obstacles between the ECB and their adoption.A Eurozone recession is not our base case for this year or next, for which we forecast growth of 1.1% and 1.3% respectively. We would expect the euro to survive both a moderate and a severe recession scenario due to strong popular support for the currency. And, in the event of the US Federal Reserve easing in response to a global recession, the single currency could benefit against the USD, at least initially, from the unwinding of the interest rate differential. But a recession, particularly a severe one, would likely lead to significant structural changes that could include deeply negative German Bund yields, Italy being downgraded to sub-investment grade, fundamental shifts in the international corporate tax architecture and/or the next generation of monetary policy being unleashed.

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