The ECB’s Ride Into the Eurozone

Erik Norland – CME’s Economist joins IBKR’s Jeff Praissman to discuss some of the biggest contributors having positive and negative effects on the Eurozone economy and the possibility of further ECB rate hikes.

Contact Information:

Email: erik.norland@cmegroup.com;

Web: www.cmegroup.com

Summary – IBKR Podcasts Ep. 102

The following is a summary of a live audio recording and may contain errors in spelling or grammar. Although IBKR has edited for clarity no material changes have been made.

Jeff Praissman

Hi, everyone, welcome to IBKR Podcasts. I’m your host, Jeff Praissman and it’s my pleasure to welcome Erik Norland from the CME. Today we’re going to discuss the prospects for further ECB rate hikes. Hey, Erik, how are you? Thanks for stopping by the IBKR Podcasts studio.

Erik Norland

Yeah, thanks for having me. It’s great to be back.

Jeff Praissman

It’s great to have you back. And for our listeners, we always have a lot of great material from Erik and the CME available on our website under Education. Today, we’re going to talk about the ECB and potential rate hikes, but I’d like to kind of just start with the core inflation rate in the Eurozone. Where is that currently?

Erik Norland

As of the end of July, it’s running at 5 ½ % so, it’s running at a pretty high level. Now we’re just starting to get the August numbers out. As of this recording, we don’t have the August Core CPI for the Eurozone yet, but we do have it for Spain, for example, where it ticked up from 6% to 6.1%. So, we also have some non-core data from various German Länder and that data is coming also pretty close to consensus for the month of August. So it’s looking like we’re probably going to keep core inflation at around 5 ½ %, which is way higher than the ECB target.

Jeff Praissman

And, you know, for our listeners, are all the countries — do they contribute equally to the to the Eurozone? Or are there countries that have  — I would kind of assume countries with maybe a bigger population or a bigger economy would contribute more. How exactly does it work?

Erik Norland

Yeah, so the big enchilada is Germany, it’s by far the biggest share of the economy, in part because Germany has a really big population of over 80 million people, and in part because they have a higher than average standard of living, so their economy is bigger than anyone else for both of those reasons. So together they are about a – Germany is about 1/3 of Eurozone GDP (Gross Domestic Product).

Jeff Praissman

So, the Eurozone really is heavily weighted toward one country in particular. Let us kind of start with Germany then, where is their wage growth right now?

Erik Norland 

German wage growth is running at 6.6% year on year, which is a very, very fast rate of wage gains and of course, that is great for workers. What is less great is that productivity growth in Germany is very slow, it is running around maybe 1 or 2% at most. So, when you have wage growth growing a lot faster than productivity growth, that tends to be very inflationary.

Jeff Praissman

So really it seems like that gap just continues to widen then as wage growth is really outrunning productivity growth. And Germany has an interesting economy as well because they are really manufacturer-heavy, correct?

Erik Norland

Yeah, it’s a very manufacturing-heavy economy. What is interesting about Germany’s economy, is it creates very high value-added manufactured goods. And what that means is that those goods are not so sensitive to fluctuations in exchange rates. So, if the Euro rallies or falls it doesn’t necessarily impact Germany’s highly differentiated exports, in the same way that it would impact the exports of a country with less differentiated exports, like Italy, or Spain or France. But what is also interesting about Germany’s exports, is that a lot of these high value-added goods include machinery that is then used in factories in other countries, like in China and Japan. And the Chinese economy has been growing very, very slowly. Recently, it just kind of put some downward pressure on their demand for manufacturing equipment that is produced in Germany, and it puts some downward pressure on German exports.

Jeff Praissman

And it seems the world is kind of moving more toward a service-oriented economy. I know especially in the US, where that’s really taking a bigger piece of the pie. Do you see any issues for Germany down the road as far as being so manufacturer-heavy versus everything kind of more moving towards service oriented?

Erik Norland

The service sector can be volatile at times as the US discovered, for example, during the subprime crisis 15 years ago, but in general, services tend to be a very diverse group of things, and they tend to be relatively stable. Manufacturing has always been a bit more cyclical. Germany has resisted some of that cyclicality by being involved in areas of again, very high value added manufacturing, but they’re not completely resistant to the cyclicality of it. So, the fact that demand for manufactured goods around the world has been falling as a result of the COVID reopening, and as a result of China’s weak economic growth has not been great news for Germany. The other thing is Germany, even though it’s a lovely place to visit, it does not attract tourists in the same way that Spain, Portugal, France, Italy, and Greece do.

Jeff Praissman

Got it. And I kind of like it take this opportunity to pivot over to another country that’s in the news a lot, France, which you just mentioned. How is France doing? It seems like they have a fairly heavy debt both in the public and private sectors.

Erik Norland

So, the French economy has been one of the big outperformers in Europe, since the global financial crisis. They’ve consistently turned in growth rates that are a little bit stronger than most other countries. But the way in which they achieved this was to leverage up the economy. So, for example, at the beginning of this century, the French public debt was 59% of French GDP. Now, it is 112%, as of the end of last year, so they’ve doubled the public debt relative to the size of the economy. French household debt at the beginning of the century was 34% of GDP, now it is up to 66%. You have also had a lot of households borrowing from mortgages, credit cards, etc. And then lastly, and most alarmingly, French non-financial corporations, all corporations that are not banks, their debt level at the beginning of the century was 94% of French GDP. Now it is up to 162% of French GDP. So, for instance, debt levels have been burgeoning across both the public and the private sector and none of this mattered much when interest rates were zero if you could just finance all this for free. But now that interest rates are up to four and a quarter, it seems likely to be heading at least a little bit higher. This is not particularly great news for France in particular.

Jeff Praissman

So, you know, with Germany and France obviously contributing heavily to the Eurozone, are there other bright spots in the Eurozone that people may not know of? Maybe, some of the smaller countries or economies are taking everything in stride given the current environment?

Erik Norland 

Since the European debt crisis, which peaked a little over a decade ago, around 2011, and 2012, certain European countries have taken great strides to deleverage. So, Ireland has gone through a massive deleveraging process, as has Spain and Portugal. So those countries that used to be very vulnerable, as they had high debts, now have very, very low levels of debt. I should also point out that Greece is also really starting to prosper. I go to Greece every summer, I was just there a few weeks ago and I think Greece has really worked through a lot of its economic problems. It does still have a lot of government debt but that government debt, part of their so-called bailout package, was restructured to have much longer maturities. Which means they are less sensitive to short-term fluctuations in ECB rates than other countries. So those four countries I think, give you good cause for hope and then Germany and Austria also have very low debt levels, much below the Eurozone average. So those two countries may also not be so negatively impacted by the ECB’s rate hikes.

Jeff Praissman

And, you know, besides for France, are there any other debt crisises brewing in the Eurozone that you know of?

Erik Norland

Yeah, so the other two countries that have increased their leverage a lot over the last several years and has significantly above average levels of debt are Finland and Belgium. So, those could also be countries to watch for a little bit that are not really in the news right now but could get into the news if we start seeing an uptick in default rates.

Jeff Praissman

So, given this environment in Europe, and especially with, obviously, Germany being the biggest contributor, but then these countries sort of a little bit all over the place from what you are saying. Some are bright spots, some sort of grenades waiting to go off there. In your opinion, what should the ECB do with rates? Do you think they should hike them or lower them and what kind of time frame would you think they should change them over?

Erik Norland

Yeah, that’s the toughest question. So they’ve already raised rates a great deal. So, they took their main refinancing rate from 0 to 4.25. It looks either possible or even probable that they’ll raise rates another quarter point on September 14, when they have their next announcement, which of course, is coming up very quickly. Though, if they do that it would bring their rates to 4 ½ %. The thing is, that is still a full percent below their core rate of inflation. When you compare them to say, the Bank of Canada or the US Federal Reserve, they now have their policy rates above the rate of inflation. So that would imply that the ECB is significantly more to go on the upside.

On the other hand, the Eurozone has a very unique property of having a whole bunch of different sovereign emitters, issuing debt into the same currency. We saw that can create these highly varied crises where some countries find themselves in deep trouble while other countries are doing just fine, so that complicates their monetary policy. The last thing that complicates it is that there’s a lot of data out there, including the PMI surveys, especially for German manufacturing showing that certain sectors of the EU economy are already contracting. So yes, the wages are growing quickly in Germany, but economic activity is not. The last last thing is they have to be aware of is the lag time between raising rates and the ultimate economic consequences of that. And that lag time is probably somewhere in the area of one to two years. So if they raise rates say through the end of this year, the full impact of those rate hikes on the general level of economic activity, as well as on inflation, may not be felt until 2024, 2025, or even later.

Jeff Praissman  

This was great by the way Erik. Is there any last thoughts you want to leave our listeners with regarding the ECB or its relationship with the US and how it kind of differs? It seems like with those different sovereignties there’s another layer of complexity that they need to worry about.

Erik Norland

There’s really two things I’d like to leave with. So, one is that there’s always been this lag time between what the Europeans are doing and what the Americans are doing. For example, the US had a recession in 1990 in 1991, Europe about a year later, around 1992. If you looked back to the last decade, or actually a decade and a half ago, two decades ago really now, that time the Fed raised rates from 2004 to 2006, the ECB raised rates from 2005 to 2008. So, they were roughly a year behind even two years behind the Fed and their policy tightening. This time around, they’ve also been behind the US Federal Reserve, the Fed may well be done where the ECB is continuing to go. And their economic cycle appears to be a bit behind the US as well, like inflation really took off in Europe, about six months after it started taking off in the US. So, what’s happening in the US is maybe a leading indicator as to what’s going to happen later on in Europe. The last thing to mention is the other really big country we haven’t mentioned, which is Italy. Italy, is in this weird situation where they have a really huge public sector debt, around 130 or 140% of GDP but they also have very, very tiny private sector debt. Italian households and corporations just don’t do much debt. So that will also be an interesting one to watch as well.

Jeff Praissman

Thank you, Erik, for stopping by the IBKR Podcast. For more from Erik Norland and the CME go to our website, go down to Education. You can see podcasts, webinars, and other educational material that they’ve been kind enough to provide us with. I also remind everyone that you can find our podcasts on our website under Education scroll down to IBKR Podcasts or on YouTube, Spotify, Apple Music, Amazon Music PodBean, Google Podcasts, and Audible. Thank you for listening, until next time, I’m Jeff Praissmen with Interactive Brokers.