Euro area goods demand should be resurgent.
Employment growth remains healthy (German employment was growing at an annual pace between 0.5-1.0% in January). Pay continues to grow rapidly (euro area negotiated wages were up 4.5%y/y in Q4). And inflation has fallen substantially, to just above 2.5% in February, from around 6% in the middle of last year. Together, that’s a healthy picture for real disposable incomes and consumer spending. So, after a prolonged period of weakness, euro area retail sales should be recovering.
They aren’t. Euro area real retail plus auto sales were unchanged in January and have trended gently downwards since mid-2021. In level terms, they are now marginally below their pre COVID peak: in short there has been no growth at all over the past 4 years.
There is as yet no sign of recovery: if anything rather the opposite. During the period of high inflation nominal retail sales growth was strong, translating into weak real sales. Over the past six months, nominal retail sales have ground to a halt meaning that real goods spending has fallen again, despite the drop in inflation and partial recovery in disposable income.
There are a couple of plausible reasons for disappointing goods demand in Europe.
Interest Rates: the sharp rise in ECB policy rates in 2022-23 has dampened euro area consumer spending through a couple of channels.Until 2022, euro area households experienced over a decade’s tailwind of falling debt interest payments, supporting discretionary spending. Since the ECB began tightening, that has reversed and become a headwind, one that could be sustained for some time. Given the long duration of their debt, households will be rolling onto higher borrowing costs for the coming two years or so, unless policy rates fall substantially.
Loan Demand: higher rates have also crushed household loan demand, as we can see from both loan officer’s surveys and actual lending data. Bank lending to households (mostly mortgages) has fallen back to zero from a post-COVID peak of about 4.5% at an annualised growth rate.
Switching back to services: another factor appears to be the strength of nominal spending on services. As noted above, goods inflation eased considerably in the last six months, but services inflation has proven more persistent, and is still running close to 4%.
Having collapsed during the pandemic, real consumer spending on services has grown faster than, or at, its pre-pandemic trend since late 2021. As the chart below shows, both goods and services spending are well below that trend path, but real spending on services has proven more resilient since 2022.
Resilient real spending on services, combined with persistent services inflation has effectively meant that strong nominal services spending has cannibalised goods demand. As the chart below shows, nominal spending on goods grew just 1.6% through the course of 2022, spending on services grew by 6.0%.
In short, euro area real goods demand has been squeezed by tighter monetary policy and stronger spending on services. What are the prospects going forward?
Somewhat better in principle. Further rate hikes are off the agenda and rate cuts will probably start in June. Services inflation should ease further in coming months. So, if jobs and wages sustain their recent strength, there’s clearly (scope) for a modest pick-up in real retail sales through the course of the year.
The most important risk is the labour market. Real GDP has nop been flat for over a year. Although potential growth in the euro area is low, we don’t think it is that bad! So, the economy has been growing below stall speed for the labour market for some time. If unemployment starts to rise then household labour incomes would weaken just as they were poised to yield stronger goods demand.
This suggests that the ECB should pre-empt that risk by starting rate cuts immediately. It's equally clear that they won't. The prevailing mantral remains that easing too soon and too fast could be a major mistake, by allowing inflation and inflation expecations to go back up again. At today's press conference So, as usual. they will commit the opposite mistake by easing too little and too late.
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