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The ECB is in for a Covid-19 shocker
It was the calm before the storm. Last week, new data showed that the eurozone economy had seen an encouraging rebound in February, as activity in the services sector expanded strongly, while manufacturing slowed less than expected. However, the disruptions from the Covid-19 epidemic look set to hit the region's businesses hard, especially as the number of cases outside of China grows. The European Central Bank (ECB) and euro region finance ministers have seemed oddly sanguine in recent weeks, but that's likely to change soon.
According to data published on Friday, the composite purchasing managers index (PMI) - a closely-watched index of economic activity - rose to 51.6 this month, above the crucial 50 level that separates an expansion from a contraction. The dominant services sector hit 52.8, up from 52.5 in January. Manufacturing touched 49.1, the highest level in a year.
The rosy figures sparked optimism that the euro area may be emerging from a soft patch at the end of 2019. The region's economy expanded by a mere 0.1 per cent in the last three months of last year, as France and Italy both contracted. The new PMI readings for Germany's manufacturing industry - which touched 47.8 in February from 45.3 last month - were particularly encouraging. This sector had shrunk substantially at the end of last year, raising fears that Germany could soon head for a recession.
The trouble is that these indicators are unusually noisy. PMI indices incorporate a number of gauges, which are both backward- and forward-looking. Unfortunately, some figures that predict future activity - such as new foreign orders - were particularly weak. A possible interpretation is that the damage from the spread of the virus outbreak is not yet fully visible in the data.
Moreover, the outbreak appears to be spreading fast. The number of infected individuals in China has risen to above 79,000, with more than 2,500 fatalities. Europe, which had been spared largely, has seen a steep increase in the number of cases: In Italy, it climbed in just a few days to more than 130. The country's government had to take some dramatic measures, including the cancellation of Venice's Carnival celebration and suspending schools and other public spaces in a number of northern regions.
Until now, policymakers had displayed little sense of hurry. At the weekend, finance chiefs and central bankers from the world's largest 20 economies failed to put in place a concerted set of measures to prop up the global economy, as they only agreed to a "menu of policy options" if conditions worsen amid the virus outbreak. Last Tuesday, eurozone finance ministers had approved a joint policy recommendation that alluded to some form of fiscal expansion if the slump deepens. However, it is unclear when the boost would actually occur or how forceful it would be. Germany's politicians appear particularly reluctant to open their purse. The German economy is now one of the worst performers in the currency area, and yet its leaders continue to rack up fiscal surpluses.
The ECB has also been surprisingly upbeat recently. At the last press conference, its president Christine Lagarde displayed excessive optimism that inflation was edging closer to the central bank's target of close to but below 2 per cent. On Friday, Philip Lane, the ECB's chief economist, said he still expected the impact from the virus to be "V-shaped", meaning there would be an economic contraction followed by a rapid expansion. The implication is that the central bank could just look through such weakness, since it would be largely temporary.
So far, the fears for the global and European economies were largely the product of what was happening in China, a large export market for European businesses and is deeply rooted in their supply chains. However, there will now be serious consequences for domestic demand and supply too. The outbreak in Italy has occurred between Lombardy, Emilia-Romagna and Veneto - the country's industrial heartland. As people choose to stay at home and travel less, this is bound to impact local services.
An important question for central bankers and governments is to what extent these disruptions will have inflationary consequences. Over the past decade, policymakers have grown accustomed to responding to slowdowns by simulating demand, especially through unorthodox monetary policy moves, including quantitative easing. Mr Lane said the central bank has room to respond to a more severe shock, for example by cutting interest rates further into negative territory. Perhaps, governments including Germany might agree to tax cuts and spending increases. However, severe supply disruptions would naturally have an upward impact on prices, as factories compete for a smaller number of providers. Of course, any slowdown in demand would have a dampening effect on inflation, for example via cheaper oil. But we just don't know what effect will dominate.
It is clear that we're entering a new phase in the spread of the virus. The financial markets appear to have finally begun to take this threat seriously. It's time for finance ministers and central bankers to do the same. BLOOMBERG