A 70 percent surge in oil prices over the past year - the price of crude oil touched $100 a barrel for the first time in New York yesterday - together with a global surge in food prices is driving up inflation across Europe even as the euro's gains against the dollar make imports cheaper. The "strong, short- term'' increase in inflation is a source of concern to the European Central Bank, the Bank of Spain said yesterday. It certainly is, since
Adverse weather conditions in food-producing countries and increasing demand from rapidly growing emerging economies, where food consumption composes a significant proportion of household expeniditure, are also pushing up food prices, increasing the inflationary pressure. Droughts in Australia, Canada and Ukraine pushed the price of wheat to a record in December while soybeans touched a 34-year high.
Inflation across the euro region accelerated to 3.1 percent in November, the fastest pace since the currency was introduced. Meanwhile consumer confidence is plummeting, touching historic lows for three months in succession in December according to the index compiled by the Instituto de Credito Oficial.
The cost of borrowing - as measured by the British Banking Association's three-month Libor rates has been falling during the last couple of weeks as central bank measures to relieve a year-end logjam in money markets continue to show signs of success, but they are still way above where most people would like to see them.
The three-month euro interbank offered rate, or Euribor, dropped almost 2 base points to 4.67 percent, the European Banking Federation said today. It was 4.93 percent Dec. 17, the day before the European Central Bank injected a record $500 billion into the banking system.
Short-term borrowing costs have fallen since policy makers in the U.S., U.K., Switzerland, Canada and the euro region announced plans Dec. 12 to counter a credit shortage threatening to undermine global economic growth. Up to the present time ubprime-mortgage defaults in the U.S. have forced the world's financial institutions to write down about $100 billion in fixed-income securities.
But these measures have yet to achieve their underlying objective of pushing borrowing costs back down to the levels of July, before the collapse of the U.S. subprime-mortgage market caused banks to stop lending to all but the safest borrowers. The three-month euro rate is still 66 base points above the ECB's key financing rate of 4 percent, and this is up considerably on the average difference of 25 base points during the first half of 2007. The comparable dollar rate is 43 basis points more than the Federal Reserve's benchmark rate, up from 11 basis points in the first half.
Basically Libor rates for one-to-three month funding in dollars, euros and sterling are global bellwethers for interbank lending.
Three-month euro Libor was fixed down again yesterday at 4.661313 percent having fallen at eleven out of the last 12 fixings and marking a second consecutive week of declines. Although still well above the 4 percent ECB base rate, this was the lowest fixing for three-month euros since November 22. So what we can say is that while the massive easing operations have reduced the spread, the underlying difficulty is still there, and this is very important in a country like Spain, where an estimated 80% of mortgage holders have variable rate packages which are normally related in some form or other to the Euribor rate.
So really what we should note here is that Spain is facing a very strong tightening on nearly all fronts - interest rates, inflation, credit conditions, and, last but by no means least, exchange rates. The euro simply rose and rose against the dollar throughout 2007 in a way which, I must admit, certainly surprised me.
So what we are faced with is a Spanish economy which is entering its most important "correction" in many years - certainly since 1992, but quite possibly the most important one in its entire history, with all the policy indicators set on tightening. This, it seems to me, is very serious indeed.
As I have pointed out on numerous occassions in the past, this is the downside for Spain on euro membership, since it means that Spain will not have anything like the policy mix that is appropriate to its current needs (the upside was, of course, the property boom, which was in part produced by having negative real interest rates - ie interest rates which were below the actual inflation level in Spain - over a considerable number of years.
The underlying situation in Spain is also highlighted by the shifting pattern of employment and unemployment, and a comparison between 2006 and 2007 is pretty revealing. If we look at the chart below we can see that in the early months of this year the employment situation was generally up over 2006. Then the situation turned (around July), and since then it is "down hill all the way" unfortunately, with unemplyment rising (as it might well do for seasonal reasons anyway, but in every case the increase is significantly more pronounced than in 2006. Spain's ever productive labour market has, unfortunately, now turned.
Also if we look at retail sales we get the same picture. Retail sales across the entire 13-nation euro region fell in November according to the most recent eurostat data, dropping by 0.7 per cent from October to a level which is just 0.2 per cent higher than the Novemeber 2006 one. Of course this average hides considerable variance, with the weakest performances coming from Germany, Italy and Belgium.
But of particulr of note is the performance of retail sales in Spain (the zones 4th largest economy) since strong growth in Spain has previously offset weaknesses in Germany and Italy at previous critical junctures. But this time it will be different, since Spanish retail sales have fell in both October and November 2007, and while the year on year readings are still in positive territory, they will not remain there for long since the earlier strong readings will eventually drop out of the data.
Also manufaturing industry in Spain may well now be contracting. Euro zone purchasing managers surveys for the manufacturing sector confirm the economy is likely to have slowed down in the fourth quarter despite pockets of resistance in some countries. The Royal Bank of Scotland purchasing managers index for the euro zone manufacturing sector eased to a final 52.6 in December from 52.8 in November, a figure was revised up slightly from the provisional reading of 52.5 issued in mid December. The Spanish manufacturing PMI fell to 49.5 from 50.7, dropping below the critical 50 dividing line between expansion and contraction. Since it was also below 50 in October this means that in 2 out of the 3 months in Q4 2007 Spanish industrial output may have been contracting. When we add this to the decline in retail sales and construction, and take into account that with a large trade deficit foreign trade is a drag not a plus for Spanish GDP, it is hard to see where the growth is going to come from in the last quarter, except of course from an expansion in civil engineering projects financed by the government. With elections looming in March, my guess is that they are deficit spending as much as they can at the moment.
The Spanish services sector purchasing managers index (PMI) stood at 51.0 in December, up from 50.7 in November, according to market research group NTC. "Commercial activity continued expanding... even though recent calculations suggest that the growth will not be maintained in 2008," Nathan Carroll at NTC Economics commented. In particular new orders fell for the second month in a row, coupled with moderate additional declines in pending orders, all of which point to a continued slowdown in activity. Basically services - which constitute the lions share of the Sanish economy - continued to expand in December, but - as can be seen from the chart below - at a much slower rate than earlier in the year. Looking at the chart it is not difficult to imagine that we will enter negative growth in services in Q1 2008, and I imagine that at that point the Spanish economy will enter recession.
