Both the European and the Portuguese economy particularly keep showing signs of robustness. This is Jari Stehn’s belief as Goldman Sachs’ chief economist and head of global research. The outlook, though, is not completely optimistic but rather careful because trade war, a no-deal Brexit and the Italian budget situation are still serious risks.
Jari Stehn, who came to Portugal to attend ECB’s Forum last week, sees bigger probabilities in the European central bank cutting the interest rates even more, reaching a new historical low. With respect to the American Federal Reserve, the chief economist is even more certain that interest rates’ reduction will take place.
I would like to start by asking you about your expectations for the eurozone economy. You said at the beginning of the year that the worst of its weakness is now behind us. Do you still believe in that?
The growth outlook has weakened in Europe and the growth numbers have slowed over the past eighteen months. The euro area was growing at 3% at the end of 2017 and we saw a pretty pronounced slow down not only in the euro area but everywhere else in the world throughout 2018.
Now GDP numbers have been a little bit better, but the survey numbers have remained weak, especially the manufacturing PMIs. Looking ahead, we think growth is going to getting better, but there are also important downside risks around the world.
An important risk is, of course, the global trade war, which has intensified and we think is going to be an important drag on global growth and possibly also in Europe. We see growth a little bit better but I do see downside risks, particularly surrounding geopolitical issues. This includes the trade war, Brexit (the possibility of a no-deal exit) and the Italian budget situation.
You mentioned manufacturing. Do you expect US tariffs on the auto industry in Europe?
That is not our baseline expectation, but it is a risk. The most likely outcome is that we will not see auto tariffs, but it’s part of the trade war risks.
Given this scenario and the risks you highlighted, do you see a recession in the horizon?
No, that’s not our baseline expectation. We think growth will get a little bit better from here. Not much, but a little bit better so there is no recession in the forecasts. I think it would really take one, or even more, of these risks to materialize and also for the global growth environment to weaken significantly. If we look, for example, to the US, the growth numbers there have also been somewhat weaker than last year, but are still around 2% and we do not expect a recession in the US either. I think we would really have to see significant changes to the economic outlook for a recession to happen.
What do you think about Portugal?
Portugal, as well as Spain, have generally surprised to the upside in terms of growth performance and growth remained stronger than in the majority of the members-states. What we found is that the reason for this is due to both demand and supply-side factors. On the demand side, the cyclical strength that we have seen over the last years is related to domestic demand and strong private consumption in particular. On the supply side, the reforms adopted in Portugal, but also in Spain, since the European sovereign crisis has borne fruits. It facilitated a more efficient allocation of resources and greater competitiveness. Looking ahead, we think that the expansion both in Portugal and Spain should remain resilient as long as global growth remains decent.
Do you believe that Portugal and Spain will continue to grow more than the euro area?
Yes, that is our forecast. We don’t have a specific forecast for Portugal, but we expect Spain to grow 2,4% for 2019 and 2,1% for 2020, which is significantly above the euro area forecast. For the euro area, we expect 1,2% for 2019 and 1,4% for 2020.
We have heard Mario Draghi in Sintra saying that the ECB is ready to act upon the economic developments and its tool box was full. What was your understanding of his speech? What do you expect the ECB will do?
President Draghi signalled a greater urgency to act and I think it’s an evolution really over the last few months that the communication has shifted from ending QE to discussing easing measures. This shift is a response to the risks we talked about, to the deceleration in growth and the weakening in inflation expectations.
Regarding instruments, the ECB signalled that there are a number of instruments on the table. The first is further changes to the forward guidance. The forward guidance currently says that the Governing Council does not expect any rate hikes at least until the middle of 2020. So one option that President Draghi mentioned is extending the forward guidance. The second is to cut interest rates further into negative territory and the third is the return of asset purchases. I think the key takeaway from his speech was that he indicated that additional easing is needed if the outlook does not improve from here. That is the main change relative to previous messaging when the Governing Council indicated that additional easing might be needed if the outlook deteriorates. Now they are saying that it might be needed if the outlook does not improve. It lowers the hurdle for action but it is still data dependent. It will depend on how the outlook evolves.
When do you expect a movement in the interest rates and in which way?
We see rising odds of a rate cut in coming months, but the decision will depend on how the growth numbers evolve, on how the G20 trade negotiations go, and on what the Federal Reserve ends up doing. We expect the Federal Reserve to cut interest rates by 25 basis points in the July meeting but they may also cut more. All of these things are important for the ECB in deciding whether to ease and how to ease.
With so much eurozone public debt with negative yields, isn’t the ECB creating an artificial bond market?
The key purpose of QE is to lower long term interest rates. In normal times, when you want to provide monetary accommodation, you cut rates, but when you can’t lower rates much more, then QE is the tool to reduce long term interest rates. The main transmission channel – and there are many channels that work, but the key one — is called portfolio rebalancing. This occurs when you take duration risk out of the bond market, push down interest rates and incentivize investors to invest in more risky assets. That has helped ease financial conditions. I think that’s the primary channel, but there are also others like the signalling channel when you signal your intentions to the market as far as the outlook for the policy rate is concerned. We have found QE has been effective via all of these channels in the past.
Do you expect this trend of yield declines to continue? Could we see the yields of countries like Portugal or Spain going into negative territory as well?
I think that depends a lot on what the ECB ends up doing. For example, an interest rate cut would probably have more similar effects across countries than a sovereign purchase program. There is evidence that bond yields in the European periphery have, in past programs, responded more to QE than yields in the core countries. But I think it will really depend on the mix of instruments and how the ECB decides to use it.
What will be Mario Draghi’s legacy?
His legacy will be the “whatever it takes” statement in the summer of 2012 that ended up being hugely effective in helping the euro area and keeping the euro area together. This week was his last Sintra forum as ECB President and a number of prominent people congratulated him for his achievements.
What do you expect from the next ECB President?
We are getting closer to the time when we will know who the next ECB President will be, but I think it is still quite uncertain. There are a number of senior European appointments that need to be made, including the European Commission. It is a very complex process and so the uncertainty around it is still very large at this point. I am sure the next President will be focused on achieving the ECB’s mandate of price stability and act to fulfil the mandate. But we still don’t know who is it going to be.
Whoever it is, do you think that Draghi already laid the foundations of his successor?
At some level, yes, of course. That has already been done in the sense that the Governing Council extended the forward guidance and pledged not to raise interest rates until the middle of 2020. The new President will take over in November and the Governing Council’s decisions already reach into the new Presidents’ term. Beyond that, and going back to what we discussed earlier, it really depends on what they decide to do in the coming months. If they decide to do bigger changes to the forward guidance, to cut interest rates, to relaunch the asset purchases… But it is still open at this point.