May 24, 2018 / 9:10 AM / 4 months ago

ECB sees 'clouds', potential for further slowdown

FRANKFURT/BRUSSELS (Reuters) - The euro zone economy continues to motor ahead but a more pronounced slowdown is possible and political uncertainty in places like Italy could undermine confidence, European Central Bank policymakers said on Thursday.

FILE PHOTO: European Union flags flutter outside the European Central Bank (ECB) headquarters in Frankfurt, Germany, April 26, 2018. REUTERS/Kai Pfaffenbach/File Photo

ECB stimulus has fueled a five-year recovery and central bankers have been setting up markets for the end of a 2.55 trillion euro bond purchase scheme. But an unexpected slowdown in the euro zone economy, global trade tensions and fears over the new Italian government’s spending plans could throw a spanner in the works.

Playing down concerns, the ECB argued that growth was still solid and broad-based but warned that a more pronounced slowdown was possible, due in part to rising capacity constraints, and that uncertainty was on the rise.

“There were signs of softening demand, which warranted monitoring,” the ECB said in the minutes of its April meeting. “A more pronounced weakening of demand, notably related to external factors, could therefore not be ruled out.”

“The moderation in growth appeared to be broad-based across countries and sectors,” the minutes added.

Indicators from gross domestic product data to Purchasing Managers’ Index (PMI) surveys are all pointing to a major slowdown in the euro zone. The question is whether activity will level off at a lower rate or if more weakness is coming, after growth rose to unsustainable levels around the turn of the year.

For now, policymakers have played down concerns, arguing that growth is still above the 19-country bloc’s potential, so the ECB could still end asset purchases before the close of the year as inflation pressures will continue to build.

But speaking privately, they say the slowdown could mean a first rate hike comes later than currently expected, while the overall interest rate path would be more shallow as the ECB could hardly afford a major tightening in financial conditions.

FILE PHOTO: European Central Bank (ECB) executive board member Peter Praet speaks during an interview with Reuters in Frankfurt, Germany, March 14, 2018. Picture taken March 14, 2018. REUTERS/Ralph Orlowski

Markets have pushed back rate hike expectations from next April to June 2019 but analysts polled by Reuters still overwhelmingly expect the bond purchases to end this year after a short taper.

CLOUDS

With a new, anti-establishment government close to taking office in Italy on pledges to cut taxes and jack up spending, ECB Chief Economist Peter Praet also emphasized some “clouds” on the horizon. They include the would-be coalition’s plans to loosen fiscal policy and roll back a pension reform, as well as broader international trade tensions.

“Economic conditions remain good,” Praet told a financial industry event in Brussels. “There are some clouds and we should be watchful because that can go into confidence in a more fundamental way.”

In a report published earlier on Thursday, the ECB warned indebted euro zone governments that loosen the purse strings risk falling out of favor with investors, particularly if economic growth slows.

It listed Belgium, France, Italy and Portugal as being at risk of breaking European Union budget rules.

Italy’s 10-year bond yield hit a 14-month high earlier this week, pushed up by growing political risks, although it fell on Thursday morning after comments by Italy’s Prime Minister-designate Giuseppe Conte. [GVD/EUR]

Praet said fiscal space to stimulate demand in Italy was limited due to its high government debt but added that the ECB was still in “wait and see” mode as the new government’s program was light on financial details.

The ECB will next meet on June 14 but a decision on whether to end or extend the bond purchases is likely to come only at the July 26 meeting.

Reporting by Balazs Koranyi; Editing by Catherine Evans

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