Europe: Mild Down, Mild Up
The U.S. recovery is making things brighter overseas.

Mr. Malpass is the Chief International Economist for Bear Stearns.
March 12, 2002, 8:00 a.m.

Though Europe has not yet officially declared a recession, it appears to have suffered a mild one late in 2001 — with the European economy weakening last year in a lagged reaction to the U.S. recession.

But signs are pointing up.

In particular, the relationship between the euro and dollar entered a more stable phase at the end of 2001. This is in sharp contrast to the super-strong dollar period in 1999-2001, and it should help Europe increase its productivity, add to the flexibility of its price and labor markets, boost the investment rate, and improve Europe's attractiveness for bond and equity investments.

Business is also looking good. Germany's business-confidence index has risen for four consecutive months and is back at pre-Sept. 11 levels. Similarly, the Italian and French business-confidence indexes have risen for three consecutive months since bottoming in November. Although the level of business confidence is still low, the improvement is a signal that firms will be getting ready to add to inventories and make new investments. Plus, the U.S. recovery should continue to boost business confidence in Germany and the rest of Europe.

On the market front, European equities are following the path of the S&P 500, which also reflects improved prospects for Europe as the U.S. economy rebounds.

More, Europe's inflation rate is declinign and should fall substantially in coming months, allowing the European Central Bank to hold off on any interest-rate increases. While it's true that Europe's consumer price index increased from 2% year-over-year in December to 2.7% in January, most of the increase was due to the introduction of the physical euro (retailers rounded their prices upward). So, going forward, if monthly inflation comes in at 0.2% in the February-May period — which is quite possible — the year-over-year inflation rate would fall to 1.5%, well below the ECB's 2% ceiling.

And while real interest rates are high at nearly 1.5% — working against the recovery — gold and commodity prices have risen some in euro terms in 2002, suggesting no inflation (or deflationary) impact from the changing value of the euro. Helped by the likely 2003 change in the ECB presidency from Wim Duisenberg to Jean-Claude Trichet, the euro should remain stable enough to keep inflation very low.

Europe's economy and currency would benefit from an interest-rate cut — especially given the likely decline in inflation and the stability in the euro — but will probably not get one under its current monetary policy model (especially given the ongoing U.S. recovery). But the ECB sums up what seems to be a turn for the better: "Although the timing and strength of the upturn remain uncertain, the available evidence points to a resumption of economic growth."