William De Vijlder

The Covid-19 pandemic has caused a decline in inflation and, in most euro area countries, an increase in the inflation dispersion between sectors. It will take considerable time until activity has been restored sufficiently to generate labour market bottlenecks, which –in the absence of exogenous shocks- are a necessary condition to see a broad-based and lasting increase in inflation. This suggests that for the coming years, we should expect inflation to fluctuate around a slowly rising trend. In the course of 2021, the unleashing of pent-up demand –under the assumption that a vaccine is sufficiently widely deployed- could cause a temporary pick-up in inflation. In this respect, a decline in the price elasticity of demand will play a key role.

The announcement that a Covid-19 vaccine that is under development is highly effective caused major reactions in financial markets, reflecting a feeling that the growth outlook has changed. The prospect of a vaccine offers hope that in the medium run activity will normalise, but the positive impact on growth will take time to materialise. Clearly, the view that better times are ahead of us very much depends on the horizon one takes. However, decisions of households and businesses not only depend on expected growth of income and profits but also on the distribution around the growth forecast. The prospect of a vaccine reduces the probability of very negative outcomes and this reduction in uncertainty should eventually contribute to a pick-up in growth.

After a mechanical and spectacular recovery in economic activity during the third quarter, there seems to be a real risk that the euro zone will see the recovery come to an abrupt halt in the final quarter of the year. This will be due to the sharp rise in the number of new coronavirus cases, the measures taken to restrict the spread of the disease and the general feeling of uncertainty that will hold back spending. This said, we can already look forward to the impetus to recovery from a relaxation of these measures once the number of new cases has been brought back under control. We are therefore living in a stop-start economy, with strong acceleration alternating with brutal slowdowns. Such an environment, with its lack of visibility beyond the short term, is depressing the propensity of businesses to invest. Households may also delay spending on large-ticket items. Monetary and, to an even greater extent, fiscal support will thus remain crucial. Spillover effects from the rest of the world will also play a key role. In this context, one thinks of China and of the USA, where a new stimulus package is being drawn up.

Activity was already slowing before the new lockdown measures and the latter will act as an additional brake. We are living in a stop-start economy. The contraction of activity should be more limited than in March-April. The measures are less strict for economic activity, businesses are better prepared and exports should benefit from a more dynamic business environment, in particular in Asia, compared to what happened in spring. The stop-start recovery should also have negative consequences that go beyond the near term. Uncertainty may last for longer which entails increased risk of bigger scars like a rise in long-term unemployment or corporate bankruptcies. It may intensify disinflationary forces and increases the burden on public finances. It will also take more time until the pre-pandemic activity level will be reached.

For a large sample of developed economies, government debt as a percentage of GDP has been on a rising trend over the past 40 years. High public sector debt weakens the resilience of the economy to cope with interest rate and growth shocks.This calls for embarking, at some point in time, on a fiscal consolidation. Clearly, now is not the time. The economy is still recovering from the Covid-19 shock and the outlook remains highly uncertain. Nor is there any urgency, considering the very low interest rates. However, the absence of urgency in the near term should not make us forget about the necessity to act at a later stage. Otherwise, the resilience of the economy would weaken further. It would also represent a bet that in every downturn, central bank QE will come to the rescue.

In its latest World Economic Outlook, the IMF considers that the economic recovery will be long, uneven and highly uncertain. This will require support from monetary and in particular fiscal policy for a long time to come.

The Covid-19 pandemic will have profound longer-term consequences. Certain industries will benefit, directly or indirectly, whereas others will suffer.The idea of thriving industries full of new opportunities and others struggling to survive reminds us of Schumpeter’s creative destruction. Such a process can entail huge costs in the short run. Research shows the key role played by active labour market programmes. More broadly, economic policy not only needs to focus on the demand side but also, and increasingly, on the supply side so as to avoid that the pandemic acts as a lasting drag on growth.

A key question in assessing the pace of the recovery in coming quarters is what will happen to corporate investment. Financial analysts are expecting profits of US companies to increase. If confirmed, we can expect better cash flows which, based on historical relationships, should lead, with some delay, to a rise in capital formation by companies. However, there is a possibility that companies which have seen a pandemic-induced rise in indebtedness would prefer to use their extra cash to pay back debt. Cash flow uncertainty is another factor that could weigh on the willingness to invest.

In his interview on “Bloomberg Markets: European Open”, William De Vijlder, Chief Economist at BNP Paribas, gives his view on ECB’s leeway on growth and inflation against the background of the pandemic-induced recession. The strenghtening of euro, fiscal dominance as well as uncertainty (surrounding notably the next American election) will also be discussed.

Unsurprisingly, this week’s GDP numbers for the second quarter were exceptionally bad. The third quarter should see strong quarterly growth, if only because of a powerful base effect. It also leaves room for disappointment however, should the growth momentum start to slip over the summer. In the US, this already seems to be the case. In the euro area, business surveys continue to improve and the employment expectations indicator sees a marked increase. Households are not convinced however and their unemployment expectations have remained broadly stable.

Survey data for the euro area continue to improve. The flash purchasing managers’ indices for July have passed the 50 hurdle in manufacturing and services as well as for the composite index, implying activity is expanding again. In addition, export orders are improving. Although companies feel more confident than the month before, the level of confidence is still rather low compared to historical averages. This is illustrated in the latest data for German and French business sentiment: better but starting from a low level. Caution continues to prevail, which shows up very clearly in the employment component of the business surveys. A lot has to do with the concern about how the pandemic will evolve. Against this background, the fiscal stimulus at the national and EU level will be more than welcome.