William De Vijlder

The Covid-19 pandemic is having a profound impact on household expenditures. The volume has dropped and its composition has changed significantly. As restrictions are gradually lifted, services such as recreation, food services and accommodation, which have seen a big reduction in demand due to the restrictive measures, could thrive, to the detriment –at least relatively speaking- of spending on goods. For the strength of the early phases of the recovery, pent-up demand is an important factor. It plays a smaller role in the services sector, which could mean that countries with a larger services sector not only have suffered more from restrictive measures but could also face a bigger challenge during the recovery.

Economic statistics for the first part of this year are better than expected, including in Japan and the euro area. Moreover, this development is broadening in terms of sectors. Looking at business surveys, there is a growing feeling of beginning to “see the light at the end of the tunnel”.

In many countries the number of new Covid-19 cases has begun rising again, forcing governments to maintain or tighten health restrictions. This is the case for the Eurozone, among others, where a true rebound in growth and demand has been postponed yet again. The timing of the recovery will depend essentially on the effectiveness of restrictive measures and the acceleration of vaccination campaigns, but also on spillovers effects with some of its trading partners whose economies are picking up more rapidly. The United States is one such country thanks to its successful vaccination campaign and the enormous recovery plan that has just been launched. America’s influence is not limited to providing greater opportunities for European exporters. The upturn in US bond yields has partially carried over to long-term rates in the Eurozone, pushing them higher. This trend largely reflects higher inflation expectations, although the Federal Reserve is convinced that the surge in inflation will be short-lived. Companies and households should welcome the bond markets’ jitters, which clearly signal the sentiment that the economy really is improving.

The emergence of spring mirrors the improvement in economic data in the euro zone. When looking at the recent flash PMIs, one cannot but be impressed by an improvement far bigger than what was expected by the consensus. The manufacturing PMIs are also reaching a very high level and sometimes historical levels. Services have also improved, however the level is still lower than the long-term average.

Since the Great Recession, the monetary base in several advanced economies has seen a considerable increase, driven by the creation of bank reserves at the central bank. Yet, contrary to what had been observed in previous decades, this has not been followed by a significant pick-up of inflation. Following the global financial crisis, the demand of the banking system for central bank reserves increased a lot. This was a reflection of the dire state of the economy and money markets as well as tighter liquidity requirements. Subsequently, quantitative easing caused an increase in reserves on the initiative of the central bank. Going forward, as the economy strengthens, money supply growth and inflation could reconnect on the back of an increase in money velocity or faster credit demand growth. Central banks have the tools to address this, if need be. Clearly, asset markets might be less relaxed about such a prospect.

In recent months, purchasing managers in the euro area and the US have reported a significant increase in input prices as well as longer delivery lags. They reflect the next stage of the disruptive impact of the pandemic with supply struggling to meet the pick-up in demand. According to an Atlanta Fed survey, firms experiencing the most intense disruption tend to be those with the highest expectation of future inflation. It remains to be seen whether this will convince them to raise prices. The Federal Reserve is relaxed about this but, nevertheless, there will be lot of nail-biting in the second half of the year as US inflation data are released in an economy that should be able to close its output gap quickly.

Euro area headline inflation has been in negative territory for several months and core inflation is stuck at a very low level. Unemployment is expected to rise further before starting to decline, so wage increases should remain limited. Does this mean that inflation is bound to remain low for a long time? Not necessarily.

The preliminary estimation for euro area inflation surprised to the upside, with annual core inflation reaching 1.4% in January. Monthly inflation was negative however, at -0.5%. Due to the Covid-19 pandemic, inflation data have become very noisy and hence more difficult to interpret. Survey data show rising input prices and lengthening of delivery times, which could exert some upward pressure on inflation. These factors should dissipate during the course of the year. Given the economic slack, any lasting pick-up in inflation should be a very gradual process

With the pace of vaccination roll-out, new infections in many countries and the emergence of variants, there is a risk that restrictions may need to be kept in place. This would induce a delay in the recovery. In the sectors impacted by the restrictions, the difficult times would last longer and could lead to bigger damage. Finally, an international comparison of the recovery pace could have an impact on capital flows and the euro, given that the eurozone is lagging behind.