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Carsten Brzeski's blog

Germany: Party on

A morning of strong data shows that the prospects for the German economy are as bright and sunny as this week’s weather

Germany’s most prominent leading indicator, the Ifo index, increased once again in May, reaching a new all-time-high. The Ifo stands now at 114.6, from 113.0 in April. Both the expectations and current assessment component improved. Earlier today, the PMI composite also increased to a six-year-high, confirming the positive momentum of the German economy.

The prospects for the German economy are as bright as this week’s weather across the entire country. As indicated by this morning’s GDP data, the economic recovery is still going strong, even though it is already in its ninth year of expansion (and even though new economic reforms have been hard to find). Remarkably, growth is now broadly spread across all sectors. This broadening is also reflected in the Ifo subcomponents, where the Ifo manufacturing has picked up significant speed since mid-2016, gradually converging with already buoyant sentiment in the service sector.

Looking ahead, there is increasing evidence that investment could also pick up through the course of the year. The combination of strong orders at hand and low inventories is currently as good as in mid-2006 and late-2010. Capacity utilization has, almost unnoticed, increased to the highest level since late 2008. And, according to surveys, companies currently consider equipment as a limiting factor to production as pressing as in the first quarter of 2012, even though labour is still mentioned as the most important limiting factor.

With the domestic economy gaining even more momentum, the biggest risks for the German economy still come from abroad. Protectionist measures from the US, a weakening of the UK economy in the wake of the Brexit negotiations and a slowdown of the French economy in the first stage of reforms under president Macron look like the biggest threats to the German economy.

Today’s strong German data add to the evidence that, not only the German economy, but the entire Eurozone economy could become the positive growth surprise of 2017. With political risks now ebbing away, economics (ie at least a positive cyclical upswing) have quickly taken over. This sentiment is also spreading across financial markets, with many market participants now realizing that the Eurozone economy had been written off too early. However, as much as the pessimism at the start of the year was exaggerated, the current euphoria is as well. Be aware of the sugar rush. Despite the cyclical upswing, structural problems in the Eurozone economy have not disappeared.

For the ECB, the latest set of data and the swinging mood on financial markets poses an entirely new problem: while the economy clearly argues for first steps towards tapering, the strong euro should lead to a downward revision of the ECB’s inflation projections, ruling out rising inflationary pressures as a reason to taper. Therefore, in our view, the ECB will continue looking through high frequency data and focus on the broader trend. For the June meeting, we expect the ECB to announce first subtle changes to its risk assessment and forward guidance. This could be followed by tasking the working committees to study several options for tapering, maybe even including the sequencing. The official tapering communication could then follow between September and December. Above all, however, will be the guiding theme that tapering does not mean tightening.