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Moderate inflation encourages the ECB to actModerate inflation encourages the ECB to actModerate inflation encourages the ECB to actModerate inflation encourages the ECB to actModerate inflation encourages the ECB to actModerate inflation encourages the ECB to actModerate inflation encourages the ECB to actModerate inflation encourages the ECB to actModerate inflation encourages the ECB to act

The euro area's recovery is continuing according to script: gradually and with differences between countries. In 2014 Q1, GDP grew by 0.9% year-on-year and most leading indicators for activity and confidence point to this rate of growth remaining steady in Q2 and perhaps even improving slightly. Nevertheless, it is important to stress that the recovery is still uneven among the region's different countries. Germany leads the field with stronger and more balanced growth, as well as the periphery countries whose recovery is consolidating. But this positive note is still marred by uncertainty regarding France's economic recovery. For the region as a whole, although the recovery is underway domestic demand is still weak in some areas and this, together with a labour market that has yet to fully recover, means that inflation has remained at unusually low levels. This situation has forced the ECB to act, announcing a package of monetary stimuli whose aim is to anchor inflation expectations and boost the region's recovery.

GDP growth in Q1 was driven by domestic demand with a year-on-year contribution to growth of 0.7 percentage points. Of note is the trend in investment, up by 1.9% year-on-year compared with –0.1% in 2013 Q4. Investment in machinery and capital goods, growing by 2.9% year-on-year, is still one of the mainstays for this performance. By country, Germany continues to head the ranking with 6.6% growth in investment. Although exports' contribution to the region's growth was 0.2 percentage points, the upswing in imports particularly stands out, up by 4.1% year-on-year (2.5% in Q4), boosted by the improvement in domestic demand.

Confidence indicators are encouraging for Q2. Although the composite PMI for the euro area fell slightly in May and June from 54.0 points to 53.5 and 52.8 points, respectively, it is still clearly in expansionary terrain, above 50 points. This decline has only slightly offset the increase achieved in April (its highest level in the last three years) so Q2 is still higher than Q1 in average terms. This slight correction is therefore still in accordance with a recovery is that gradually picking up steam. Along the same lines, the European Commission's economic sentiment indicator fell slightly by 0.6 percentage points in June, affected by the decline in the confidence of industry and consumers. The rate of this expansion still varies from country to country. In France indicators are still weak, fuelling doubts regarding the French economy. However, the trend is opposite in the rest of the European countries and most data suggest that activity is continuing to grow at a good rate.

Business indicators endorse the slight improvement in Q2. The figures for industrial production and retail sales available to date seem to confirm what the confidence indicators had suggested. Regarding the former, in April industrial production grew by 1.2% year-on-year (compared with 0.5% in March), above the average for Q1and boosted by the increased production of non-energy manufacturing, maintaining its upward trend. With regard to demand, retail sales rose in April by 2.4% year-on-year (compared with 1.0% in March), suggesting that domestic demand will continue to support GDP growth in the region as a whole thanks to the greater confidence of households and more stable labour market. There are still marked differences between countries, however, with France lagging behind the majority.

The export sector is weakening. Exports of goods had a good start to the year but this positive trend cooled down in March and April. Specifically, in April exports fell by –0.7% year-on-year (compared with –0.8% in March) and leading indicators do not point to any substantial change in trend. The European Commission's indicator for expected volumes of exports over the next three months decreased slightly in Q2 while the indicator for new orders for exports also fell. This weakness in leading indicators therefore points to Q1's slump in exports continuing in Q2. Nevertheless, given that April's contraction in the imports of goods was more pronounced than for exports, foreign demand is likely to continue contributing positively to GDP growth for the region as a whole.

The labour market is starting to show signs of improvement. For the whole of the euro area, employment grew slightly by 0.1% quarter-on-quarter in Q1, this being the second consecutive quarter with positive figures since 2011 Q2. Nevertheless, there are still big differences between the four main powers in Europe: Germany saw the largest rise in employment at 0.3% quarter-on-quarter, followed by Spain with 0.2%. However, France remained at the same level as the previous quarter and Italy continued with job losses, with employment falling by –0.1%. Given this weak growth for the region as a whole, unemployment is therefore still high (11.7% in April). Another factor underlining the sluggish labour market is labour costs which are still moderate, rising slightly in 2014 Q1 in general but by more in France and Germany, helping the periphery countries to gain competitiveness.

Inflation has remained low, forcing the ECB to act. After the ups and downs in the latest figures for inflation due to the calendar effects of Easter, June's figure stood at 0.5% year-on-year (0.5% in May), confirming the weak growth in prices. This situation led ECB to act via a package of monetary stimuli with the aim of achieving its mandate of price stability and keeping inflation expectations anchored. Particularly of note in this package, made up both of conventional and non-conventional measures, are refinancing operations with the condition of credit being granted to the private sector (see the Focus «The ECB makes a move» for a more detailed discussion). In spite of the current weakness in prices, over the coming months a change in trend will appear in the inflation rate as confidence in growth capacity recovers and domestic demand builds up. In the short term, the upswing in oil prices due to geopolitical tensions in Iraq and the Ukraine will also support a change in trend for inflation. Given this situation, we expect the inflation rate to be slightly above 1% by the end of 2014 and to remain around 1.5% in 2015, a figure more in line with the euro area's economic situation as a whole. Any significant deviation from this scenario could force the ECB to introduce more monetary stimuli.

Looking at individual countries, there is notable uncertainty regarding France's economic recovery. The French economy stalled in 2014 Q1 with zero growth compared with the previous quarter. In fact, GDP only managed to avoid a negative growth rate thanks to an increase in stocks, as exports made a negative contribution to growth and household consumption and investment both declined (–0.5% and –0.9%, respectively). Business and confidence indicators for Q2 are not encouraging either. Industrial production fell by 2.0% year-on-year in April (compared with –0.2% in Q1) as did goods exports, down by –6.4% year-on-year, although in this case the larger fall in imports could mean that the foreign sector ends up contributing positively to GDP growth. Confidence indicators are equally pessimistic: the composite PMI remains below 50 points and, even more worrying, below the average figure for Q1.

A slight setback for the Portuguese government. The Constitutional Court annulled some of the measures that had been approved by the government to reduce the public deficit. The measures annulled are valued at 800 million euros, including permanent wage cuts for the civil service. This means that Portugal has ended the Troika's bail-out programme without the last payment of financial aid being made, forcing the Portuguese Treasury to resort to the markets to offset the loss of this source of financing. Although the measures annulled by the Constitutional Court were meant to cover one fourth of the fiscal adjustment budgeted for 2014, the government's total commitment to fiscal consolidation, the good pace of growth in Portugal's economy and the breadth of the structural reforms already implemented are helping the market to remain confident in Portuguese sovereign debt.

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