MacroResearchBoard

The Euro Area: Fade The Secular Stagnation Narrative – September 20, 2021

There is widespread belief, reflected in regional bond market pricing and at the ECB, that the euro area is mired in secular stagnation: chronically weak growth and near-zero inflation. While this narrative seemed to describe the 2010s, we expect that the current decade will show both better growth and higher inflation.

A just-published report took a deep dive into the components of euro area inflation and revealed that the regional economy is not as deflationary as is generally perceived, setting the stage for upside surprises. There have been important changes in the longer-term economic, wage and pricing fundamentals, which are no longer a drag on inflation. Regional bond markets are ill-prepared for even a mildly inflationary outcome, although many will initially dismiss the rise as temporary (like in the U.S.).

Firming regional inflation will provide a voice back to the hawks at the ECB, implying that the Governing Council will be increasingly divided, adding to policy uncertainty and volatility. Together these forces will put upward pressure on euro area government bond yields, and lift a key anchor on G7 government bond yields.