LDN - Business

Slide in euro zone service sector sharpens ECB's rates dilemma

[August 23, 2023] By Jonathan Cable

LONDON (Reuters) -Euro zone business activity declined far more than thought in August with the slide in Germany particularly fast, while some inflationary pressures returned, surveys showed.

Wednesday's purchasing managers' indexes complicate matters for the European Central Bank which wants to control still rampant price rises without causing a recession.

It is expected to pause interest rate hikes in September, according to a narrow majority of economists polled by Reuters, despite elevated inflation. A further rise in rates by year-end remains on the cards, however, following the central bank's most aggressive policy tightening cycle.

"The continuing sharp drop in the PMI data will test the ECB's growth optimism," said Mark Wall, chief European economist at Deutsche Bank.

"We are expecting the ECB to pause in September, but it is not clear that inflation is where the ECB wants it yet. A pause should not be misinterpreted as the peak."

Activity in the bloc's dominant services industry declined for the first time this year and the contraction in manufacturing output continued, although there were some signs of a turnaround for factories.

HCOB's flash Composite Purchasing Managers' Index (PMI) for the bloc, compiled by S&P Global and seen as a good barometer of overall economic health, dropped to 47.0 in August from July's 48.6, its lowest since November 2020.

That was well below the 50 mark separating growth from contraction and lower than all expectations in a Reuters poll which had predicted a slight dip to 48.5.

A chunk of that activity was driven by firms completing old orders, with the backlogs of work index falling to its lowest since June 2020 when the COVID pandemic was cementing its grip on the world.

Business activity in Germany, Europe's largest economy, contracted at the fastest pace for more than three years as a deepening downturn in manufacturing output was accompanied by a renewed contraction in services, an earlier survey showed.

Firms there remained pessimistic about the outlook as rising interest rates, customer uncertainty and high inflation continued to weigh on demand.

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People walk past a restaurant at the Butte Montmartre in Paris, France, July 10, 2023. REUTERS/Sarah Meyssonnier/File Photo

In France, the dominant services sector contracted further as falls in demand and new orders hinted there would be a contraction in the euro zone's second-biggest economy this quarter.

Britain's economy, outside the European Union, looks on course to shrink in the third quarter and risks falling into a recession as its PMI showed a slump in factory output and broader weakness in the face of higher interest rates.

Euro zone government bond yields and the euro tumbled after Wednesday's data as traders bet the ECB may soon pause its interest-rate hiking campaign.

SERVICE SECTOR SLIDES

The euro zone services PMI sank as indebted consumers feeling the pinch from rising borrowing costs reined in spending.

Demand fell sharply as prices rising far faster than the ECB would like put off customers. The services output prices index remained elevated at 55.9, albeit the lowest since October 2021 and below July's 56.1.

"Another weak PMI for the euro zone confirms a sluggish economy with recession as a downside risk. Inflation pressures for services remain stubborn as wage pressures continue to be a concern," said Bert Colijn at ING.

"The latter adds to our expectations that the ECB's hiking cycle is not over yet."

Inflation was 5.3% in July, official data showed, more than double the ECB's 2% target but well below readings seen late last year.

Manufacturing activity has been in decline since mid-2022, but the latest PMI survey offered some hope the nadir may have been passed. The headline index rose to 43.7 from 42.7, its first uptick in seven months and confounding expectations in the Reuters poll for a dip to 42.6.

Optimism among factory purchasing managers improved, also suggesting the worst may be over for manufacturers.

(Reporting by Jonathan Cable; Editing by Hugh Lawson and Toby Chopra)

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