While the Greek sovereign default saga steadily trundles along its course, contagion is not the only problem European policymakers are going to have to struggle with. The Euro Area recovery is slowing, and fast.
While what is involved is only likely to be a notable “soft patch” in the core, all along the fragile periphery the recession warning bells are now sounding.
In principle this development should present serious monetary policy dilemmas for the European Central Bank, given the risks to the integrity of the monetary union that could result from growing recession weariness out on the fringe.
And while the opinions Monsieur Trichet voiced in Amsterdam over the weekend leave little doubt about his opinion that the next move should be up, and on Thursday, a consensus is now emerging among ECB watchers that this will in all probability be the last such move in quite some time.
In addition, since the shift in emphasis away from “strong vigilance” mode will effectively mean withdrawing one of the principal points of support for the current euro/US dollar valuation it is not that hard to augur that difficult days may lie ahead for the common currency if a more tenable wrapping is not placed around the Greek restructuring agreement, and quickly.
The June manufacturing PMI report effectively leaves little room for doubt on what we can now expect in terms of the immediate growth outlook.
The French and German manufacturing sectors continued to expand during the month, but the rate of expansion dropped sharply, and for the second month running.
And new order growth, and especially new export orders, continued to weaken.
In contrast, the economies on the periphery all moved closer to outright contraction.
There seems to be little doubt that the pace of the slowdown in the core will mean that the peripheral economies are about to experience a double dip (and particularly worrying in this sense is the way Italian growth has been drifting downwards, while Spanish growth has never really taken off).
Thus those economies that are not already contracting will likely fall right back into recession.
This general impression of a steadily slowing Euro Area economy is confirmed by a reasonable number of other indicators, like the German machine manufacturers VDMA orders growth, or the business expectations component of the German IFO, or Italian business confidence.
Which brings us to the ECB, and the potential policy implications of what these leading indicator readings are telling us.
Naturally most of the post meeting entrail-divining will centre on the phraseology used to describe the perceived level of risk to price stability.
A smart move, if what you are worried about is credibility, would be to change the wording of the risk assessment for price stability from "on the upside" to "balanced".
This would avoid a lot of potential difficulties in the months to come.
But this is hardly a conceivable outcome when the ECB has just announced a rate hike and when evidence exists of increased pass-through from high commodity prices into core inflation.
In addition the euro zone hourly labour cost data published this month for the January to April period surprised on the upside.
On the other hand the June PMIs suggested that input price inflation continued to ease back in June, and particularly in the leading manufacturing sector, while every time the Greek rescue deal wobbles oil prices drop a notch.
Evidently inflation in the Euro Area remains above the ECB target of 2 percent, but there are signs that it is stabilizing and may well move below this key level in the medium term.
But the critical point is that ECB decisions themselves are one of the main factors which will influence the outcome here, not simply via the standard monetary policy path but through the impact its decisions will have on policy sustainability on the periphery, and though this channel on the level of global risk sentiment.
Growth is not the only distraction facing the ECB from its principal mandate of defending price stability, there is also debt stability to think about too.
Recent days have show that large peripheral economies like those of Spain and Italy, far from having totally decoupled from the smaller and weaker countries, are now once more being drawn back into the maelstrom.
In particular Italy’s government debt to GDP (gross domestic product) level of 120 percent has been attracting growing attention.
Simple calculations show that just to stabilize debt at this level with prevailing interest rates the country needs a 3 percent annual growth in nominal GDP.
Real GDP growth this year will be under 1 percent, so pushing the country’s inflation rate down below 2 percent will obviously nudge the debt level upwards, which will raise the premium investors will ask to buy Italian debt, meaning that next year the country will need an even higher rate of nominal GDP growth, and so on, and so forth.
And the situation is Spain is hardly better, with 85 percent of mortgages being attached to variable rates, pushing Euribor upwards simply starts to weaken the hitherto comparatively robust performance of the bank mortgage books, while the slower economic growth will make government deficit targets even harder to maintain.
So really, the issue is not whether the ECB is right to go ahead with this week’s rate rise given its main mandate, the issue is whether members of the Governing Council could by any chance prove themselves sufficiently flexible to change discourse in the face not just of Greek default woes, but of growing recessionary and debt management risks?
In his latest report Deutsche Bank’s Gilles Moec argues that the present situation is “not bad enough” for the Bank not to raise, but I would ask how bad does it have to get, and just what is prudent and what is risky behaviour in current circumstances?
Certainly Council members need to be vigilant, but in particular they need to be vigilant that their attempts to avoid one problem do not inadvertently generate another, even more difficult to handle, one.
Edward Hugh is an independent economist.