Deepening economic pain leaves ECB in policy dilemma

© Reuters. FILE PHOTO: Empty chairs and tables are pictured on the first day of the temporary closing of restaurants, as the spread of coronavirus disease (COVID-19) continues in Berlin, Germany, November 2, 2020. REUTERS/Annegret Hilse/File Photo

LONDON/FRANKFURT (Reuters) -Euro zone business growth stalled this month as a manufacturing recession deepened and a previously resilient services sector barely grew, leaving the European Central Bank in a policy dilemma as it presses ahead with rate hikes to fight inflation.

HCOB's flash Composite Purchasing Managers' Index (PMI) for the 20 nations sharing the euro currency, compiled by S&P Global (NYSE:SPGI) and seen as a good gauge of overall economic health, sank to a five-month low of 50.3 in June from May's 52.8.

That was barely above the 50 mark separating growth from contraction and below all forecasts in a Reuters poll that saw a modest decline to 52.5.

The figures suggest that the bloc's economy is at best stagnating after a recession in the previous two quarters and a recovery is nowhere on the horizon, even if robust holiday bookings suggest that the tourism sector could keep the bloc afloat in the near term.

"This speaks against a recovery of the economy in the coming months, which is expected by many," Commerzbank (ETR:CBKG) economist Christoph Weil said. "We see our assessment confirmed that the euro area economy will contract again in the second half of the year."

"The so far 400 basis points of ECB rate hikes are increasingly slowing down the economy," he added.

For the ECB, the data deepen a dilemma.

Inflation at just over 6% is far too high and the labour market is running hot, suggesting more price pressures ahead as workers enjoy improved bargaining power.

But economic activity is weak and the ECB has clearly failed in its goal of tightening policy just enough to contain price pressures without pushing the bloc into recession.

Another issue is that a recession would normally push up unemployment, making the bank's job easier.

But firms appear to be hoarding labour, keenly remembering how difficult it was to hire back workers after the pandemic and offering the ECB little relief.

Indeed, the jobless rate is at a historic low and nominal wage growth is at its highest in decades, even if wages are just catching up after inflation eroded their real value.

Friday's PMI data only confirm this trend, as firms still increased headcount this month, with the employment index at 54.1, somewhat below May's 54.6.

For now, policy hawks who fear inflation more than a recession, appear to be in a majority.

"Another quarter of negative GDP growth is not unimaginable, although the current slump clearly remains mild enough for the European Central Bank not to change course on rate hikes," ING economist Bert Colijn said.

The ECB has de facto promised a rate hike in July and quite a few policymakers have also put one more move, to 4%, on the table for September or October.

Friday's real surprise was that PMI data covering the services industry slumped to 52.4 from 55.1, well below a median forecast of 54.5.

While Germany, the bloc's biggest economy, outperformed on services, France was a big drag with a services PMI at 48.

Manufacturing activity has been in decline since July and the downturn deepened this month with the euro zone factory PMI dropping to 43.6 from 44.8, also below all forecasts in the Reuters poll and its lowest since May 2020 when the COVID pandemic was cementing its grip on the world.

Germany, with its oversized manufacturing sector, was a drag on the bloc as its own manufacturing PMI fell to 41.0 from 43.2, hitting a 37-month low.