ECB paper identifies demand and supply as key drivers of euro area business expectations
A new European Central Bank working paper introduces a framework to analyze the drivers of business expectations in the euro area. It finds that demand-side shocks primarily drive overall expectations, while supply-side shocks significantly influence price expectations.
Demand shocks dominate overall expectations
The paper develops a novel empirical framework to analyze business expectations in the euro area, building composite business expectations indices (BEI) for activity and prices across manufacturing, services, and construction.
These indices demonstrate strong predictive power for near-term real GDP growth and GDP deflator inflation.
Using sector-specific structural Bayesian vector autoregression models, the study identifies six structural shocks.
Demand-side shocks, particularly product demand and financial conditions, are found to account for over half of the fluctuations in both activity and price expectations.
This dominance of demand forces is consistent across sectors, though financial conditions are more impactful for capital-intensive sectors like manufacturing and construction.
The framework offers a granular, survey-based approach for real-time economic analysis and policy assessment.
Supply factors drive price outlook
Supply-side shocks, particularly materials supply and labour conditions, significantly influence price expectations, especially during the post-pandemic inflationary period.
The study highlights sectoral differences: financial conditions are more critical for manufacturing and construction, while services are more sensitive to product demand and labour-related supply shocks.
Materials shortages are prominent in manufacturing and construction.
Historically, demand-side factors drove crises like the global financial crisis.
During the COVID-19 pandemic and subsequent inflation, both demand and supply shocks were critical, reflecting mobility restrictions, reopening effects, and supply bottlenecks.
A timely toolkit for policymakers
This paper provides a crucial, updateable toolkit for policymakers to interpret business expectations in real time.
By distinguishing between demand and supply forces, it enhances the ability to accurately diagnose economic situations and tailor policy responses.
The granular, survey-based approach offers valuable insights for real-time economic analysis and policy assessment, especially in dynamic environments.