The contours of the European economic recovery are changing, from one led by a rebound in industrial activity to a more services-based pickup. A lower incidence of COVID-19 and the broad rollout of vaccines across Europe is enabling governments to lift most restrictions to economic activity, paving the way for a strong restart this summer. Purchasing managers' surveys show the rotation in growth already started in May, following first month of the reopening (see chart 1). We now expect GDP to increase 4.4% this year and 4.5% in 2022, from 4.2% and 4.4% previously.

Chart 1

The key driver of the recovery is consumption now that households are not forced to save anymore. While survey data suggests that higher-income households, which have a lower propensity to spend, put more money aside, it also highlights that even lower-income households saved more than usual (see chart 2). Thanks to measures like short-time work schemes, eurozone gross household income managed to rise 0.17% in 2020 despite a 6.5% drop in real GDP. Unlike other crises, this means that households don't have to run down their savings to smooth their consumption as the economy reopens. As such, we expect the savings rate to return to its pre-COVID levels by the end of year.

Chart 2

The shape of the recovery is not only about the saving rate (a flow concept) but also the stock of savings accumulated during the pandemic because of higher saving rates during lockdowns. We estimate that European households have accumulated excess savings of about 12 percentage points of disposable income (€300 billion or 2.7 percentage points of GDP) last year, compared to a trend that would have prevailed without the pandemic (see chart 3). These reserves are likely to have increased further in the first quarter of 2021. Not all of these excess savings are easily convertible, as only one-third is parked as cash and bank deposits. It remains challenging to figure out how much, how fast, and how households will spend it, but excess savings definitively pose a sizable upward risk to our baseline assumptions for housing investment, consumer spending, and domestic prices.

Chart 3

Meanwhile, even though European manufacturers will no longer be the main engine of growth, they will continue to provide steam to the recovery. First, the outlook for external demand has continued to improve this year. Although China has played an important role in kickstarting the manufacturing recovery in Europe, the fast-paced U.S. economic recovery and reopening in most parts of the world are helping to further boost European export orders (see chart 4). Second, demand-side pressures on industry are set to translate into investment as well, especially as profit margins recover (see chart 5). Capacity utilization is already back to its pre-COVID level and firms are starting to cite equipment as a constraint to production. Meanwhile, European governments have committed to a significant increase in public investment in the next two years, giving another incentive for firms to use their profits to invest.

Chart 4

Chart 5

The shift to a broad-based recovery is showing up in the labor market, with job postings rebounding even in the most affected sectors like retail and hospitality, confirming our view that the recovery will be rich in jobs (see chart 6 and "This Time, Europe Is Set To Stage A Jobs-Rich Recovery," published on March 16, 2021). There is still no evidence of any cliff effects from the phasing out of short-time work schemes. This is because governments are taking a gradual approach to lifting support measures and only about 2% of the eurozone's active population was using such schemes during the third lockdown (see chart 7). Adding to that, firms are unlikely to have kept workers on furlough schemes until now if they didn't expect demand to recover after the third lockdown. Keeping workers on the payroll has some costs, even with those schemes. With this in mind, we now expect eurozone employment to recover to its pre-COVID levels by the second half of 2022. This is half a year ahead of our previous forecasts. By comparison, it took the eurozone economy almost eight years after the global financial crisis to recover its pre-crisis level of employment.

Chart 6

Chart 7

Even if labor market slack evaporates by the end of 2022, we expect wage pressures to take a bit longer to build and feed through to inflation. In contrast to the situation in the U.S., European employers are likely to struggle less to fill vacancies because they have kept their employees in their jobs through short-time work schemes. This also means that firms will want to restore their profit margins first before raising salaries, to make up for the costs of furlough schemes during lockdowns. As a result, we don't see core inflation reaching 1.6% before the end of 2024.

Nonetheless, headline inflationary pressures will be higher this year, linked to the rebound in energy prices last year. The oil price in euros is set to be 60% higher on average this year than in 2020, pushing up the Harmonised Index of Consumer Prices (HICP) an average 0.8 percentage points this year. Input prices for industry have risen more quickly as well, linked to raw material or semiconductor shortages, yet the pass-through of these input costs to consumer inflation is relatively muted. We find that a 1 percentage point rise in the Purchasing Power Index (PPI) for industry only translates into a 0.06 percentage point rise in industrial non-energy goods inflation rate after 12 months. In other words, even if the PPI increased 5% on average this year, it would only add about 0.1 percentage point to the HICP next year. Meanwhile, the core inflation rate is still hovering around 1%, highlighting that underlying pressures are still muted.

A coordinated policy response is limiting long-term scarring

The main difference in our third-quarter projection compared with our second-quarter outlook is the rosier long-term outlook, now that we have more clarity about implementation of the Next Generation EU plan. In our view, the size of the plan will be enough to limit long-term scarring from this crisis as well as close the eurozone output gap by 2024 (see chart 8).

Chart 8

Running low- and high-impact scenarios, we find that just the Recovery and Resilience facility part of the Next Generation EU plan could add between 1.3% to 3.9% of GDP to eurozone GDP over the next five years (see "Next Generation EU Will Shift European Growth Into A Higher Gear," published on April 27, 2021). What's more, we find that countries like Greece, Portugal, Italy, and Spain are set to benefit the most from Next Generation EU, reducing the economic divide across the eurozone (see map). We have integrated these findings in our new baseline, where we implemented an effect closer to that of the higher-impact scenario. Indeed, we believe that EU member states will be able to absorb EU funds better than they did in the past and that public spending will have strong impact on GDP. The strength of fiscal multipliers is debated, but many economists believe they are higher when interest rates are negative, the economy is running below capacity, uncertainty is high, and when public spending focuses at investments for the future in infrastructure, institutions, and human capital. The think tank Bruegel estimates that more than 70% of the public spending submitted by 23 national governments under the European plan will go toward greening, digitalizing, and reforming the European economy.

Implementation of the Next Generation EU plan also marks a shift in the nature of fiscal support. At the start of the crisis, governments concentrated on maintaining household incomes and companies' access to finance. Now, they are looking to restart growth through large investment programs. The focus of these investments on the green transition and digitalization also suggests a boost to the eurozone's long-term productivity prospects.

In the meantime, the European Central Bank will continue to support the nascent economic recovery by ensuring loose financing conditions. After the June meeting, ECB President Christine Lagarde emphasized that it was too early for financing conditions to tighten in the eurozone, especially as tightening pressures were coming from the U.S. and current inflationary pressures were temporary (see "How Long Can The ECB Yield Shield Last?" published on June 11, 2021). That said, the summer's grand reopening could pave the way for the ECB to start reducing the pace of its net purchases under the pandemic emergency purchase programme in September. At the very least, the ECB will probably start talking about reducing the pace of quantitative easing, especially if the rollout of vaccines signals an end to the pandemic.

Nonetheless, we still expect the ECB to continue net asset purchases through to 2023 and refrain from hiking rates before late 2024. That's when the output gap should close and inflationary pressures head closer to 2%. Keeping rates low for so long will also ensure that the EU fiscal stimulus will be at its most powerful, as this will keep the costs of investing low for companies and governments (see "The Case For Bold Fiscal Stimulus In The Eurozone," published on Nov. 17, 2020).

The risks to growth now appear to be more balanced. On the downside, COVID-19 variants are still a cloud of uncertainty on the horizon. What's more, financing conditions could tighten again as a result of earlier monetary policy tapering in the U.S. or a rise in political risk. On the upside, more powerful implementation of the EU fiscal stimulus--for example, if more countries decide to take advantage of both grants and loans--could bring GDP back to its pre-COVID level earlier than we now expect. A bigger question is how much households decide to spend down their accumulated savings on consumption.

Table 1

Research Contributors: Aude Guez and Maxime Brun. Digital Designer: Tom Lowenstein.