The eurozone economic rebound surprised on the upside in the second quarter (Q2), with GDP rising by 2.2% over the three months April-June. This was despite some restrictions to economic activity in April, suggesting the vaccination rollout has given consumers more confidence to go back to the shops and hospitality (see charts 1 and 2). The share of the fully vaccinated population has nearly doubled in the past three months in the eurozone to reach 65% by mid-September. Companies have also continued to invest, looking forward to a less disruptive future and increased government investment. As a result, and on the basis of higher GDP at the end of Q2 than assumed in our previous baseline, we have upgraded our growth forecast for this year to 5.1%. This forecast uplift for 2021 means that the pre-crisis level of GDP could be reached before the end of this year, one quarter ahead of our previous projections. Our forecast for 2022 remains unchanged at 4.5%.

Chart 1

Chart 2

At the same time, the labor market has also been recovering at a fast pace. In France, employment in Q2 was already back at its pre-COVID-19 levels and job postings have continued to rise since that time in France and across Europe (see chart 3). We also estimate that only around 1.2% of European workers were still on short-time work in July (see chart 4), compared to close to 12% in April 2020. This corroborates our view that we are unlikely to see unemployment rise as those schemes are tightened. As such, we now expect the unemployment rate to average 7.9% this year and fall to its pre-pandemic levels by then end of 2022.

Chart 3

Chart 4

The vibrant labor market has not yet led to labor shortages in the eurozone, in contrast to the U.K., where Brexit led to many EU nationals leaving during the pandemic, in the order of around 200,000, according to some estimates (see "Economic Outlook U.K. Q4 2021: Recovery Still On Track," published Sept. 23, 2021, on RatingsDirect). Labor shortages in the eurozone are confined to the construction sector, which to an extent was already being observed before the COVID crisis. In the total economy, job vacancy rates are still a little below pre-COVID levels. Companies cite equipment shortages, which have outpaced lack of demand, as a main factor limiting production (see charts 5 and 6). This reflects supply chain pressures in industry globally, linked to the semiconductor shortages and more recently a peak in shipping demand. We expect these bottlenecks to ease slowly but to remain a drag on industrial production in the eurozone in the next two to three quarters, while services' activity will continue pacing ahead, assuming broad-based vaccination continues to keep the pandemic in check without new lockdowns.

Chart 5

Chart 6

While the pace of growth is set to slow in the second half (H2) of 2021, there is still some space for a catch-up in services, especially in the tourism industry. Although the 2021 summer season was better than 2020, travel restrictions continued to weigh on tourism activity in the EU. In Spain, tourist arrivals were only at around 50% those of 2019, and France's hotel occupancy was still around 20 percentage points (pp) short of 2019 levels. Meanwhile, consumers still have a large pool of savings at their disposal, which is likely to continue boosting the consumption recovery until the savings rate normalizes next year. We estimate that European households accumulated around 2.7 percentage points of GDP (€300 billion) in excess cash reserves last year and that these reserves increased further at the start of this year. This large pool of savings is set to continue bolstering investment in housing, which already reached pre-crisis levels in Q2, leading to a boom in construction activity and fast increases in house prices.

As domestic demand recovers at full steam, external demand is set to be a lesser contributor to growth. This is in part due to the dichotomy between economies with large vaccination rates that have been able to avoid reimposing restrictions to keep the spread of the delta variant in check and others with lower vaccination rates (such as some countries in Asia), that have had to resort to new lockdowns.

Fiscal Policy Is Starting To Feed Through To Higher Growth

Looking to the medium term, the rollout of the Next Generation EU recovery fund is starting to gain traction in most EU countries. The European Commission (EC) has approved most countries' recovery plans and issued €45 billion of long-term bonds between mid-June and mid-July to finance them. The EC foresees issuing €80 billion in long-term bonds this year and €800 billion by the end of 2026 (5% of EU GDP). Aside from the large fiscal stimulus that will likely add 3.9% to eurozone GDP by 2026 (see "Next Generation EU Will Shift European Growth Into A Higher Gear," published April 2021), some countries have started the reform process as well. Italy passed the justice reform in parliament over the summer. In France some parts of the unemployment insurance reform are set to be applied from October, and discussions on the pension reform have restarted. Spain is also working on its public administration and labor market reform. Taken together, large-scale investment and structural reforms should help reduce inefficiencies within European economies and boost their potential growth.

Meanwhile, there is more evidence that the COVID-19 crisis has done limited damage to the overall economy--likely a result of the swift government and monetary policy response put in place to avoid layoffs and bankruptcies. First, the labor market has been recovering at a faster pace than usual, with employment almost twice as responsive to GDP as in normal times. Second, companies' margins have already surpassed pre-crisis levels and their investment ratio has been recovering to much higher levels than in past crises (see chart 7). The ECB Bank Lending Survey shows that investment is likely to gain more steam, as it is now cited by companies as a reason for taking out credits (see chart 8). Now, the political issue will be to deal with the legacy of the COVID crisis, primarily a higher public debt. In this context, the discussion over the future of European budgetary rules, the outcome of which is expected by the end of next year, will be crucial.

Chart 7

Chart 8

Transitory Increase In Prices No Reason For The ECB To Tighten Monetary Policy Yet

As macroeconomic and financial conditions improve, the ECB has announced it is reducing the size of its net asset purchases from the Pandemic Emergency Purchase Programme (PEPP) in Q4--from around €80 billion per month to something we estimate closer to around €60 billion. The ECB already dialed back its PEPP purchases to €65 billion in August from €88 billion in July, adapting to the lower issuance of debt securities and not jeopardizing financial conditions. Yet, as ECB President Christine Lagarde has emphasized, "this is not tapering".

Although inflation has edged up above the ECB's 2% target, reaching 3% year on year in August, this is mainly linked to a series of temporary factors. Half of this increase comes from higher energy prices. The end of tax breaks, the delay in sales in some countries last year, and the reopening have also contributed to a temporary surge in prices. Supply-chain pressures are also translating to higher input prices for companies, although, on past form, the pass-through to consumers takes around 12 months. We are therefore more likely to see the impact of the latter on inflation in 2022. We estimate it will add around 30 basis points to inflation next year as the pass-through of input prices to consumers remains small. As a result, we expect eurozone inflation to hit 2.2% this year and decrease to 1.6% in 2022. That said, while rising raw material prices put pressure on production costs, the past depreciation of the euro helps European manufacturers on the revenue side. As a result, the "terms of trade" in goods--the ratio of export prices to import prices--has not worsened much (see chart 9). This could contribute to containing the pass-through of cost pressures on final prices.

Chart 9

We expect the ECB to remain more focused on the long-term drivers of inflation, such as wages. For now, there has been no liftoff in salaries for European workers. As such, negotiated wages averaged 1.5% year on year in H1 2021, still 0.7pp short of the 2019 average, which was still a bit too low to push inflation up to the ECB's target. As the labor market is still recovering, it will likely take a bit more time for workers to negotiate higher wages. What's more, prior to the pandemic, European firms were not passing on much of the cost of rising wages to their customers, and it remains unclear whether their pricing power will have changed much after COVID-19.

Finally, some risks to the outlook remain. A resurgence of the pandemic could spark new restrictions in the autumn or winter across Europe, while the recent rise in energy prices--especially gas prices--could act as a drag on growth, with some countries already experiencing supply-chain pressures as a result. On the positive side, consumer spending could surprise on the upside, as the pool of savings remains very large.

All in all, this means that the ECB is likely to remain patient and wait to see a sustainable increase in core prices before it decides to tighten monetary policy. We expect the ECB to stop net purchases under the PEPP by the end of March 2022, as planned. At the same time, the ECB is likely to step up net purchases under its traditional QE program (the APP), possibly redefining it. We therefore don't expect the ECB to stop total net asset purchases before the end of 2023, and thus do not expect it to hike rates until the end of 2024. As a result of a large balance sheet, the ECB will hold a large part of the eurozone's government bonds for a long time. This will keep long-term yields below zero until at least mid-2022 and lead to only a slow rise in yields from then on.

Table 1

The views expressed in this report are the independent opinions of S&P Global Ratings' economics group, which is separate from but provides forecasts and other input to S&P Global Ratings' analysts. S&P Global Ratings' analysts use these views in determining and assigning credit ratings in ratings committees, which exercise analytical judgment in accordance with S&P Global Ratings' publicly available methodologies.