Post-Pandemic Consumer Spending Boost Will Fade Toward Year-End

The eurozone economy's focus has shifted away from COVID-19 toward the inflationary environment and rising interest rates. Yet, recovery from the pandemic remains a key factor protecting the eurozone from a recession so far. We expect the growth tailwind from pent-up demand will continue to provide some momentum to activity over the summer, although it will likely fade toward the end of this year.

Even though inflation has exceeded 2% since mid-2021, households have continued to accumulate excess savings, putting aside a significant buffer at close to 7% of 2019 GDP in the eurozone (see chart 1). Even lower-income households are today reporting a greater ability to save than before the pandemic. Nonetheless, high inflation is now starting to bite into households' savings buffers. While COVID-19-related restrictions in the first quarter (Q1) of this year seem to have maintained the consumer savings rate above 2019 levels, this is likely to have changed for Q2 as restrictions were lifted (see chart 2). This is backed up by the European Commission sentiment survey, with consumers indicting their savings expectations for the next 12 months are now back to pre-pandemic levels.

Chart 1

Chart 2

For now, however, consumers still appear keen to loosen their purse strings. Sizable pent-up demand for services following pandemic-related restraints remains an important impetus for consumer spending. This is especially visible in the tourism industry, where the recovery has gathered pace since the start of the year. Tourism arrivals in Spain were just 15% short of their 2019 level in April compared to 60% down in 2021 (see chart 3). Anecdotal evidence in the aviation industry suggests that the summer months are off to a good start, with many European airports struggling to accommodate excess demand. Nevertheless, we expect demand will moderate toward the end of the year as rising energy bills come back into focus, even though European governments are providing another cushion to consumption with various support measures.

Chart 3

The Production Catch-Up Should Also Stay Supportive

Alongside services, industrial production is also still catching up to pre-pandemic strength. Survey data suggest this is still linked to ongoing supply-chain bottlenecks (in part because of the lockdowns in China), meaning that manufacturing production could accelerate as supply constraints ease. On average, industrial companies in the eurozone estimate they have five assured months of production based on their orders, according to the European Commission sentiment survey. For example, in Germany, inventories have barely risen since their low point at September 2021, and factory orders continue to exceed production by a significant amount (see chart 4). Closing the gap between production and orders could ultimately put on four points of gross value added to the German economy.

That said, as inflationary pressures rise, some signs are starting to show that demand for consumer durables is slowing. Motor vehicle orders are moderating in Germany, which is coherent with households now reporting less likelihood of upcoming major purchases than in 2019. This also suggests some orders in the backlog could be cancelled. Adding to this, export orders are likely to moderate as growth prospects deteriorate among Europe's major trading partners, such as the U.S. and China.

Chart 4

A Positive Labor Market Will Be Key To Consumer Spending

As the tailwinds of the pandemic recovery fade, labor market trends will be the decisive factor in whether consumers can hold up their spending in an environment of high inflation, rising rates, and slowing growth. We forecast inflation will reach 7% this year and 3.4% next year. We expect rising energy prices will contribute one-half of these pressures this year, while we see food and services prices taking over as the biggest impetus of price rises in 2023 (see chart 5). This has prompted the European Central Bank (ECB) to start tightening monetary policy, which will add another constraint to household consumption because debt-servicing costs will rise (see "Implications Of The ECB's Policy Normalization For Interest Rates, The Balance Sheet, And Yields," published June 9, 2022, on RatingsDirect). The erosion of net wealth caused by the disorderly market reaction to the ongoing normalization of monetary policies around the world might affect households' willingness to tap into their excess savings.

Chart 5

So far, employment creation is continuing to provide solid support to household incomes. The eurozone has posted an impressive labor market recovery, creating almost 2 million additional jobs between Q4 2019 and Q1 2022. Vacancies are still on the rise and employment expectations remain consistent with above-average job creation across all sectors and in all main European countries (see chart 6). By mid-June, real-time data on online job posting suggested a softening, but no hard landing, for the European labor market. At the same time, the unemployment rate is at an all-time low and has fallen below our estimates of the eurozone's NAIRU (non-accelerating inflation rate of unemployment; see chart 7). This explains why increasingly more companies are reporting hiring difficulties and wages have been picking up. We expect employment growth to moderate and the unemployment rate to be broadly unchanged over the next few years (falling from 7.5% this year to 7.2% by 2025). This means household real disposable income will find relatively less support in job creation compared to the past year.

Chart 6

Chart 7

As for wages, the increase thus far is consistent with an underlying inflation rate of 2%: negotiated wage growth accelerated to 2.8% in Q1 2022 from 1.6% the quarter before--with a large part of this acceleration coming from extraordinary bonuses. However, with inflation running at 6.1% in Q1 and rising further in Q2, current wage increases are not enough to offset losses in purchasing power. Although earnings' growth is set to accelerate further this year, it is likely to stay in the 3%-4% range, which won't be enough to offset higher prices entirely. In other words, consumers will continue to feel a squeeze on their purchasing power until the end of 2023, the time that will be needed for their incomes to catch up with higher prices. The relative increase in the cost of living is set to be more pronounced in the Netherlands, Belgium, Spain, and Germany, where inflation is forecast to be higher than the average, while Italy and France will see somewhat lower price increases.

All in all, against a backdrop of falling unemployment and rising wages, consumers are likely to expect their real incomes to eventually recover. We therefore expect households to continue to save less and seek to recover their pre-pandemic consumption habits over the next quarters. This means, we continue to forecast a recovery of consumption, but at a slower pace than three months ago given higher inflationary pressures and lower financial wealth. We pencil in a 2.5% and 1.9% increase in consumption this year and next, down from 4.4% and 3.2%, respectively, in our previous forecasts.

Inflation Will Weigh On The Trade Balance, But Investment Should Hold Up

Besides consumption becoming a smaller pillar of growth, the trade balance of European countries is also set to continue to deteriorate. We now expect energy prices will rise higher than we previously forecast, and expectations for growth outside the eurozone have also been downgraded. In short, the only component of growth demand that we expect to hold up well despite a deteriorating environment is investment.

One reason for this is that investment is lagging the European recovery. Companies continue to cite equipment as a constraint to production, suggesting they are in need of further investments. Meanwhile, through the Next Generation EU recovery plans, governments have committed a large part of their budget to investing in the green transition and digitalization as well as a set of business-friendly reforms (see "The Case For Bold Fiscal Stimulus In The Eurozone," Nov. 17, 2020). In countries where underinvestment and administrative inefficiencies have been a drag on growth in the past (such as Italy), we expect the reform and investment impetus to have high multipliers and spur a rise in private investment, especially over the next two years. Finally, energy security concerns across Europe are also set to support investment in the energy sector as EU countries seek to green and electrify their grids more quickly (see chart 8).

Chart 8

Chart 9

Slower Growth Ahead

All in all, this backdrop suggests that the eurozone will return to its potential output path less quickly than we anticipated three months ago. As a result, we have lowered our growth forecasts for the eurozone economy to 2.6% this year and 1.9% next (from 2.7% and 2.2% in our interim forecasts; see table 1). Given the strong carryover to the end of a solid first quarter, this forecast means that we barely expect the eurozone economy to grow over the remaining three quarters of the year. Downside risks to growth remain significant. They primarily relate to the conflict in Ukraine. Gas shortages could become more pronounced this year, which would be another blow for consumers and may--in the most extreme case--also result in a halt of production altogether for some firms, if substitute sources of energy are only partially available. Meanwhile, while the ECB has committed to design a facility to prevent fragmentation in the eurozone, an unwarranted tightening of financing conditions, especially for the periphery, could turn into a drag on growth. A recession is not excluded in the U.S. for next year and the slowdown in China could become more pronounced, two additional downside risks for the eurozone economy. Finally, while the COVID-19 pandemic has lost most of its grip on the economy, some countries in Europe are reporting a resurgence in incidences that could become widespread.

Table 1