The economic disconnect

The European economy at the moment appears to be disconnected from reality. Prices for many imported commodities--energy, industrial goods, and food—have risen sharply, and the worsening in terms of trade for Europe is of unprecedented magnitude. But growth remains solid. Employment is at an all-time high. What's going on?

Typically for the European economy, a negative terms-of-trade shock from higher imported energy costs leads to a slowdown two to three quarters later. The severity of the shock is not indicative of the magnitude of the decline in GDP growth, as many other factors come into play. But one causes the other whenever commodity prices rise sharply, as we've seen in 2007 and 2008, 2009-2011, and more recently in 2017 and 2018.

The apparent disconnect, however, may only be a matter of time. We believe the European economy is on the brink of a sharp slowdown, to the point that we cannot rule out a full-blown recession. The questions today are about the length and depth of the downturn and the impact on employment.

Chart 1

Soaring commodity prices have already left a deep mark on various measures of inflation, such as GDP price deflators and CPI (consumer price index) inflation. At the end of the second quarter, the more comprehensive GDP deflator was up 4.3% on the year and the consumption deflator even more at 6.4%. The trend to higher prices continued in the third quarter, as CPI inflation rose to 9.1% on the year in August. And while the energy component of the consumer price basket has stabilized at 4 percentage points of headline inflation, food prices have soared in the meantime. They now contribute to 2 points of headline inflation. What's more, a certain pass-through to other prices is visible. Core CPI reached 4.3% in August, the highest in the history of the European Monetary Union (EMU), also suggesting that inflationary pressures from the labor market are starting to increase.

Uncertainty still surrounds the near-term outlook for inflation. Sequential, seasonally adjusted price increases have not yet been reversed. Only their cause has really changed, from energy to food and goods (see chart 2).

Plus, the policy response to soaring gas and power price is developing (see "What Europe's Energy Redesign Might Mean For Its Power And Gas Markets," published Sept. 13). Decisions made in this respect can impact our forecasts in either direction. The relaxation of the shield that protected the German consumer from increases in wholesale gas prices is a major contributor to our higher inflation forecasts (see "Europe Braces For A Bleak Winter," published Aug. 29). A price cap on gas or power, as was just decided by some governments, is going in the other direction.

Based on the latest trends and considering that recent wage developments have confirmed our view that a price-wage spiral is not a major risk, we believe that inflation in the eurozone could reach 8.2% this year, before slowing down to 5.2% next year, but will not return below the European Central Bank's target before 2024. This represents another upward revision to our inflation forecasts for eurozone CPI (that previously were 7% in 2022, 3.4% in 2023, and 2.2% in 2024).

Chart 2

Chart 3

Two or three quarters of much slower growth are now looming ahead

Despite accelerating price pressures, the eurozone enjoyed its fifth consecutive quarter of solid growth in the second quarter, with GDP increasing a quarterly 0.8%. This corresponds to a 3.2% annualized increase, twice as much as potential growth and even accelerating from the first quarter (to a 2.6% annualized rate).

The second-quarter expansion in GDP was mainly driven by consumer spending, up an annualized 5.1%. Business investment was also up. Net foreign trade was negative due to a larger rebound in imports than exports, which is linked to inventory rebuilding. The expansion of the European economy in the second quarter was broad, encompassing most countries in the eurozone. The only exception was the three Baltic states, whose GDP contracted because of fewer consumer protections from soaring energy prices than elsewhere in the EMU. Inflation in the Baltic states is above an annualized 20% versus 9% on average in the eurozone.

The main reason for solid GDP growth over the past six months is an incomplete recovery from the pandemic in terms of domestic demand. Even if GDP is now 1.8% above the pre-pandemic level, this is mostly due to construction activity; exports (now 6% above the pre-pandemic level) from the restart of international supply chains; and the quicker recovery from COVID-19 in the U.S., Europe's main trading partner. Locally, consumer spending is still 1% below and investment 5% below pre-pandemic levels (see chart 4).

Unfortunately, the weak recovery in investment is no big surprise, even if deeply negative interest rates in real terms and robust corporate balance sheets should have been incentives to make investment plans. In fact, the unusually high GDP volatility and uncertainty arising from back-to-back external shocks (the pandemic and the Russia-Ukraine war) contributed to a delay in investment decisions (see chart 5).

Chart 4

Chart 5

The solid GDP growth in the first half of the year was above our expectations. With this report, we have revised our GDP growth forecasts upward to 3.1% from 2.6% for 2022. That said, a sharp slowdown is now imminent for the second half of this year, with a severe contraction in consumer spending looming in fourth-quarter 2022 and first-quarter 2023.

Recent developments in the gas and electricity markets lead us to expect that inflation will peak 1.5 points higher and about one quarter later. We now expect eurozone inflation to reach double digits in the fourth quarter of 2022, before slowly declining from the first quarter of next year. Real wages are still negative. The household savings rate is still higher but declining and now very close to the long-term average. Higher interest rates will further erode financial wealth.

What's more, policy measures to shield the consumer from soaring energy prices--in the form of direct transfers or even, possibly, price caps--might take time to reach the consumer. The support to households and businesses by the EU member states since 2021 has amounted to an estimated €230 billion, or 0.1%-3.6% of national GDP, according to Bruegel (see "A grand bargain to steer through the European Union's energy crisis," September 2022).

Similarly, measures at the EU level currently under discussion to complement national support could take time to dampen inflation. On Sept. 14, 2022, the European Commission unveiled the contours of its energy emergency tool. An increase in electricity savings targets and a discussion of a reform of the electricity market are part of the spectrum of measures. A cap on the revenues of low-cost energy producers and a solidarity contribution from fossil fuel companies, which together could bring in up to €140 billion, are also part of the proposed policy response.

Investment is also likely to suffer further from the lack of visibility about developments in the Russia-Ukraine war and as companies see a dampening in consumer spending. In the latest European business confidence survey, firms are starting to report demand constraints as a limiting factor to production, and are lowering their expectations for sales prices.

All in all, this landscape suggests that GDP has continued to grow in the third quarter with the booming tourism season, but clearly less than in the first half, and probably not in all eurozone countries (German GDP is likely to contract in the third quarter already). We now expect eurozone GDP to contract moderately in fourth-quarter 2022 and in the first quarter of 2023. We see a significant risk of a full-blown recession by 2023, spreading across countries, sectors, households in all income categories, and the labor market. Our models that take into account different yield curves, money market volatility, and business confidence currently assess such a probability at 47% (see "A Eurozone Slowdown Is For Sure; Recession Is Less Certain," published on July 19).

Unless the Russia-Ukraine conflict escalates, a recession is likely to be shallow and not exceed three quarters at the eurozone level, without massively reducing employment. Disinflation, further acceleration in wage income, and policy support to the economy should more strongly undergird GDP starting in second-quarter 2023. If that happens, full-year GDP growth in 2023 could be almost flat (we expect 0.3%). We think the sharp slowdown will lift the unemployment rate to 7% in 2023 (from 6.7%) before it edges down in 2024, which we explain further in the next section. Risks to the growth outlook remain, however, firmly on the downside, not only for 2023 but also for 2024 as it appears that gas supply for winter 2023 and 2024 is not yet clear.

The labor market is a strong windbreaker

The outlook for the European economy in 2022 and 2023 is not only about headwinds. As supports, we already mentioned the ECB's still accommodative monetary policy and growing policy support to deal with the energy crisis. We could also add that supply chain bottlenecks have eased and large production backlogs remain. In July, the German industrial association estimated that it would take more than eight months for German industry to process past orders. This could help the economy grow unless high energy costs force businesses to halt production, especially small and midsize enterprises. What's more, European money from the NextGen EU program has already flowed to member states and public investment is on the rise. The strong inflow of people from Ukraine, which will probably add more than 1% to the population of Germany this year, is supportive for domestic demand and workforce dynamics.

Indeed, more workers might help the European economy deal with labor shortages, constituting an eventual tailwind. At the end of first-half 2022, the European economy had never offered as many jobs as it does now. It has added 2.9 million jobs since outbreak of the pandemic, more than 605,000 in second-quarter 2022 alone. The unemployment rate (6.6% in July) is at an all-time low, probably below equilibrium. Job openings are at their highest level in decades, and still rising. The rate increased 20 basis points (bps) to 3.3% in the second quarter (see chart 6), and real-time indicators suggest that momentum continued in the third quarter, albeit at a slower pace, as suggested by the employment component in the S&P Global Market Intelligence PMI (Purchasing Managers Index) for services and manufacturing (see chart 7) and by online job postings. With an aging native workforce, strong population inflows from Ukraine, and more flexible labor market conditions than ever, wage growth remains moderate for now (a yearly 2.4% in the second quarter for negotiated wages), but we expect that to accelerate.

Chart 6

Chart 7

Monetary policy will become slightly restrictive in terms of interest rates, with other moves toward normalization to come later

Given strong economic conditions and inflation well above the ECB's target, the central bank opted for a large rate hike in June (50 bps) and even more in September (75 bps) for all three key interest rates (see chart 8). ECB President Christine Lagarde also indicated in her last press conference that the central bank would take further action in upcoming meetings. This leads us to frontload our expectations for further hikes. We now believe that the terminal rate on ECB deposits could be reached at 2% by the end of first-quarter 2023 (versus 1.5% in our previous baseline). A deposit rate of 2% would be in the high range of current estimates of the neutral rate, meaning that monetary policy is going to be slightly restrictive next year but not very tight in the eurozone. What's more, we think the ECB could reduce the deposit rate to the median of 1.5% in early 2024, as inflation might recede rapidly below target at this stage.

Perhaps as important to monetary policy are the ECB's nonstandard monetary policies, such as the purchases of assets that have supported the economy but have ballooned its balance sheet. When and how quickly the balance sheet might start shrinking are two questions market participants are asking and the ECB probably needs to address. For now, we expect the ECB to start reducing its balance sheet by the end of 2024, in order to normalize monetary policy once it has raised interest rates.

The ECB's liquidity injection framework to the banking system is another aspect of monetary policy normalization, namely the continuation or discontinuation of TLTROs (long-term refinancing operations) and of the full-allotment procedure that has been in place since October 2008 (see "Implications Of The ECB's Policy Normalization For Interest Rates, The Balance Sheet, And Yields," published June 9, and "From "Whatever It Takes" To Wherever It Leads: How The ECB Has Reshaped The European Economy And Markets," published June 23). Decisions by the ECB about normalizing its balance sheet and the liquidity framework over the quarters to come have the power to influence financing conditions as much as changes in interest rates.

Chart 8

Chart 9

Editor: Rose Marie Burke.

Related Research

S&P Global Ratings

• What Europe's Energy Redesign Might Mean For Its Power And Gas Markets, Sept. 13, 2022
• Europe Braces For A Bleak Winter, Aug. 29, 2022
• From "Whatever It Takes" To Wherever It Leads: How The ECB Has Reshaped The European Economy And Markets, June 23, 2022
• A Eurozone Slowdown Is For Sure; Recession Is Less Certain, July 19, 2022
• Implications Of The ECB's Policy Normalization For Interest Rates, The Balance Sheet, And Yields, June 9, 2022

External research

• A grand bargain to steer through the European Union's energy crisis, September 2022, Bruegel