A milder recovery from mid-2023 onward

Following the European economy's better resilience in the summer months, we revised our GDP growth forecast upward for 2022 to 3.3% from 3.1%. This improvement brings us back to the March vintage of our forecasts. Looking ahead, we continue to expect the European economy to contract around 1 percentage point of GDP over the next two quarters. This expectation is underpinned by our models, which now give a mean probability of recession of 70%, compared with 47% three months ago, after inversion of the forward yield curve and flattening of the spot yield curve. That said, looking at real-time data, we see an increasing likelihood that the negative demand shock will shift by one quarter (see chart 1). So, the first quarter of 2023 could see a larger contraction than the fourth quarter of 2022. That's because the hiring cycle still appears to be resilient early in the fourth quarter; domestic gas and electricity rate adjustments may be more significant in the first quarter than in the fourth quarter; and government transfers to shield consumers from higher energy rates may not reach them until late in the first quarter. All in all, the impact on demand in the first quarter of 2023 being still hard to estimate, we expect the eurozone economy to stagnate in 2023, with GDP growth of 0% versus the 0.3% we expected previously.

We also expect a milder recovery than previously forecasted for GDP from mid-2023 onward, because a stronger rise in long-term interest rates will reduce private demand for investment and likely compound the effects of high uncertainty (see chart 2). We see GDP growth reaching 1.4% in 2024 and 1.5% in 2025, down 0.3 and 0.2 percentage points, respectively, from our previous forecast exercise. A faster normalization of monetary policy (see the section below) as well as slightly stickier inflation explain these higher interest rates. The fading of base effects on energy prices should soon bring down headline inflation, but it will take time for core inflation to return to 2% from the current 5% owing to a slower recovery in productivity and accelerating wages. We now expect German 10-year yields to slightly exceed 3% in 2024 and remain at this level in 2025.

Chart 1

Chart 2

Clear negatives for the European economy next year: A slow decline in inflation, weaker employment growth, and higher interest rates

The strong hiring cycle is expected to reverse next year. As production catches up with the backlog, job openings should decrease. Companies may also find it harder to generate profits by passing on rising costs to consumers as pent-up demand withers and excess savings are no longer. We therefore expect the unemployment rate to edge up to 7.0% in 2023 from a record low 6.7% in 2022. Operating surplus to fixed investment has turned down and is now below average (see chart 3). This will probably constrain corporate investment plans. What's more, banks have started to tighten credit standards across the board and borrowing costs are on the rise. Borrowing costs for small and midsize enterprises and mortgages are already at an eight-year high, at 3.5% and 2.4%, respectively, in nominal terms (see chart 4).

Higher unemployment and borrowing costs will also pinch households' demand for housing. Transactions have already slowed in several housing markets across the eurozone, pointing to lower housing demand as affordability constraints become more pronounced. Similarly, residential investment is already decreasing after having surged during pandemic lockdowns, with households focusing on immediate consumption needs rather than long-term investments. All in all, we expect total investment to be a drag on GDP next year and to contract, as much as consumption, by 0.2%. Note that private investment should contract more than total investment, as public investment is likely to increase further (see section on supportive factors).

Chart 3

Chart 4

Consumption and production still give the European economy resilience

The European economy continued to expand over the summer months, with GDP rising 0.2% in the third quarter, once again above our previous expectations. This quarterly increase is the sixth consecutive one since COVID-19-related restrictions were lifted. It is also the first increase in six quarters to drop below potential growth, indicating that the economy has started to cool down.

Consumer spending continued to prop up demand in the third quarter. Consumption even increased by a quarterly 1.1% in Spain and turned the expected contraction of GDP in Germany into a slight increase of 0.3%. Pent-up demand in contact-intensive services like tourism and hospitality and rising employment (still up 0.2% in the third quarter) explain this increase in consumer spending despite soaring prices and low confidence. Strong population growth in some EU countries is an additional supporting factor. In Germany, the large influx of refugees from Ukraine and the conflict region led the population to exceed 84 million in the third quarter. This represents a striking yearly increase of 1.2%, as strong as but more sudden than the increase from the previous wave of refugees in 2014 (see chart 5).

Chart 5

A strong rebound in industrial production was the other supportive factor to third-quarter GDP, particularly in the European automotive and pharmaceutical sectors. Production in these two sectors, accounting for 19% of industrial value added, is up 8% and 6%, respectively, from the previous quarter. We have long pointed to a likely acceleration in European production to meet the large existing backlog of orders, in a context of easing supply bottlenecks. Freight at sea on stationary ships remains higher than usual but is clearly down (see chart 6). Although new orders are declining, existing orders suggest that the production catch-up will remain a positive factor for the European economy well into next year. Eurozone industries continue to report five months of assured production in the European Commission Survey. However, production in energy-intensive sectors such as chemicals, metallurgy, coke and refined petroleum product manufacturing, and paper products did not keep pace with this positive trend. Production in these sectors fell more than 4% in the third quarter due to the surge in gas prices. Together, energy-intensive sectors account for nearly 80% of industrial gas use but only 20% of industrial value added.

Chart 6

Chart 7

The export benefits of a lower euro will remain limited for now

While domestic demand is likely to restrain GDP next year, net external trade should drive GDP slightly up. Lower freight rates and a small increase in global GDP should keep world trade expanding. What's more, the strong depreciation of the euro against the dollar should make European exports more competitive on a price basis, and we expect the trade balance to follow a J-curve pattern (that is, the initial deficit to turn into a surplus as exports outpace imports, see box). However, these benefits might remain limited for now for several reasons.

• First, short-term growth prospects for the U.S. and China are subdued. They will translate into moderately higher external demand to the eurozone.
• Second, the depreciation of the euro might not be sufficient to offset the losses in export competitiveness caused by lastingly higher energy costs.

Soaring energy costs have resulted in the eurozone losing cost competitiveness with the U.S. by up to 4 percentage points of GDP, especially in energy-intensive sectors, which have been forced to lower production. On the other hand, the 7% depreciation of the euro in real effective terms could translate into an additional 0.3 percentage points of GDP via higher net exports. It is also important to note that the eurozone has yet to regain the market share it has lost in global trade in goods since the pandemic (see chart 8). It is not yet clear whether these losses reflect structural elements that are permanent in nature or the shock of COVID-19 restrictions, as supply chain bottlenecks have prevented the production of intermediate goods (for example, in the automotive and aerospace industries), which may normalize over time.

Chart 8

Wages and public investment to become supportive demand factors in the years to come

While rising unemployment and interest rates will be a drag in the coming year, two positive factors will continue to drive domestic demand. First, wages are expected to accelerate. Until recently, wage acceleration has been slow, as we have expected. This is because cyclical tightness has been outweighed by structural developments in the labor market (see "Where Is The Wage Inflation? Not In Europe," published on Dec. 16, 2021). At the end of the second quarter, negotiated wages were up a yearly 2.4% and effective compensation growth per hour was just a bit higher at 3.3% (see chart 9). However, we see negotiated wages further and more firmly accelerating, toward about 5%, because of an increasingly tight labor market that does not show any imminent signs of turning around. The recent wage agreement passed in the German metal industry, to increase wages by a yearly 5.2% from June 2023 and 3.3% from May 2024 on top of a €3,000 tax-free payment, goes in that direction. A 5% yearly increase in nominal compensation should be enough to stem the decline in real wages without triggering a price-wage spiral.

Chart 9

Second, we expect increases in public investment will boost demand and drive GDP further up. A turnaround is already evident. Public investment, which accounted for 2.7% of GDP in 2018, has reached 3.1% of GDP this year in gross terms, reversing a decade-long downward trend for the eurozone (see chart 10). What's more, the NextGenerationEU plan to foster the green and digital transition of the European economy is coming closer to implementation and will reinforce this upward trend. European money in the form of loans and grants is being increasingly disbursed to member states. For many countries, the amount of money allocated is a sizable share of GDP (see chart 11) and should be invested until 2026.

Chart 10

Chart 11

The ECB's balance sheet could shrink by about €3 trillion in three years

As the rotation of consumer price pressure from energy and food toward core components is set to continue because of higher unit labor costs, the ECB is likely to go on normalizing its monetary policy. The policy rates cycle is probably closer to the end than the beginning, but is not over yet. We expect the ECB to raise rates by 50 basis points at its December meeting, and then by another 25 basis points in February, before pausing and examining the effects of higher rates on inflation expectations and financing conditions. The deposit rate, which has finally become the advertised preferred policy rate following ECB's decision to remunerate required reserves at this rate instead of the repo rate, could peak at 2.25% in early 2023 and remain there until mid-2024.

In parallel, we expect the ECB to start reducing its balance sheet. A key milestone will be the repayment of €2.1 trillion of outstanding TLTRO funding--cheap, long-term, and stigma-free funding for banks. The ECB has set incentives for their repayment, and banks have already repaid some 14% (€296 billion) in the first possible tranche at the end of November. Note that banks might replace some of the liquidity repaid from TLTROs by liquidity funded under shorter and less cheap MROs, the ECB's main refinancing operations. Furthermore, the ECB is likely to clarify the timing and pace for ending the reinvestment of maturing bonds held under quantitative easing and amounting to nearly €5 trillion at its December meeting. While reinvestments in the Pandemic Emergency Purchase Program (PEPP) portfolio are to continue in full through the end of 2024, reinvestments in the larger APP portfolio may start to decline from mid-2023.

We believe the reduction of bondholdings will be gradual and to some extent targeted so as to avoid an unwarranted tightening of financing conditions. Active quantitative tightening (selling bonds in the market) will remain an option for the ECB. What's more, since the average maturity of the ECB's bond portfolio is around seven years, reducing bondholdings passively by not reinvesting their proceeds prevent any significant reduction in the balance sheet position before 2025.

All in all, it seems that the ECB balance sheet is not likely to shrink by more than €3 trillion in three years, according to the current survey of monetary analysts (see chart 12). This would leave the balance sheet close to €6 trillion at the end of 2026, or €1 trillion bigger than its pre-COVID-19 level. Should the ECB trigger its new Transmission Protection Instrument as it normalizes its monetary policy to prevent any risk of financial fragmentation, the interventions will likely be sterilized, so they do not permanently affect the size of the balance sheet. This suggests long-term rates are set to rise further as the ECB will no longer be a net buyer on the market. For now, term premium compression, which we estimate at 90 basis points, is holding and represents an outcome of the ECB's balance sheet expansion (see "Implications Of The ECB’s Policy Normalization For Interest Rates, The Balance Sheet, And Yields," June 9, 2022).

Chart 12

Risks are still mostly to the downside

Risks to our baseline forecast for the eurozone are still mostly to the downside, both in terms of the size of the contraction during first-half 2023 and the strength of the subsequent recovery. They relate to a possible resumption of the energy crisis, a wage-price spiral resulting in much higher interest rates, possibly in a disorderly manner. Lastly, downside risks to our macro baseline relate to developments in the Russia-Ukraine conflict. That said, risks could also be on the upside. They relate to another show of resilience of the European economy (production and employment) at the turn of next year as well as stronger public investment in the next two years.

Editor: Rose Marie Burke. Digital Design: Joe Carrick-Varty.