No Material Changes In Our Baseline Assumptions

Disinflation is starting to nudge the eurozone out of its winter stagnation.

With the eurozone economy in the grip of stagflation at the start of the year, our baseline scenario has largely materialized to date. Three recent developments now prompt us to amend our GDP forecasts.

First, the labor market remained robust. Unemployment remains on a downward trend in most countries, although we had already expected it to stabilize this spring.

Second, some fiscal measures had a stronger impact on GDP than initially thought.

Third, the European Central Bank (ECB) appears to have a more negative view on core inflation than three months ago. It leads us to believe that the ECB will seek to raise rates once again in July, 25 basis points (bps) higher than we expected three months ago, before pausing.

Therefore, compared with our March baseline, we expect GDP growth to be slightly higher in 2023 (revised to 0.6% from 0.3%) and marginally lower in 2024 (revised to 0.9% from 1.0%). Otherwise, our narrative remains valid. Disinflation started this spring, helping the eurozone economy to emerge from stagflation. The tailwinds that emerged from the COVID-19 recovery are fading and the higher interest rates have started to dampen demand. Activity may contract again as we enter 2024, perhaps more sharply and broadly than during the last winter.

That said, even if the economic cycle is weakening, we do not see the eurozone economy sliding straight into a deep recession that would put a massive strain on balance sheets. On the contrary, we largely confirm our forecasts for 2025 and 2026 (at 1.6% for both years) and continue to think that the medium-term economic outlook (2025-2026) is brighter than the short-term outlook (2023-2024).

Monetary policy should have moved away from restraining demand within the next two years, purchasing power should have recovered somewhat and fiscal policy will continue to provide some stimulus through the implementation of NextGenEU--the European Commission's up to €750 billion (5 to 6 percentage points of GDP) public spending plan--until the end of 2026.

By allocating more money to the region's less strong economies, NextGenEU also acts as a shield against potential risks of financial fragmentation. What's more, an ageing population and progress in labor market flexibility should ensure that the unemployment rate does not rise sharply in response to this cyclical slowdown, or at least rises less sharply than in the past.

On the price side, actual developments are very much in line with our previous forecasts. Disinflation has started, but it will be a slow process. Energy prices are falling, but food inflation remains at a double-digit level, and labor costs are progressively on the rise.

We expect headline inflation to slow from 8.4% in 2022 to 5.8% in 2023 (5.9% in our March forecasts)--with last year's energy price increases now out of the year-on-year comparison--and 2.7% in 2024. Core inflation is likely to exceed headline inflation from the end-2023 to mid-2025 (see chart 1). We see no possibility of a return to central banks' price stability sooner than early 2025.

Chart 1

Emerging From Winter Stagflation

Eurozone GDP fell by 0.1% in the first quarter--as much as in the final quarter of 2022. Private consumption was the driving force behind these two slight but consecutive declines in GDP, hampered by double-digit inflation: an obvious case of stagflation (see chart 2).

At the same time, inventories fell for the first quarter in five. They have now completely normalized, after the pandemic caused them to plummet (see chart 3). This helps explain the manufacturing sector's underperformance at the start of the year, a few months earlier than we expected.

In addition, public consumption fell significantly in the first quarter, with the noticeable exception of Italy, as COVID-19-related measures--such as mandatory testing--were phased out in most countries.

Chart 2

Chart 3

Given that investment, income, and employment rose in the first quarter of the year, it can't be said that the eurozone has already entered a recession. Data seems to be pointing to an exit out of stagflation as winter ends. Disinflation has begun and wage growth is accelerating (see chart 4).

Consumer confidence has recovered two points from its lowest point reached last year, at the height of the energy crisis, mostly because consumers expect their financial situation to improve as disinflation should continue, according to the European Commission's consumer survey. Real disposable income already recovered 3 points from its fall in 2022. It should stagnate over full-year 2023 and increase modestly in 2024 (by 1 point). As a result, retail sales volumes stopped falling in early spring.

In addition, Europe is just ahead of the first normal tourist season in three years. In March, tourist arrival was back to the pre-pandemic average (see chart 4). This represents a 27% increase compared with 2022 for Europe's six main tourist destinations.

The normalization of the tourism season should bring an additional 0.3 points of GDP to the eurozone economy this year, according to our estimates. This is less of a support than we saw in 2022 (1.2 points of GDP according to our estimates), but is a support nonetheless.

Some countries and regions will benefit more than others from the normalization of tourism (see chart 5). Overall, the combination of a recovery in purchasing power and the normalization of the tourist season should enable the eurozone economy to get back on track for moderate growth in the second and third quarters of this year.

Chart 4

Chart 5

Recession Risk Endures

We think that the return to growth could be temporary. The risk of recession is still significant, particularly in fourth-quarter 2023 and first-quarter 2024, when the impact of rising interest rates on demand will be strongest and employment begins bearing the brunt of the economic slowdown.

Although tourism demand is catching up, other tailwinds stemming from the pandemic recovery are subsiding. The purchasing managers' index (PMI) for the broad service sector remains in expansion territory (at 52.4 in June), but some data for consumer-facing services are less positive. For instance, OpenTable data show that restaurant bookings have stalled year-on-year since early spring.

The manufacturing cycle has also turned. The sector PMI is in contraction territory (at 43.6 in June). This is because inventories have returned to pre-pandemic normal levels and production has absorbed most of the backlog (see chart 5).

It also seems that energy-intensive sectors have not yet recovered. In April, their output remained 11% lower than before the energy crisis, even though gas prices have fallen considerably.

It is still too early to say whether the loss of energy-intensive production in Europe is permanent or merely transitory. A transitory loss implies a recovery, which would represent a positive risk to our baseline scenario.

The fading post-pandemic recovery should also leave its mark on the labor market; employment still rose by 0.6% in first-quarter 2023, but a much smaller increase is likely in the coming quarters. Productivity has fallen, unit labor costs are rising, still-high job vacancies have fallen over the past two quarters, and online job vacancies suggest that the downward trend continues throughout the second quarter (see chart 6).

Our expectation is of a slight increase in the unemployment rate once hiring for the tourist season is complete.

Chart 6

Monetary Policy Is Working

Besides a fading recovery from COVID-19, higher interest rates are the main reason for a possible recession at end-2023/early 2024. Monetary policy may be neutral in the long run, as economists usually claim, but it definitively affects short-term demand.

We already flagged the deeply negative credit impulse in our previous publication (see "Economic Outlook Eurozone Q2 2023: Rate Rises Weigh On Return To Growth," published March 27, 2023). New bank loans to the private sector have not recovered since then, and European companies now report the strongest deterioration in financing conditions since 2009 (see the ECB's "Survey on the Access to Finance of Enterprise in the Euro Area," published June 7, 2023).

In addition, we can observe that higher interest rates have triggered an unprecedented shift from sight deposits to term deposits and money market instruments (see chart 7).

Short-term deposits (with three months' to two years' duration) have increased by €740 billion over the past 12 months, while sight deposits have dropped by €612 billion. This shift in savings represents almost twice the excess savings households had accumulated since COVID-19 (€400 billion remaining in fourth-quarter 2022, according to our estimates).

In other words, monetary policy works. Its transmission to the real economy is powerful. Higher interest rates encourage economic agents to delay spending, just as disinflation and higher wages improve the consumer's purchasing power. The personal savings rate already jumped 0.8 points to 14.2 in fourth-quarter 2022.

Increased preference for saving money may last, because our analysts expect European banks to continue raising interest rates on term deposits this year (see "European Banks: Resilient and Divergent as the Economic Reset Kicks In," published Jan. 23, 2023).

Chart 7

Disinflation Is A Slow Process

With food inflation still at double-digit levels (12.5% in May) and core inflation remaining high and sticky (5.3% in May), it will probably take until 2025 for headline inflation to be back to the 2% target. That said, the fall in headline inflation to 6.1% in May, after peaking at 10.6% in October 2022, is clearly positive, as is the general decline in 12-months-inflation expectations among consumers, market participants, and professional forecasters (see chart 8).

The main driver of disinflation is a base effect on fuels, electricity, and gas prices, with last year's increases now coming out of the comparison, a sufficient mechanical effect to expect disinflation to accelerate in the coming quarters.

Another positive factor in terms of inflation is that the labor market is less tight than it was six months ago. The number of job openings per unemployed has peaked, which normally indicates that core inflation should not be far from doing the same (see chart 9).

Chart 8

Chart 9

The ECB has largely confirmed its June forecasts for headline inflation, but against a backdrop of a stronger exchange rate and lower commodity prices. In other words, the bank is less confident than previously about the decline in core inflation, which it still sees at 3% in 2024, compared with 2.5% in its March forecasts.

This revision should be enough to convince the ECB governing council to raise rates again at its July meeting, the last one before the summer break. This would bring the deposit rate to 3.75%, 25 basis points higher than today.

For the September meeting, the ECB will receive new economic projections. It is therefore too early to say what it may decide after the summer break. For the time being, we expect the ECB to pause in September. Economic data may have deteriorated, and disinflation will have progressed over the summer.

The current market's view is close to that of S&P Global Ratings: the likelihood of a hike in July is very high, that of a September hike is rather split. Extending the time horizon, the picture looks a little clearer. Given that the return to the inflation target will not take place before 2025, it seems unlikely that the ECB will start cutting rates before the second half of 2024.

Furthermore, while the ECB has confirmed its intention to stop reinvestments under its asset purchase program (APP) as of July 2023 and to continue those under the pandemic emergency purchase program (PEPP) until the end of 2024, we expect the discussion about the speed of the balance reduction to continue at the governing council, potentially covering whether the ECB should start considering selling assets held under the APP.

ECB inflation, which is expected to remain above target for the next two years, is not really compatible with maintaining a bond portfolio that accounted for 42% of the ECB's €7,700 billion balance sheet at the end of April, a portfolio that is shrinking very slowly by non-reinvesting maturing bonds (at a monthly pace of €23 billion from July 2023), and whose objective at launch nine years ago was to boost inflation, which was at that time non-existent. What's more, the yield curve has been inverted for eight months now, despite the consensus view that expansion of nominal GDP is likely to continue over the medium term.

Not only could a permanently inverted yield curve become an issue in terms of financial stability, but this conundrum could be a sign that safe, free-floating assets are in short supply. The ECB holds a lot of them in its bond portfolio.

So far, the ECB's balance sheet has shrunk by €1.12 trillion from peak (and in one year), mainly due to repayments of targeted longer-term refinancing operations (TLTROs), the long-term refinancing operations for banks (see chart 10). A further trillion TLTROs are due until the end of 2024, with almost half in June this year.

Abandoning the full allotment procedure and reverting to the normal fixed allotment procedure of pre-global financial crisis days to provide liquidity to banks could also be discussed at some point. This would, however, come after a discussion on possible asset sales, and should conclude the normalization of monetary policy. At the latest ECB press conference, President Christine Lagarde said that the bank stands ready to adjust all monetary policy instruments to ensure that inflation returns to target.

Chart 10

The Medium-Term Looks Brighter

Our comments so far have highlighted several factors that are pulling the eurozone economy in opposite directions.

Disinflation, the normalization of tourism demand, and the increase in public investment triggered by NextGenEU are among the positive factors. In contrast, restrictive monetary policy and the waning of the COVID-19 recovery in terms of excess savings, pent-up demand, inventories, manufacturing production, and employment are negatively weighing on the eurozone economy. Meanwhile, there is the ever-present possibility of external shocks, notably those caused by geopolitical developments. However, these factors may operate at different time horizons.

Most of the net negative factors are concentrated at the end of 2023 and 2024, but should give way to net positives in 2025 and 2026 (see chart 11). For example, we expect the moderating effects of a restrictive monetary policy to be strongest in 2023, still strong in 2024, and more than limited by 2025--especially if the ECB has started to lower rates in the meantime, while the normalization of tourism will truly support the economy for only two quarters this year.

The implementation of NextGenEU is a positive factor which, by design, is likely to support the European economy throughout 2026. As we have previously noted (see "Next Generation EU Will Shift European Growth Into A Higher Gear," published April 27, 2021), the strength of this support will not only depend on the disbursement made by the European Commission to recipient countries, but also the ability of countries to spend the money in a timely and well-considered manner, and the multiplier effects of public spending in the economy (for example, whether public investment triggers private investment).

Chart 12 shows how beneficent countries have used the money granted by the Commission under the Recovery and Resilience Facility in the past two years. Implementation looks rather slow. We will monitor whether the money is spent in a way that really fosters the green and digital transition of these countries, and how large the multiplier effects are, in the years to come.

For the time being, while the projects are slowly underway, we consider that the implementation of NextGenEU improves market perception of the economies that benefit from it most, and that it is a driver of intra-EU sovereign spreads compression.

Chart 11

Chart 12

Short-Term Risks Rely Mostly On The Downside

The risks to our economic outlook have not changed much since March. Downside risks prevail. They are still mainly linked to geopolitical developments and the consequences of higher interest rates, in terms of the calibration of monetary policy for both demand and financial stability. But external demand might also become a downside factor, especially if the landing of the U.S. economy is less soft than expected.

That said, should financial stability be maintained, risks to our economic outlook could also be on the upside. Disinflation could be quicker, and the labor market may prove more resilient than thought. Production in energy-intensive sectors could resume, because gas prices have lowered significantly.