In an environment of high interest rates, we still believe that a soft landing of the European economy remains the most likely scenario for the rest of 2023 and the first half of 2024. The International Monetary Fund (IMF), the World Bank, and the Institute of International Finance (IIF) endorsed this scenario at their annual meetings in Marrakech in October this year. The European Commission's autumn economic forecasts point in the same direction.

Three Reasons For A Soft Landing

Rising real incomes

The strongest argument for a soft landing is the increase in real incomes as a result of disinflation and strong wage growth. Inflation in the eurozone will likely ease by two percentage points to an average 2.9% next year, wages will rise by 4%, compared with 5% this year, and employment will stagnate. We expect household purchasing power will increase by one percentage point in 2024, after it contracted sharply in 2022, which will support consumer spending. Real income growth has already resumed, thanks to disinflation, high compensation of employees, and social benefits in the first quarter of 2023 (see chart 1). The harmonized index of consumer prices (HICP) fell to 2.9% at the beginning of the fourth quarter, compared with 5.5% at the end of the second quarter. Real-time data suggest that wage growth was still at 4% at the beginning of the fourth quarter, after it peaked at 5% in the fourth quarter of 2022. Job vacancies, even though they have declined, remain high by historical standards, which reduces the likelihood of a spike in unemployment rates over the next 12 months.

Chart 1

Strong balance sheet of the private sector

At the end of June 2023, the private sector in the eurozone had a net financing capacity of 4.5% of GDP, which exceeded governments' financing needs by 0.6 percentage points (see chart 2). Households provided more than half of this net financing capacity, while non-financial companies contributed about 25%. Even if these excess savings are less liquid than they were before mid-2022 since the rise in interest rates makes term deposits--which are interest-bearing--more appealing to households and businesses than sight deposits, they still constitute a buffer in the event of a pronounced economic downturn.

Chart 2

Resilient financing conditions

So far, European financial institutions have managed interest-rate risk well. Longer durations made European bond markets more resilient, while the high proportion of fixed-rate mortgages acted as a shock absorber for European real estate markets.

Growth Momentum In Services Dwindles But The Manufacturing Recession Could Recede

The economic growth slowdown of the European economy in 2023 was more pronounced than that of other large economies. GDP growth stagnated over the past 12 months, with the 0.1% contraction in the third quarter of 2023 almost completely erasing the 0.2% increase in the second quarter. The reasons for the stagnation are manifold.

Low output

Manufacturing suffered from high energy costs, particularly in Germany, where energy-intensive industries are strong. Additionally, construction stalled as high interest rates and high building costs weighed on demand. The only sector that contributed to output growth this year was services, not least because Europe enjoyed its first normal tourist season in four years (see chart 3).

Restrictive monetary policy

Fiscal policies were less supportive this year, with the cyclically adjusted primary budget balance improving by 0.4% of GDP, according to IMF estimates. Monetary policy turned restrictive, with key interest rates increasing by 450 basis points in less than 18 months. This quickly translated into a reduction in domestic demand since higher interest rates encouraged households to save money. Accordingly, personal savings rates increased by 1.5 income points in 2023 to 14.9% at the end of June 2023.

Inflation and trade stagnation

Consumer price inflation outpaced wage growth in the first half of 2023. Had it not been for job growth and net social transfers, consumer spending would have decreased. In addition, net trade stagnated, while post-pandemic inventory rebuilding came to a halt, particularly in the automotive sector.

Chart 3

Key economic indicators suggest that the pattern of the economic slowdown is changing. According to the purchasing managers' index (PMI), the services sector is losing steam, while the manufacturing sector seems to be bottoming out. This is particularly the case in Germany, which has adjusted most of its domestic production to account for higher energy prices and where inventory levels seem to have normalized (see charts 4 and 5). This does not mean that the slowdown is over, but it suggests that we might have reached the trough of the manufacturing recession.

Chart 4

Chart 5

What Could Cause A Hard Landing?

The case for a soft landing is currently so strong that it is hard to counterargue. At the same time, it is almost too good to be true, especially considering that crises often start with an unexpected development. Therefore, it might be worth taking a closer look at what could go wrong. Exogenous risks doubtlessly abound and include the potential effects of the wars in eastern Europe and the Middle East on commodity prices and value chains. Beyond geopolitics, European and international politics could be further causes of volatility. Yet, we focus on the three main endogenous risks that could derail a soft landing of the European economy next year.

Labor markets could suffer from productivity declines

European labor markets are still tight, for cyclical and structural reasons. On a positive note, companies hired more people to meet the strong recovery in demand. According to Eurostat data, however, each employee tends to work almost 45 minutes less per week since the pandemic, the workforce is aging, and employees need to keep up with rapid technological changes. The still high, albeit declining, number of job vacancies makes a sharp rise in unemployment rates in 2024 unlikely.

That said, our previous economic outlook for the eurozone evidenced that the hiring spree is closely correlated with corporate profits. Labor costs, which increased by 6.3% year on year in the third quarter of 2023, have not risen that fast since 2009 and 2020. While this uptick in labor costs largely results from wage increases, a rising portion also stems from productivity declines (see chart 6). Employment increased by 0.3% between the second and third quarter of 2023, even more than between the first and second quarter, while the economy shrunk. As a result, productivity fell again and is now below pre-pandemic levels. Developments in output per hour worked are even more worrying, particularly in France (see chart 7). Not one but several factors induced this drop in productivity, including the composition of labor markets, the rise in apprenticeships, absenteeism, labor hoarding, and production stops.

Chart 6

Chart 7

In the face of rapidly rising labor costs, estimates suggest at best a stagnation of unit profits in 2024--and that is without considering higher refinancing costs for companies. If employment rates do not hold up in 2024, the recovery of real incomes could be more muted than expected.

Inflation expectations lag price developments

Inflation has fallen further to 2.9% in October 2023, from 4.3% in September this year. Even though energy prices are still important to propel disinflation, especially after some governments in Europe extended existing subsidies, they are no longer the only driver. Core inflation has passed its peak and food inflation is no longer in double digits. This enabled consumers to spend more on food for the first time in months, with food sale volumes increasing by 1.4% between August und September 2023. We believe inflation will continue to recede to an average of 2.9% in 2024 and 2.0% in 2025. Progress on disinflation has already led the ECB to pause on rate hikes.

In our base-case scenario, we expect, as the consensus does, that ECB rates have peaked at 4% for the deposit facility rate (DFR) and that the ECB will gradually cut rates from June 2024 onward. It is early to tell, but we currently believe that only three rate cuts will occur in 2024, before the rate-cutting cycle accelerates in 2025. The trough of the rate-cutting cycle could materialize in the third quarter of 2025, at about 2% for the DFR.

That said, inflation expectations lag actual inflation. The distribution of medium-term inflation expectations remains unusually skewed toward an inflation overshoot. In the ECB's survey of professional forecasters, the probability of inflation remaining at 3% or above over a five-year horizon is still at 11.5%, which is twice as high as it usually is (see chart 8). Market-based inflation expectations over two, five, and 10 years have peaked and remain consistently above the ECB's inflation target, at 2.3%, 2.4%, and 2.6%, respectively (see chart 9). Consumers also doubt that price stability is in sight. According to the ECB's most recent consumer expectations survey, consumers' median expectations for inflation over the next 12 months increased to 4.0%, from 3.5% in August 2023, while inflation expectations three years ahead remained unchanged at 2.5%.

If inflation expectations do not keep up with actual consumer price trends, the ECB could cut policy rates later than expected. This could affect long-term yields and jeopardize the recovery in demand, particularly demand for investment, that we expect in the second half of 2024.

Chart 8

Chart 9

The resilience of financing conditions will change after 2023

Two macro aspects will contribute to less resilient financing conditions after 2023. First, most eurozone countries' policy mix is no longer in sync (see chart 10). Monetary policy is dampening demand, while fiscal policy is not really--at least not everywhere. If the policy mix remains out of sync for too long, long-term yields and bond spreads could come under so much pressure that the ECB might trigger the transmission protection instrument (TPI). The European parliament election in 2024 and the review of the ECB's operational framework, which should be completed next spring, add pressure. As a result the ECB's balance sheet could reduce, even if ECB chief economist Philip Lane largely backed the current framework in a speech he gave at an ECB conference in November.

The second aspect is the difference between the level of interest rates and nominal growth, the so-called "r-g" differential in equations on debt dynamics. Until now, nominal GDP growth has exceeded interest rates, which supported lower debt-to-GDP ratios and likely contributed to the European economy's resilience to rising interest rates. But things will change in 2024. We expect nominal growth will halve because of disinflation, while interest rates will likely remain high. Therefore, the interest rate-nominal growth differential might turn positive in 2024 (see chart 11). Debt-to-GDP dynamics will be on investors' minds in 2024, even more than they already are.

Chart 10

Chart 11

Related Research

• CreditWeek: What Are the Credit Ramifications of the War in the Middle East?, Nov. 2, 2023
• Europe’s Risky Credits: Liquidity And Refinancing Risks Start To Bite, Nov. 1, 2023
• Messages From Marrakech: Takeaways From the IMF, World Bank and IIF Annual Meetings, Oct. 19, 2023
• Economic Outlook Eurozone Q4 2023: Slower Growth, Faster Tightening, Sept. 25, 2023
• European Housing Markets: Sustained Correction Ahead, July 20, 2023
• European Banks: Potential Interest Rate Volatility Calls For Caution, July 19, 2023
• Sovereign Debt 2023: Borrowing Will Stay Elevated Despite Rising Cost Of Debt, March 9, 2023

External Research

• Central bank liquidity: a macroeconomic perspective, Nov. 9, 2023, welcome address by Philip R. Lane, member of the executive board of the ECB, at the ECB conference on money markets
• Port, electronics and healthcare: Supply chain impact of conflict in Israel, Oct. 10, 2023, S&P Global Market Intelligence
• Climate Crossroads: Fiscal Policies in a Warming World, Oct. 2, 2023, IMF Fiscal Monitor
• Recent changes in labour productivity in the four main Eurozone economies, Dec. 21, 2022, Insee Economic Outlook