The key changes to our forecasts are a weaker growth rebound in the medium term, less room for disinflation, and fewer rate cuts in 2025. The eurozone economy is on the verge of a soft landing. Developments in GDP, inflation, real wage growth, and employment over the past quarter confirm this, in our view. As a result, we have trimmed our short-term forecasts. We now expect modest GDP growth this year in the region of 0.7%, compared with 0.8% in our previous forecast. The major part of this revision comes from a weaker carry-over effect from 2023 GDP.

We continue to believe that the medium-term outlook is brighter than the short-term outlook. We are less convinced, however, that the rebound in growth will be strong. As such, we forecast GDP growth of 1.3% next year, compared with 1.5% in November 2023. We have also revised down our 2026 figure to 1.3% from 1.4%. Our projections are close to the consensus of private forecasters and international institutions (see table 1).

Table 1

As far as consumer prices are concerned, the speed of disinflation in recent months has prompted us to revise our forecast for 2024 downward, to 2.6% from 2.9%. But we don't believe that disinflation will continue at such a pace (see chart 1). On the contrary, prolonged high wage growth against a backdrop of sluggish productivity and trade developments has prompted us to revise our medium-term inflation forecasts upward, to 2.1% from 2.0% for 2025, and to 1.9% from 1.7% for 2026. Most of the upward revision stems from labor market developments.

Chart 1

Higher inflation over the medium term will mean the ECB has less scope than we previously expected to continue its rate-cutting cycle through to 2025. We see the current deposit rate of 4.0% falling to 2.5% by the end of 2025, compared with 2.0% in our previous forecasts. We haven't changed our view that the ECB will cut rates three times in 2024, starting from June.

Another change in our forecasts concerns our assumption of long-term interest rates. The ECB's new operational framework is much the same (see section below titled "The ECB's Unchanged Operating Framework Keeps Quantitative Tightening At Bay"). Consequently, an acceleration in the pace of the ECB's balance sheet reduction is less likely than we previously thought to exert upward pressure on the term premium of long-term bond yields. And considering our less upbeat medium-term growth forecasts, we are lowering our projections for benchmark 10-year German government bond yields this year to 2.4% from 2.9%.

The Next Six Months Should See A Boost In Activity And A Dip In Employment Growth

Forward-looking indicators suggest a moderate improvement in activity over the next six months. Both the European Commission's Economic Sentiment Indicator and S&P Global Market Intelligence's Purchasing Managers' Index (PMI), as well as the Center for European Economic Research (ZEW) and Sentix surveys of investor confidence, improved at the start of the year. The European Commission's survey indicates that household confidence is recovering slowly as inflation recedes, wages accelerate, and employment rises.

The PMI survey shows that the manufacturing recession is easing, with new manufacturing orders climbing. This benefits services as companies need business services to manufacture goods. Sentix and ZEW suggest that most investors expect growth to improve over the next six months (see table 2).

Table 2

The eurozone economy continued to stagnate over the final quarter of 2023. Business investment made the largest positive contribution, while inventories and net trade held back GDP growth, and household consumption remained largely unchanged. The share of productive investment in eurozone GDP is high by historical standards (see chart 2).

Chart 2

This may bode well for future growth, but it also reflects the constraints on household spending due to high inflation over recent years. We expect this demand pattern to rebalance somewhat this year in favor of consumption, as real wage growth has turned positive and higher interest rates in real terms may dampen investment.

Activity will accelerate in the coming quarters, but employment will moderate, in our view. Employment was strong in the fourth quarter of 2023. Hiring in the service sector helped drive a rise of 0.3% in the final quarter of 2023, while wage growth was 4.4%, well above productivity growth (-1.2% year on year). Soaring unit labor costs are now better absorbed by falling unit profits, allowing inflation to recede (see chart 3). This rebalancing of income distribution in favor of wages and away from profits suggests that the hiring cycle will weaken further. Real-time data on job postings confirm this: they now show a plunge at a similar pace across most areas (see chart 4).

Chart 3

Chart 4

The question is no longer whether the unemployment rate will rise this year, but by how much it will rise. We except the unemployment rate to be 6.7% at the end of this year compared with 6.4% in January 2024. A few key reasons explain why we don't expect a more pronounced upturn in the unemployment rate, namely:

• Subdued demographic growth;
• Job vacancies still represented 2.7% of the labor force at the end of last year, down from a peak of 3.4% in the second quarter of 2022; and
• The manufacturing recession appears to have had little effect on GDP and employment (see chart 5). The rise in energy costs has led European industry to either stop or outsource low value-add activities, but has not significantly damaged its core business--at least at this stage.

We continue to see labor market developments as a key point in our soft-landing narrative.

Chart 5

The Medium-Term Rebound May Be Weaker Than We Expect

Two key reasons explain why we are less convinced about the strength of the rebound to come in 2025 and 2026.

First, the implementation of the European Commission's plan to foster the green and the digital transition--Next Generation EU--through public investment and reforms has fallen behind schedule. The European Investment Bank (EIB) estimates the fulfilment of only 44% of milestones and targets that were due for completion by the third quarter of 2023 in the Recovery and Resilience Facility, the largest Next-Gen EU facility (see the EIB Investment report 2023/2024). This represents a gap of €127 billion below the target for public spending, that is, 0.7% of 2023 EU GDP.

It remains to be seen whether governments will be able to make up for the delay--which would be positive for medium-term GDP growth--or request an extension beyond 2026. We believe that the second option has become more likely (see: "EU RRF At Half-Time: Italy And Spain Will Likely Need Extra Time To Spend Their Funds," published on RatingsDirect on July 19, 2023).

Second, uncertainty surrounds potential growth after the pandemic and energy price shock. Productivity has recently fallen below the long-term trend (see chart 6), and it is premature to say whether the decline is cyclical or structural. These productivity losses may continue. The terms of trade have not yet fully recovered from the energy price shock, and China is increasingly challenging Europe's trade advantage, particularly in the automotive sector.

Chart 6

Despite the German economy's record trade surplus of €27.5 billion in January, the rebalancing of the terms-of-trade shock is ongoing. What's more, the shrinking working-age population is likely to reduce potential growth by 0.5% to 0.6% per year over the next five years, according to the United Nations Department of Economic and Social Affairs' demographic projections (see chart 7). At the same time, the positive net immigration shock that the war in Ukraine has triggered in several European countries could reverse these gloomy projections.

Chart 7

The recent fall in inflation will be short-lived, in our view. We continue to believe that inflation will not return to 2% before mid-2025. Inflation largely comes from its domestic components, especially services, with labor costs setting the pace. Unit labor costs have hit record highs due to strong wage growth and weakness in productivity. Marginal wage growth has barely slowed, and remains at 4% according to real-time data (see chart 8). This is well above the rebound we expect in productivity and therefore does not provide much scope for a rapid return of core inflation to 2%.

Chart 8

Inflation fell over the past three months, from 2.9% in October to 2.6% in February. This is more disinflation than we had anticipated. The reasons for this are a sharp decline in energy prices in the fourth quarter of 2023 and a moderation in core inflation to 3.1% in February from 4.2% in October.

Moreover, geopolitical developments continue to hamper trade in the Red Sea, forcing ships to take longer routes, which inflates costs. Our colleagues Jack Kennedy and Chris Rogers at S&P Global Market Intelligence estimate that transits via the Cape of Good Hope add at least 10 days to the usual route and more than 15% to shipping costs. At the same time, they assess that 8.6% of total Asia/Gulf imports come to Europe by sea.

All in all, European companies appear to be coping with the higher cost burden. But as shipping costs are generally fixed by long-term contracts, most of which run for 12 months, their impact on final consumer prices is likely to become more evident early next year (see chart 9 and "Red Sea Maritime Risks Likely To Extend Beyond Israel-Hamas War, Alternative Routes Entail Economic Or Operational Compromises," published by S&P Global Market Intelligence, Dec. 21, 2023).

Chart 9

ECB: Three Rate Cuts In 2024 And Three More In 2025

The door will open to a first rate cut in June, and the rate-cutting cycle will be gradual, barring another external shock. We base these forecasts on statements over the past three months by ECB president Christine Lagarde and other ECB board members. We continue to forecast three 25 basis point (bp) rate cuts over 2024 (probably in June, September, and December), with the ECB basing each cut on new growth and inflation projections and updated data for wages.

By contrast, we no longer expect the ECB to accelerate its rate-cutting cycle next year. We now forecast only three 25 bp rate cuts in 2025, compared with five previously, so that the deposit facility rate will bottom out at 2.5% instead of 2.0%. Indeed, in our soft-landing base case, where inflation falls less than we expect in 2025 and 2026, and GDP growth picks up to the level of potential growth, a modified Taylor rule approach to monetary policy does not suggest greater scope for rate cuts in 2025 (see chart 10 and the box below on the Taylor rule). Admittedly, the uncertainty about potential growth that we highlighted earlier inevitably has an impact on our ECB rate forecasts.

Chart 10

The ECB's Unchanged Operating Framework Keeps Quantitative Tightening At Bay

We see three key takeaways from the announcement of the ECB's new operational framework, that is, the way the central bank steers monetary policy and injects liquidity into banks (see "Eurozone Banks: ECB's Operational Framework Review Backs The Status Quo," published March 14, 2024).

The new framework does not tighten the conditions for access to central bank liquidity.   The ECB will continue to fully service eurozone banks against the same pool of collateral assets. Long-term refinancing operations (so-called structural operations) might resume at a later stage.

It does not imply any acceleration in the reduction of the Eurosystem's balance sheet.   The unwinding of targeted long-term refinancing operations and the passive run-off of current bond portfolios will probably remain the driving forces of the balance sheet reduction. Accordingly, the Eurosystem's balance sheet is likely to total about €5,000 billion by the end of 2026, compared with €6,800 billion today (see chart 11). Beyond that, the ECB will consider establishing a structural bond portfolio, probably once the current asset purchase programs and pandemic emergency purchase programs have run to maturity. The ECB has yet to decide on the most important details, namely the size, composition, and duration of this portfolio. This ambiguity has the power to contain a rise in European bond yields in the near future, as it suggests that the balance sheet could increase again from 2026.

Chart 11

The spread between the main refinancing rate and the deposit facility rate will fall.  From Sept. 18, 2024, it will fall to 15 bps from 50 bps (see chart 12). Such a record narrowing of the spread aims to limit volatility on money market rates, and, along with the continuation of the full allotment procedure, is likely to prevent any strong resurgence in money market transactions.

Chart 12

Risks To Our Macroeconomic Outlook Are A Squeeze On Growth And Rise In Inflation

The unemployment rate could rise more than we expected this year. Companies and households have drawn down the financial reserves they accumulated during the pandemic, which now limits the potential rebound in demand. With underlying inflation remaining high, central banks may be slow to cut rates.

The main risk is for less disinflation than we expect due to historically high labor costs and higher refinancing costs for businesses, and to a lesser extent, the trade situation in the Red Sea. Moreover, political decisions arising from the elections in the U.S. and EU in 2024 will not be taken before 2025. The eurozone is aiming for a soft landing, but factors remain that could derail it.

Table 3

Related Research

• Eurozone Banks: ECB's Operational Framework Review Backs The Status Quo, March 14, 2024
• EU RRF At Half-Time: Italy And Spain Will Likely Need Extra Time To Spend Their Funds, July 19, 2023