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Euro area: Core inflation keeps the ECB in hiking mode

The expected weaknesses in consumption that eluded us during much of 2022 have become more evident, and consumption fell around year-end. We expect a weak 2023, but resilience − especially in the service sector − will improve the situation.  Energy insecurity has diminished, but high prices are still hampering growth. Despite increased financial sector turmoil, the ECB will hike key interest rates in three more 25-basis point increments at its upcoming policy meetings. 

Despite energy problems, high inflation and rising interest rates, euro area economies are still showing resilience.  Rising cost pressures are squeezing all parts of the economy mainly households but the outlook diverges across sectors. The expected slowdown for households became increasingly apparent last autumn.  Consumption fell sharply amid unchanged real GDP in the final quarter of 2022. Meanwhile, confidence indicators rebounded late last year and early in 2023. The service sector is showing relatively good confidence, which is a bit surprising given the number of challenges the region still faces. In the manufacturing sector, optimism about the near future has fallen in recent months, but this is mainly because global value chains are functioning more normally.

Mild recession. All in all, we believe it is too early to dismiss the recession scenario, but the downturn looks likely to be protracted. A weak 2023, with economic

Key data

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*% of labour force **% of GDP ***At year-end. Source: Eurostat, SEB

growth totaling only 0.6 per cent, will be followed by a mediocre 2024. Despite it being a recovery year, growth will be a mere 1.6 per cent, barely above trend.

Better than expected, but partly for the wrong reasons. GDP fell less than expected around year-end 2022, partly due to weak imports and inventory build-up, which both push up growth. The inventory build-up is in line with a global trend among companies towards creating larger buffers in response to supply problems in recent years. Larger inventories temporarily lead to higher demand, as reflected in order statistics. More surprisingly, imports meanwhile fell. A decline in imports at the same time as inventories are growing is a clear sign of weakness driven by lower consumption and construction investments as well as by companies preparing for tougher times. We interpret GDP statistics as indicating that a further slowdown lies ahead and that consumption will fall by 2 per cent in the next three quarters.

An improved energy situation reduces downside risks. Energy supply and prices were better than previously feared, especially towards the end of last year. This was one major reason for euro area economic resilience. Yet many types of energy remain substantially more expensive than two years ago, and electricity prices have not fallen to the same extent as natural gas prices. Meanwhile, continued high food prices and tighter monetary policy have taken over as growth headwinds.

Continued strong service sector. Rapid inflation, but also a high initial level of consumption, are now causing goods consumption to fall. Consumers were expected to shift towards more service consumption as economies re-opened, but this shift took a long time and seems to have been almost unaffected by sharply rising prices.

High savings a finite buffer. High pandemic savings are now being used as an additional source of funding. But because of negative real wage growth, continued high inflation and rising interest rates, these funds will run out sooner or later, and overall consumption will have to deal with lower purchasing power. The timing varies between consumer categories, and exactly when households will have totally exhausted these savings is highly uncertain. The savings ratio has come down but still remains above its pre-pandemic level. Our conclusion is that households will be forced to restrict consumption, compared to their previous habits. This is the main reason why we forecast weak GDP growth.

A messy start to the year, also politically. Tensions are rife in the euro area. Energy and inflation problems are just one part of the picture. Various kinds of protests are pressuring governments. In Germany, collective bargaining negotiations are continuing, punctuated by strikes in which employees are essentially demanding full compensation for inflation. German wage rounds usually end with pay hikes of half as much as unions have requested but often include one-off solutions that are hard to interpret. France has seen massive protests but there the focus, as so often, has been on unpopular solutions to structural problems such as raising the retirement age. The reasons for public anger vary. Some people oppose a higher retirement age as such, while others are upset about the way President Macron rammed through his proposal. Meanwhile global tensions for example related to the Ukraine war and US-China relations will force the EU to find its place in a world of changing trade patterns and climate transition. The EU is caught between major blocs and risks having to make tough decisions while dealing with a complex internal political agenda. 

The labour market is holding up, despite weaker growth.  Despite a decline in GDP around the end of 2022, employment rose. The explanation is strong demand in the service sector. Difficulty in finding staff after the pandemic is probably another reason why companies are choosing to retain employees, despite falling demand.  Right now, hiring plans remain decent, but we believe that employment will fall as the economy decelerates further. Unemployment will increase by just over one percentage point from 2023 to 2024, a relatively moderate rise.

Spill-over effects crucial to the ECB

Inflation is the biggest constraint on growth, both directly and indirectly via central bank key rate hikes. If energy prices were the focus of attention when rate hikes began, uncertainty is now more connected to how much inflation remains in the system and how today’s high inflation will affect such costs as wages and rents. In addition to general uncertainty, government subsidy programmes that have softened past price upturns will conversely reduce downside potential, depending on how and when they are phased out.

Total inflation is rapidly declining, driven by such factors as lower energy prices and large base effects from 2022. In this context, it is important to bear in mind that the general price level is continuing to rise from an already high level. As measured by the consumer price index, the situation has been slightly less strained in France than in the other three largest euro area economies. Consumers will continue to have a tough time, even though central banks will find the situation somewhat easier late in 2023 from an inflation-targeting perspective. 

More sluggish core inflation in the spotlight. As energy prices have eased somewhat, the focus of attention has shifted towards how price increases spill over into broader portions of the consumer basket­ that have a greater impact on core inflation. It is normal to see a certain time lag between highly variable prices such as energy and food, which strongly affect CPI, and more sluggish prices such as rents and wages. This can be illustrated by looking at input goods prices, producer prices and consumer prices (see chart below). Although the impacts of different stages of price formation on each other are uncertain, our view is that there are still price increases in the system that have not yet reached consumers. For example, price changes for services occur after a certain delay, and strong demand also makes it easier for such prices to rise. Although monthly price changes for core inflation do not stand out as much as in certain months of 2022, they are still high in a historical perspective. Our overall view is that no decline in core inflation will occur until after summer 2023. 

Small signs of coming price declines. Price expectations of companies in the PMI have declined. In the manufacturing sector, perceptions of intermediate goods price hikes have rapidly fallen, even indicating a price decline. In service sectors, indicators are showing the opposite trend, though at a slower pace than before. Prices of freight and many commodities have fallen greatly in recent months, which may exert downward pressure on prices at various stages of production and consumption. But the total cost situation in downstream production stages remains higher than before. This is why a large total price decline cannot be expected. Higher rental, interest rate and labour costs will be crucial to the inflation dynamic.

Uncertainty about wages is keeping the ECB on its toes. Core inflation will start to slow in the second half of 2023 but will still end up at 2.8 per cent for the full year 2024, above the ECB’s inflation target. To get there, we need improved supply chains and lower input prices. The decisive factor in determining where inflation ends up will be the rate of pay increases. Wage formation varies. Some countries (such as Belgium) have labour agreements that automatically raise wages and salaries in response to CPI. Germany is currently in the midst of a collective bargaining round, but it will be protracted and the outcome is uncertain.  Wages are a key reasons why the ECB must stay on its toes, prepared to respond to all sorts of spill-over risks that could threaten its inflation target in the long run. High wage agreements increase the risk that the decline in inflation will take more time. Like the ECB, we estimate that pay hikes both this year and next will be close to five per cent in the euro area. Such wage increases is normally considered high from an inflation perspective, since we expect productivity growth to remain moderate over the next few years. But we believe the increases will still be manageable, even if core inflation does not fall to 2 per cent until after 2024.

Another 75 basis points from a data-oriented ECB. What will determine ECB interest rate policy in the near future will be incoming statistics. Both PPI and CPI figures will thus be important in the coming months, almost regardless of what happens in the real economy. We believe that the ECB will not receive any clear signals that inflationary pressures are easing before this summer. As a result, it will raise rates by another 75 basis points during the summer, and the deposit rate will peak at 3.75 per cent. A surge in financial sector uncertainty might completely redraw the monetary policy stance. Previous rate hikes have created tensions in the system and will remain a concern for some time to come. The recent banking sector turmoil has tightening credit conditions. This means that the ECB will not have to hike its key rates quite as much as would otherwise be the case. Once there are clearer signs of a disinflationary trend, along with a slowdown in the economy, the ECB will start cutting rates. We believe it will lower key rates by a total of 75 bps during 2024.