Euro area: Despite economic resilience, a downturn is imminent

The euro area remained surprisingly resilient in the third quarter, but indicators suggest that GDP began to fall in late 2022. We are thus sticking to the view that high inflation and rising interest rates will finally lead to a mild recession − with GDP being unchanged in 2023. Inflation has passed its peak but will remain relatively high in 2023. The European Central Bank has adopted a more hawkish stance, which means that we now expect the ECB deposit rate to reach 3.25 per cent some months into 2023 − before rate cuts begin. in early 2024.

For many months, euro area economies have withstood increasingly fierce headwinds. Household spending has been resilient, with pent-up post-pandemic consumption demand weighing more heavily than pressure from rising prices and interest rates. Another upside surprise has been capital spending. But a lengthy period of higher prices should eventually result in falling consumption as savings buffers begin to shrink (see theme article, page 39). By all accounts, economic growth turned negative in the final months of 2022. We expect falling GDP during the first half of 2023 before a recovery begins. After an increase of 3.4 per cent in 2022, we expect zero growth in GDP in 2023. During the second half of 2023 a recovery will kick in, with GDP growth accelerating to 1.9 per cent in 2024.

Key data

Year-on-year percentage change

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

Delayed impact on households

Some cost increases are having an impact on household finances only after a significant time lag − which has helped to sustain consumption. While higher food prices, for example, have had an immediate effect, delays in the impact of rising energy and interest expenses have varied greatly between individuals and countries. Some households have energy contracts that are directly affected by higher market prices, but many European households have fixed contracts − leading to significant delays in price increases. In countries with a high proportion of rented accommodations, such as Germany, the delay will also be longer. It often takes a relatively long time before energy and interest expenses trigger rent hikes. There are also signs that consumer price index statistics in some places have exaggerated the increase in energy costs, suggesting a more gradual decline in consumption (see more below). About 70 per cent of euro area household loans carry fixed rates, which will also delay the impact of interest rate increases.

Service consumption has softened the downturn. When pandemic-related restrictions were lifted in the spring of 2022, service consumption rose significantly as expected, while goods consumption fell from bloated levels in some areas. More surprising, however, is that service consumption was still strong in late 2022. Both economic theory and historical experience suggest that households prioritise the consumption of more necessary goods in times of crisis when they are being pressured from different directions. Our interpretation is that households have had such a strong preference for returning to normal habits that they have been prepared to greatly reduce the large savings buffers that they had built up during the pandemic. Because of continued price hikes going forward, we expect households to finally be forced to tighten their belts. In some euro area countries, preliminary statistics show that households have already started to behave according to accepted economic theory, cutting back on their entertainment spending and slowing capital goods purchases. We expect overall household consumption to decline by 0.5 per cent in 2023.

Large underlying investment needs. Capital spending activity has also held up relatively well, partly because public and private investments are being stimulated by previous crisis measures. The need to address both the short-term energy crisis and the longer-term green transition is also driving energy investments. Overall, we expect capital spending to fall only marginally in 2023, which is unusual during a recession.

Exports have recovered from the pandemic, but China's lockdowns have continued to have an adverse effect. This is especially apparent from weak export figures for Germany and France. -Another contributing factor is that the level of vehicle production in Europe has been weak for a long time. Thanks to China’s reopening, falling transport costs and generally decreasing disruptions in global value chains, exports will eventually gain more momentum, posing some upside risk to our GDP forecast.

Continued high demand for labour

The resilience of euro area economies is also reflected in continued strong labour markets. Unemployment fell to pre-pandemic levels during the summer of 2022, and business hiring plans suggest continued rising employment in the near term. But further ahead, weaker economic activity − especially in the service sector − will push up unemployment. Due to the time lag between GDP changes and the labour market, unemployment will not rise until the second half of 2023. Measured as an annual average, it is expected to climb to 6.9 per cent in 2023 and 7.9 per cent in 2024.

Compensatory wage hikes a key issue for inflation. High inflation is creating strong pressure for compensatory wage and salary increases. The risk of a wage-price spiral has been widely debated as central banks around the world have hiked their key interest rates at a rapid pace. Because wage formation in the euro area is more likely than in the US and UK to take place by means of centralised negotiations, the wage response will be more delayed, which has helped to create increased uncertainty for the ECB. Businesses have generally been able to maintain their profitability relatively well, which increases the likelihood of an acceleration in the rate of wage growth. Our forecast is that pay increases in the euro area as a whole will end up at around 4.5 per cent annually during 2022-2024, which is in line with the outcome of German pay negotiations. Pay increases at this level should be manageable from an inflation targeting standpoint, but some indicators suggest an upside risk to our forecast – with wage and salary growth reaching well above 5 per cent.

Plummeting inflation during 2023

We believe that inflation peaked in October when the EU’s harmonised index of consumer prices (HICP) rose 10.6 per cent year-on-year. We expect a relatively clear downturn during 2023, but inflation -will still be above the ECB target all year, with a December figure of 3.0 per cent. The average will be a bit above 6 per cent. This means that prices will still climb substantially. The fact that the energy situation in Europe now looks significantly better than assessments in early autumn 2022 means that the risk picture can quickly be changed in the other direction. The energy issue has also affected food prices. If a larger rebound and energy prices also affect food prices, a downward trend could be reinforced. The chart below shows a mechanical scenario where 2/3 of the energy and food component increase in the HICP since mid-2021 gradually reverses over the next two years.

Greater focus on core inflation. Sharp increases in food and energy prices have accounted for about half the rise in headline HICP. Core inflation, which excludes these items, was around 5 per cent at year-end 2022. One important question in 2023, aside from wage formation, is how much price increases that are in the system have not yet worked their way through to consumer prices. Energy and food prices, as well as other cost increases, have obviously had a broad impact on downstream prices. The existence of price indexation clauses in contracts (such as rental agreements) will also contribute to a slower downturn in core inflation than in headline inflation.

Signs of moderating inflationary pressures. There are now various signs that the rate of monthly price increases is about to decelerate. According to surveys, corporate price expectations have come down markedly, although they still indicate rising prices. Producer price indices (PPIs) also suggest that prices early in the production chain have levelled off. After a natural lag between input goods and consumer goods, the slowdown has now also reached consumer goods. This will mean less uncertainty about how much price pressure is left in the system. But service price increases are affected by goods price increases only after a certain time lag. Combined with indexation clauses and accelerating pay increases, rising service prices are thus likely to be a driving force that will keep core inflation up throughout 2023.

Overestimated inflation surge?

Late in 2022, Eurostat issued a clarification highlighting information-gathering problems related to household energy prices – one example of large current statistical uncertainties. In the Netherlands, for example, all electricity contracts are approximated by new contracts and are thus linked to the prevailing (high) market prices. But many households are on fixed contracts. This is one reason why the upturn in energy prices has been exaggerated in inflation statistics. The Netherlands Bureau for Economic Policy Analysis (CPB) estimates that the inflation rate may have been overstated by as much as over 2 percentage points in late 2022. Data availability and differences in calculation methods thus seem to have been an important reason why the contribution of energy prices to inflation metrics in various countries differed so greatly in 2022. It is one example of how methods that work in “normal situations” can go awry in extreme conditions. This overestimation of inflation may also explain the resilience of consumption, when we economists are fooled by “excessively high” inflation statistics (and thus an excessive decline in real household incomes).

Controversial fiscal policies Fiscal policy continues to play a central role in the euro area. Large pandemic-related stimulus programmes have now been replaced by policies that are primarily aimed at covering part of household and business energy costs. But there are major differences among EU members. Since the autumn of 2021, Germany has offered subsidies equivalent to 7 per cent of GDP, while most other member countries are offering 3 to 5 per cent. The design of these programmes has also varied, contributing to major differences in inflation rates. Fiscal policymakers are facing a balancing act, in which they must avoid making it too difficult for central banks to bring down inflation. One large stimulus programme that is now being rolled out is Next Generation EU (NGEU), which provides a boost to investments in such fields as digitisation, the green transition and energy. This multi-year programme is mainly focused on structural change, but due to the EU energy crisis it has also been used for more short-term purposes.

A hawkish ECB believes it will not achieve its inflation target for a long time. Early in the rate hiking cycle, the ECB lagged other central banks. Recently it has adopted a more hawkish tone, causing long-term bond yields to rise, and not only in Europe. The nuances of ECB communication shifted during the autumn, implying that its tone may conceivably change again. The ECB is also being more vague than other central banks, so the scope for interpretation is quite large. Its recent harsher tone is partly because the ECB now regards the path back to its inflation target as a more protracted process. However, we believe that subdued economic activity will help to dampen wage and price pressures during the latter part of our forecast horizon. In the short term, we predict that the ECB will raise its deposit rate in 50 basis point steps at the next two meetings followed by a final 25 basis point increase from today’s 2 per cent to 3.25 per cent. In response to developments in the real economy, and with inflation falling towards target, the ECB − like other central banks − will ease its monetary policy in 2024. We believe that the deposit rate will be back at 2.50 per cent by the end of 2024.