By contrast, we predict that countries more reliant on manufacturing and most vulnerable to the previous increase in natural gas prices (Germany, Czechia, Hungary) will see a full-year decline in GDP. This is due to: (1) destocking of previously accumulated inventories, (2) the impact of earlier increases in energy prices on energy-intensive industries, (3) higher interest rates that manufacturing activity is particularly sensitive to, (4) spending rotation from goods to services and (5) weak consumer demand.
Looking ahead, we anticipate economic activity in Europe will pick up throughout 2023H2 and 2024, as significantly lower inflation supports recovery in real incomes and consumer demand. Additionally, we forecast that government investment will increase on the back of absorption of the EU Recovery Fund, while a gradual increase in external demand and lower energy prices will stimulate manufacturing sector activity. However, we expect the recovery to be sluggish, because the effects of monetary policy tightening are increasingly feeding through to the real economy and the withdrawal of fiscal measures introduced in response to the pandemic and the energy shock will also weigh on demand. Therefore, we expect only modest acceleration of GDP growth in the euro area to 1.2% in 2024 and 1.4% in 2025.
Economic activity remains subdued also in the UK, with ongoing strikes and an extra public holiday hindering output in recent months. Elevated inflation will continue to erode household income and pressure the Bank of England to tighten monetary policy aggressively, thus constraining consumer spending and business investment. Tighter financial and credit conditions together with increased fiscal headwinds will likely constrain GDP growth to 0.4% in 2023 and 0.8% in 2024.
Compared to Western Europe, we forecast a much stronger rebound in Central and Eastern European (CEE) countries that will realize their much higher potential growth, supported by rapid disinflation. Despite this, almost all European economies are expected to remain well below pre-Covid trends over the projection horizon, pointing to the long-term negative effects of the pandemic and the war in Ukraine.
Inflation has passed its peak and is quickly declining… but core inflation is showing persistence, reflecting tight labor market conditions and high nominal wage growth
In the euro area, inflation nearly halved from 10.6% in October 2022 to 5.5% in June 2023, initially driven by declining energy prices and base effects. More recently, however, receding supply bottlenecks, slowing demand and declining commodity prices have also begun to filter through to core and food prices. Disinflationary pressures are therefore broadening. Inflation will continue to decelerate in the coming months, which is also reflected in companies’ business outlook across the majority of sectors, although to a lesser degree in services.
Trends in inflation are similar across European economies, but inflation levels vary significantly, primarily due to differences in the sensitivity to the experienced commodity price shocks as well as differences in labor market tightness. The highest inflation rates, often well in double-digit territory, are in CEE countries due to their fossil fuel-based energy mixes, higher shares of food and energy in inflation baskets, tight labor markets and past exchange rate depreciation. Southern Europe (incl. Italy, Spain, Portugal and Greece), on the other hand, exhibits the EU’s lowest inflation as labor slack, while declining, remains relatively significant. Despite these differences, we anticipate that most EU countries will see inflation near or at central bank targets in 2024. Two clear exceptions are Poland and Hungary, where tight labor markets, expansionary fiscal policy and the phasing-out of temporary indirect tax cuts will keep inflation elevated for longer.
As the indirect effects of past energy and other supply shocks gradually fade, “free lunch” disinflation will peter out and labor costs will likely become a dominant driver of inflation. With tight labor markets, workers are using their bargaining power to recoup lost income which will maintain upward pressure on wage growth and prices, especially in the services sector where wages represent double the share of direct input costs in manufacturing. The risk of sticky inflation is reflected in elevated core inflation (excluding food and energy) which is cooling only slowly in Europe. Therefore, while we anticipate that inflation in the euro area will reach the European Central Bank (ECB) target of 2% in the first half of 2024, core inflation will stay above the target throughout next year.
Central bank rates are likely to stay higher for longer
The current tightening cycle is already the strongest in the ECB’s history and the full impact of interest rate hikes is yet to be fully felt. Despite this, sticky services inflation and strong wage growth will likely embolden the ECB to continue its policy, with one more final 25bps interest rate increase in September.
We expect the ECB to maintain a data-dependent approach and will refrain from providing guidance on the future interest rate path. However, in our view, most policymakers consider the costs of protecting the economy from upside risks to be much lower than the costs of reacting only after upside risks to inflation have materialized. Therefore, a rapid decline in headline and core inflation indicators may not be sufficient stimulus for a policy rate cut in Q1 2024. In particular, if nominal wage growth remains high and is not sufficiently absorbed by firms in their profit margins, the ECB may hold rates steady even until June 2024. Therefore, in our baseline, monetary policy in the euro area is overtightened and businesses should be prepared for a “higher for longer” scenario.
With headline inflation cooling to 7.9% in June and core inflation moderating slightly to 6.9%, the BoE is likely to favor a 25bps rate hike in July after a 50bps rate increase in June. With forward-looking indicators suggesting inflation will fall further in the second half of 2023, and the labor market now decisively cooling, we expect one more final 25bp hike, to 5.5%, and a first rate cut in Q2 2024. This makes our BoE monetary policy forecasts more dovish than implied by market expectations.
With the ECB tightening policy further and core inflation remaining above the target, we expect the central banks of Switzerland, Sweden and Norway each to raise rates twice more and we do not anticipate rate cuts in these countries before the second half of 2024. In contrast to advanced economies, CEE central banks ended the hiking cycle many months ago and have either already begun the easing cycle (Hungary, though from a very high level of 18%) or are expected to start cutting rates in Q4 2023 (Czechia and Poland), despite inflation remaining close to 10%. Given its continuing heightened inflation, we anticipate the easing cycle to be gradual in Poland. By contrast, the Czech central bank is likely to cut interest rates much faster next year as inflation quickly approaches the 2% target.
While we consider both upside and downside scenarios for the inflation outlook and monetary policy path, in either case the era of “low for long” interest rates is over and business models should account for a higher cost of capital compared with the pre-pandemic period.
On one hand, private indebtedness is historically high in Europe, which can greatly heighten the sensitivity of the private sector to higher interest rates. The effects of monetary policy tightening have already become apparent in the overall negative loan growth in the euro area. On the other hand, the pass-through from higher interest rates to debt service burdens has been delayed, as companies lengthened maturities of their debt during the period of low inflation. In addition, in many countries, more people have moved to longer-term fixed-rate mortgage contracts, which reduces the direct effect of interest rate changes on homeowners’ mortgage costs. However, a growing proportion of owners and companies have already or will soon need to refinance at much higher interest rates.
The balance of risks continues to lean to the downside
High nominal wage growth, if not absorbed by firms’ profit margins, poses a risk for a more prolonged cost-push inflation dynamic and more persistent inflation in services. This would put additional upward pressure on interest rates, leading to tightening of credit and financial conditions which could precipitate non-linear private sector responses with pullbacks in consumer spending and business investment.
Excessive monetary policy tightening can lead to a resumption of banking sector stress, commercial real estate fragilities and other unknown unknowns that could trigger severe funding pressures on businesses, drive further bank failures and put significant strain on the availability and cost of credit. However, as we argued in our April Outlook, the risk of bank failures in Europe is limited and the position of European banks remains strong.
Geopolitical tensions, including the war in Ukraine, continue to be a key risk and if they intensify, could lead to more energy and food price spikes. Potential harsh weather conditions could exacerbate imbalances in energy markets, particularly ahead of the 2023-24 winter.
The good news is that post-winter natural gas storage levels in Europe are historically high, which has significantly reduced the short-term energy security risk. Despite this, energy costs in Europe remain higher than in the US and many other countries. In addition, in the short to medium term, Europe will remain more vulnerable to potentially more frequent negative supply-side shocks originating in the energy market. On one hand, we will see an increasing share of renewables in the energy mix that should help strengthen Europe’s energy security over time. On the other hand, these intermittent renewable energy sources, due to their fluctuating nature, can make energy supply in Europe more unpredictable. This in turn could trigger large price movements in energy markets that businesses should be prepared for and include in their scenario planning to navigate uncertainty.
While in our baseline we forecast a decline in food price inflation as the effects of previous food and energy commodity price shocks fade and partially revert, there are significant upside risks to this scenario. These include extreme weather conditions in many countries (e.g., very high temperatures in Southern Europe and arrival of the El Niño weather pattern) and policy decisions such as Russia quitting the Black Sea Grain deal and India, as a top rice exporter, banning some shipments of the commodity to reduce domestic price pressures.
Our analysis shows that Europe is more vulnerable to a renewed increase in commodity prices than other major economies, in particular the US. In the event of another spike in energy costs and food prices, CEE countries would be most adversely affected in terms of both GDP and inflation, with the greatest impact on GDP for Czechia, Hungary and Romania and the strongest increase in inflation in Poland, Hungary and Slovakia. Southern and Nordic countries would be affected less, though still more than major non-European economies such as the US or Japan.
Elevated debt levels increase vulnerability to financial market turbulence, especially among emerging markets and developing economies. They also limit the fiscal space to offset new negative shocks and their impact on households and businesses.
An upside risk to the outlook stems from a faster disinflationary cycle and a more rapid supply and productivity rebound supported by a faster labor market rebalancing, easing wage pressures and less cost passthrough. In such a scenario, lower inflation would lead to a lower interest rate path, thereby supporting stronger growth.
Moreover, structural labor market tightness and labor shortages should incentivize firms to invest more in productivity-enhancing and labor-saving technology, including exploiting the economic potential of generative AI. This potential to boost productivity seems to be relatively large in Europe, as European firms lag the US in R&D investment and the adoption of digital technologies.
Summary
In the April edition of our economic outlook, we signalled that latest data increased the likelihood of a softer landing for the European economy. Indeed, it has proven more resilient than many expected and our current growth forecasts for Europe remain largely unchanged. However, the recovery will be sluggish and downside risks continue to prevail. Despite a rapid decline in inflation, nominal wage growth remains strong and service price pressures are proving sticky. With the ECB viewing inflation risks as tilted to the upside, policymakers are more likely to err on the side of doing too much rather than too little. Central bank rates are thus likely to stay higher for longer.
