EY European Economic Outlook – July 2023

We forecast euro area inflation to reach 2% by the spring

Inflation has continued to decline, with the euro area noting 2.9% inflation in December 2023 due to the effects of earlier supply shocks gradually fading, supported by reduced supply bottlenecks, weak demand, pass-through from the drop in commodity prices, and falling inflation expectations. Disinflation has finally encompassed services, while both headline and core inflation have surprised to the downside in recent months. 

We expect disinflation in the food, core goods and services components to continue in the coming months, while energy inflation is set to rise. The inflation rates in food and core goods are predicted to fall below 2% around mid-year as the effects of earlier shocks partially unwind, though disruptions to Red Sea shipping constitute an upside risk to this forecast. However, service inflation may stabilize close to 3%, mainly as elevated wage growth continues to exert pressure on costs in labor-intensive sectors. Simultaneously, energy inflation is expected to gradually increase towards 0% from current negative levels, as substantial price drops recorded in 2023 H1 fall out of the calculation.

Taken together, we anticipate headline inflation in the euro area to reach the ECB’s target of 2% in 2024 Q2 and subsequently fall slightly below this level. Concomitant to this, core inflation is expected to drop to 2.5% in 2024 Q2 from 3.4% in December 2023, but may linger slightly above 2% until mid-2025, given the persistent pressure on prices in services.

While inflationary trends are similar across European economies, inflation levels continue to vary, even though disparities are narrowing. The highest inflation rates continue to be seen in Central and Eastern European countries (CEE: in the 5%-8% range, as of December 2023). These countries were most significantly impacted by the commodity price shocks of 2021‒22 due to their fossil fuel-based energy mixes, higher shares of food and energy in inflation baskets, and tight labor markets. While inflation in the CEE has been declining rapidly on the back of weak demand and reversal of supply shocks, it remains high. In contrast, the lowest inflation rates, below 1%, are observed in the Netherlands, Italy, Denmark, and Belgium, where energy price spikes were highest and therefore price reversal is the strongest due to lesser regulation of energy prices and issues related to CPI measurement (the inclusion of only new energy contracts into CPI calculations).

We anticipate disparities between nations to dwindle – the 2024 headline inflation is expected to fall within the range of 1.5%–3.0% in most EU economies. Two clear outliers will likely include Romania, where inflation is stickier due to robust domestic demand and thus we project it to exceed 5% in 2024. The other is Denmark, where price pressures have been particularly weak, leading to our forecast of inflation below 1% in both 2024 and 2025..

We expect the ECB to ease monetary policy, beginning in Q2, but to a lesser degree than markets expect

Given headline inflation approaching the 2% target, we expect the ECB, Fed, and the Bank of England (BoE) to initiate an easing cycle during April–June 2024, with rates ending the year around 1 pp below current levels. Even though ECB communication has retained its hawkish tone, a faster-than-expected decline in inflation, which is already close to the target, economic stagnation, and cuts in the Fed’s interest rates will likely bring about normalization of interest rates in the euro area, beginning in the second quarter. We predict cuts to ECB rates at every meeting until the deposit rate reaches 2.75%–3%. Rates may then stabilize for a while, considering that we forecast core inflation to stay slightly above the target until mid-2025.

Following Norges Bank’s 25 bp hike in December 2023, Swiss and Nordic central banks have finished increasing interest rates. However, the first cuts are expected to come several months after the ECB begins reducing rates (Sweden and Norway in Q3, Switzerland in December) due to weak currencies and more persistent price pressures in the Nordics and a lower inflation target of 0%–2% in Switzerland. 

Central and Eastern European central banks are ahead of the more advanced economies in their monetary easing cycle, although the pace of easing varies between countries. 

We foresee that the Hungarian and Czech central banks will cut rates relatively quickly throughout 2024, by 4.75 pp and 3.25 pp, respectively. This is attributed to rapid disinflation, in addition to high interest rate levels in Hungary and very weak demand in Czechia. In contrast, Poland’s rates may remain constant throughout the year, following earlier cuts. In Romania, the easing of monetary policy may be postponed until mid-year due to persistent inflation.

The balance of risks continues to lean to the downside 

The economic outlook remains highly uncertain, with the balance of risks continuing to lean towards lower GDP growth and higher inflation in Europe. In the short term, the key risk stems from a prolonged downturn in manufacturing. Monetary policy effects and their lags are subject to substantial uncertainty and may prove to be stronger and more delayed than currently expected. As a result, the downturn in manufacturing and stagnation in world trade may continue longer than anticipated, leading to sub-trend economic growth and reduced labor demand. This, in turn, could trigger an increase in job losses and unemployment, further slowing economic activity.

We estimate that if global trade stagnates throughout 2024, growth in euro area GDP will be 0.4 pp lower than the baseline scenario in both 2024 and 2025. Switzerland, Germany, Czechia and Hungary will be among the countries most affected, while Southern Europe will be least impacted. Germany’s GDP will shrink by 0.7% in 2024, compared to the baseline prediction of a 0.1% contraction.

Geopolitical tensions continue to pose a downside risk. An increase in tensions related to the war in Ukraine, escalation of the conflict in the Middle East or strained China-Taiwan relations may generate spikes in commodity prices, further increase shipping costs, and create renewed bottlenecks in world trade. This might precipitate a renewed increase in inflation and adversely affect global economic activity. 

Energy and food prices may also rise due to factors beyond geopolitics, such as unfavorable weather conditions or local political unrest. These circumstances could reduce the supply of or increase demand for energy and food commodities, prompting a resurgence in inflation and a reduction in economic activity.

In a high interest rate environment, there is a heightened risk of financial market turbulence originating from the banking sector, commercial real estate or sovereign debt markets. Specifically, with inflation no longer bolstering revenue growth or contributing to reducing debt to GDP ratios, and with spending on interest payments and other components, often indexed to past inflation, continuing to increase at an accelerated rate, the risk of renewed stress in emerging economies’ sovereign bond markets, or those in Southern Europe, is on the rise.

Despite significant downsides, there are factors posing an upside risk. Disinflation may continue faster than expected, with inflation running below central bank targets for some time, leading to a faster and stronger cycle of monetary easing. This could be facilitated by a further decline in commodity prices to pre-pandemic levels. Lower inflation and interest rates would support real incomes and spending, thereby stimulating economic activity.

The rebound in consumption may also outstrip current expectations. With improving sentiment and declining interest rates, European consumers may decide to utilize some of their substantial excess savings accumulated during the pandemic. This would result in stronger GDP growth.