EY European Economic Outlook – July 2023

Disinflation continues, but the last mile will be the hardest

Inflation in Europe has continued to decline, falling in the euro area to 4.3% in September from its peak of 10.6% in October 2022. Initially, disinflation was driven by base effects and falling energy inflation, but easing supply bottlenecks, weak demand and the drop in commodity prices later began to filter through to core (i.e. non-food non-energy) goods  and food prices. 

Over recent months, energy disinflation has run its course with energy inflation increasing slightly on the back of higher oil prices. Core goods and food price disinflation has continued, though local food price shocks (for example in olive oil whose harvest was severely impacted by drought and heatwave) have made the decline in the food inflation somewhat slower than we anticipated. Coupled with the persistent inflation in services, this has resulted in slightly worse figures than we expected in the July outlook.

We forecast inflation to decline further over the remainder of 2023 as disinflation in food and core goods components continues, while services’ inflation is projected to soften following  the recent decline in September. This view is supported by leading indicators such as PPI inflation and price expectations of companies which continue to decline.

We expect that in 2024, as the indirect effects of past energy and other supply shocks gradually fade,  “free lunch” disinflation  will peter out and labor costs will play an increasingly important role as a driver of inflation. With tight labor markets, workers are using their bargaining power to recoup lost income from the effects of inflation which will maintain upward pressure on wage growth and prices, especially in the services sector where the share of wages in direct input costs is twice as high as in manufacturing. 

While we anticipate headline inflation in the euro area to fall below 3% by the end of 2023, its further decline will be more problematic. We expect headline inflation to remain slightly above the European Central Bank’s 2% target throughout 2024, reaching 2% only in 2025. Core inflation should be even higher in 2024 but is also likely to reach the 2% target in 2025.

Trends in inflation are similar across European economies, but inflation levels vary significantly. This is primarily due to differences in sensitivity to experienced commodity price shocks, varying levels of labor market tightness and some methodological quirks in how inflation is measured in selected countries. The highest inflation rates continue to be seen in CEE countries (in the 7%-12% range, as of September 2023), largely due to their fossil fuel-based energy mixes, higher shares of food and energy in inflation baskets and tight labor markets. The lowest, close to zero, inflation rates are observed in the Netherlands, Denmark and Belgium – countries where energy prices are calculated based on the prices of new contracts only, which has resulted in the currently deeply negative energy inflation.

However, these national disparities will continue to diminish, and we expect that most EU economies will see 2024 headline inflation in the 1.5%-3.0% range. Price pressures are likely to remain elevated in some CEE countries, most notably Poland and Hungary, where tight labor markets, expansionary fiscal policy and the phasing-out of temporary indirect tax cuts and energy price freezes will keep inflation elevated for longer.  

While the monetary tightening cycle is over (almost everywhere), central bank rates are likely to stay higher for longer

In our view, all major central banks are finished with rate hikes, but given persistent price pressures and elevated wage growth, interest rates will stay higher for longer. We expect the European Central Bank (ECB), US Federal Reserve (Fed) and the UK’s Bank of England (BoE) to cut rates for the first time in June 2024 and continue gradual easing afterwards.

• As anticipated in our July outlook, the ECB ended the tightening cycle with a 25bp hike in September and the deposit rate reached 4%, while flagging that interest rates will stay at current levels for some time.
• In line with our expectations, the Fed stayed put in September with interest rates staying at a 22 year high of 5.25%-5.5%. While the dot plot  indicated one more hike this year,  we stick to our view that the tightening cycle in the US has come to an end. 
• Following a 25bp hike in August, the BoE kept rates unchanged at a 15 year high of 5.25% in September (five to four split vote against rate increase), which likely marks the end of the tightening cycle. 

The position of other European central banks differs between countries. CEE monetary policy authorities have already begun, or are about to begin, reducing interest rates. The Swiss central bank has ended  its hiking cycle, while Nordic central banks continue tightening monetary policy.

• The Polish central bank (NBP) surprised analysts with a 75 bp cut in September, followed by a 25 bp interest rate decrease in October to a level of 5.75%. These decisions were driven by the political cycle (elections on 15 October). With the opposition likely to form a new government, uncertainty over the central bank’s next moves has increased. We anticipate the NBP to continue easing but at a slower pace than expected before the parliamentary elections.
• The central bank of Hungary has been normalising interest rates from very high levels (the de-facto policy rate was at 13% as of September versus 18% at its peak) and is expected to continue doing so.
• The Czech (CNB) and Romanian (BNR) central banks have kept interest rates unchanged at recent meetings. We anticipate the CNB to start cutting rates by the end of this year and to continue interest rate reductions at a relatively rapid pace next year (given inflation will hit the 2% target in early 2024 ). The BNR in turn is likely to initiate a very gradual easing cycle early next year.
• The Swiss National Bank made a surprise move in September by pausing interest rate hikes and is now expected to keep rates unchanged at 1.75% for an extended period, as far as early 2025.
• Nordic central banks have continued monetary policy tightening. As of October 2023 interest rates reached 4% in Sweden and 4.25% in Norway and we expect one more rate hike in each country. Given weak currencies and relatively persistent underlying inflation in Sweden and Norway, initial rate cuts are likely to come a few months after the ECB’s first interest rate reduction. 

The impact of monetary policy tightening is yet to be fully felt 

The effects of interest rate hikes are delayed by between four and eight quarters and as a result  their maximum impact will materialize only next year. Debt servicing costs will continue to go up as an increasing share of debt is refinanced at elevated rates. As inflation falls and nominal rates stay unchanged, real rates will continue increasing, resulting in effective policy tightening. That said, the effects of monetary policy vary across countries, not least due to differences in the level of indebtedness and the popularity of fixed rate loans.

The effects of rising interest rates have become apparent in negative credit growth which has been impacted not only by high interest rates, but also tightening credit conditions. The real estate sector is particularly vulnerable to monetary policy tightening, as evidenced by a strong contraction in commercial real estate activity. Housing starts have also declined, while house prices have stabilised in nominal terms following rapid rises during the pandemic, but have fallen in real terms.

A major talking point in financial markets recently has been a significant rise in bond yields, though in Europe they have increased less than in the US. Yields have rallied both at shorter maturities, with markets pricing in that central bank rates will stay higher for longer, and at the long end. The latter has resulted both from the repricing of natural interest rates (i.e., interest rates in long-run equilibrium) and an increase in term premia, which may be related to the expectation of a permanently more expansionary fiscal policy and higher supply of government bonds. While the increase in the risk premium component may be warranted, we do not think that natural interest rates have permanently increased (considering demographic developments, for example, which support a further decline in natural rates). As a consequence, we expect bond yields to decline in the medium term. 

While we estimate that the impact of the recent increase in bond yields on the European economy is likely to be very limited (less than 0.1% of GDP), tighter financial conditions reduce the likelihood of further rate hikes (especially in the US) and, if sustained, may support an earlier policy easing. 

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. 

Geopolitical tensions have again come to the forefront as the key source of risk, with the eruption of the Israel-Hamas conflict.  At the current stage, the effects of the conflict on the European and global economy are likely to be very limited (less than 0.1% of GDP) and come mostly in the form of increased volatility in oil prices and in broader financial markets. However, should the conflict escalate throughout the Middle East, it could lead to a spike in oil prices, supply chain disturbances and a tightening of financial conditions. In addition, the war in Ukraine and potential China-Taiwan tensions continue to be important sources of risk for the global economic outlook.

Energy and food prices are also likely to be volatile, remaining a key source of risk for the inflation and growth outlook. While natural gas storage levels in Europe are very high, thereby reducing the short-term energy security risk, Europe remains vulnerable to energy shocks as gas imports remain fragile and the increase in renewable energy sources makes energy supply more unpredictable. Under these circumstances, any significant shock to supply or demand for energy, such as a total cessation of supply from Russia, a reduction in imports from the Middle East or a harsh winter will still have a substantial impact on prices, even if more limited than at the peak of the energy crisis last year.

Our analysis shows that Europe is more vulnerable to a renewed increase in energy prices than other major economies, in particular the US. In the event of another spike in oil, gas, and coal prices, potentially caused by an escalation of the conflict in the Middle East, CEE and Baltic countries would be most adversely affected in terms of both GDP and inflation. The GDP decline would likely be most significant in Czechia, Hungary and Slovakia, while Poland, Latvia and Slovakia would see the strongest increase in inflation. Southern and Nordic countries would be affected less, though still more than the US.

Weather conditions leading to droughts, heatwaves or late spring frosts constitute an important source of risk for food prices. Geopolitical tensions may also lead to further food price shocks. 

Inflation may also prove more persistent for other reasons. High nominal wage growth, if not absorbed by corporate profit margins, poses a risk of more prolonged cost-push and demand-pull inflation, resulting in more persistent inflation in services. This would extend the era of high interest rates even further, with negative consequences for consumer spending and business investment.

The environment of high interest rates also generates additional downside risks: banking sector stress could resume, commercial real estate fragilities could spill out of control and other unknown unknowns could trigger severe funding pressures on businesses, drive further bank failures and place a significant strain on the availability and cost of credit. 

Last but not least, 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.

One should not be overly pessimistic though, as there are also upside risks to the outlook. One of these  stems from a faster disinflationary cycle and a more rapid supply and productivity rebound supported by a swifter  labor market rebalancing, easing wage pressures and less cost passthrough. In such a scenario, reduced inflation would lead to a lower interest rate path, thereby supporting stronger growth.