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Economic Outlook Eurozone Q2 2023: Rate Rises Weigh On Return To Growth

A Complicated But Not Dire Economic Outlook

GDP growth for 2023 should be slightly higher than we previously estimated, at 0.3% compared with 0.0%. However, this revision is not akin to stronger demand. Given that the growth carryover from 2022 is 0.4% after a solid year-end for the European economy in the fourth quarter, our scenario for 2023 is still one of stagnation, with continued elevated risk of a mild recession. Indeed, the economy needs time to absorb and adapt sustainably to the unprecedented terms-of-trade shock stemming from the war in Ukraine. We have also revised down our GDP forecast for 2024 to 1.0% from 1.4%.

Inflation is even more persistent than expected, and this will force the European Central Bank (ECB) to raise rates more than we had originally thought, probably until the deposit facility rate reaches 3.50% by the summer, barring further financial market turmoil that could jeopardize prospects for growth and inflation. With monetary policy clearly turning restrictive in 2023 and likely to remain so in 2024, we think it will take until 2025--when inflation has returned to target and monetary policy to neutral--for the European economy to close the negative output gap it has accumulated since the pandemic, and which it would have closed in 2022 without the geopolitical shock (see chart 1). We expect GDP growth to be more solid in 2025 and 2026, at 1.7% and 1.6% respectively.

While conditions were favorable at the beginning of this year, whether in terms of production, demand, or employment, we think 2023 and 2024 will prove complicated years for the European economy, for several reasons. Firstly, long-term interest rates are likely to exceed inflation in 2024 for the first time in several years, which will inexorably slow down domestic demand, weighing on its financing. Added to this, the strong momentum seen in 2022 in industrial production and the labor market is likely to wane somewhat as the recovery from COVID-19 begins to level out. However, complicated does not mean dire: fiscal measures, accelerating wages and disinflation, should bring some relief to consumer spending; the reopening of China should help tourism demand to fully normalize; and public investment schemes will help cushion the cyclical slowdown and could enhance long-term GDP.

Chart 1


Inflation Still Points To Higher Interest Rates

A few positive developments can be observed on the inflation front, but this is certainly no "all clear". Higher up the price chain, producer prices have more than halved since the peak of inflation, reaching "only" 15% growth year-on-year versus more than 40% last summer. Further down the price chain, consumer price inflation also appears to have peaked, with headline Harmonised Index of Consumer Prices (HICP) falling to 8.5% in February from a peak of 10.6% in October (see chart 2). The drop in consumer price inflation is largely driven by the energy component, which now accounts for 1.5 percentage points (pps) of total inflation compared with 4.5 pps in October. This reflects lower commodity prices and government measures taken to shield the consumer.

That said, the decline in consumer price inflation is likely to be a slow process, and we expect HICP to remain about 4% at the end of the year. This is for two reasons: first, food prices, which accelerated again in February and now contribute twice as much as energy to overall inflation. Second, less-volatile price components, which saw core inflation accelerating to 5.6% in February because of pressure on services prices. Core inflation in the eurozone is now as high as that in the U.K. and the U.S.

Even more striking, core inflation is as high as growth in unit labor costs (see chart 3), while the output gap is still supposed to be negative. This unusual pattern suggests a strong pass-through from costs (both labor and nonlabor) to retail prices, to the point that companies' profits may have increased. This is what president of the ECB Christine Lagarde suggested in her recent speech to the European Parliament. These developments led us to revise our forecasts for inflation up to 5.9% for 2023 and to 2.7% for 2024. A return to the central bank target is not foreseen before first-quarter 2025 for headline inflation, and not before third-quarter 2025 for core inflation.

Chart 2


Chart 3


When core inflation is almost three times the target and still accelerating, the monetary policy response of a central bank with a price stability mandate like the ECB should be beyond doubt: policy rates must go up. Given that core inflation is unlikely to peak before late spring, we think the ECB could raise the deposit facility rate to 3.50% from the current 3.0% by the summer, but in prudent 25-basis-point steps and barring further market turmoil. Potential fragilities in the banking system and concerns over financial stability are on the rise but they should be addressed by policy instruments other than interest rates (see "The Macro Fallout from the Silicon Valley Bank Collapse Appears Limited for Now," published March 16, 2023). The ECB has plenty of instruments at hand to steer bank and market liquidity. On March 16, 2023, following Swiss authorities' decision to support troubled bank Credit Suisse, Ms. Lagarde confirmed to the press that the ECB will ensure a continued smooth transmission of monetary policy. The withdrawal of liquidity has so far been swift, with the Eurosystem's balance sheet having shrunk by 11% (€1 trillion) since its peak in June 2022, through targeted longer-term refinancing operations (TLTRO) repayments. In the meantime, the ECB has started to withdraw liquidity directly from bond markets by not reinvesting €15 billion per month in bonds maturing from its asset purchase program (APP) portfolio.

The ECB is due to reassess the pace of reinvestments in June and, prior to the market turmoil in mid-March, the consensus was for a sharper reduction in reinvestments from July (to €22 billion per month), which would be equivalent to a full stop on APP reinvestments (see chart 4). Steering market expectations downward on this amount could be a way for the ECB to calm market tensions if they persist. Should tensions abate, we see no reason why the ECB would continue to reinvest in a quantitative easing (QE) program that was intended to revive inflation at a time of undershooting. Diminishing reinvestments in another QE program, the pandemic emergency program (PEPP), is a different story. Since it is unlikely that domestic demand will fully recover from the fallout of COVID-19 before the end of 2024 (see chart 1 on the output gap), we see a case for the ECB to continue to fully reinvest this program until then.

Chart 4


Tighter Monetary Policy Will Further Dampen Domestic Demand In 2024

We think the ECB could decide to stop raising rates this summer, as high interest rates take their toll on the economy, assuming current market tensions ease and do not undermine the outlook for growth and inflation. A high degree of bank intermediation and sensitivity of European savers to interest rates makes the transmission of monetary policy quite direct. We can already see that the household savings rate has stopped falling and stabilized at 13.3% in third-quarter 2022, slightly above its long-term average and contrasting with the decline in personal savings rates still observed in the U.S. The stabilization in the saving rate of European households reflects a sharp slowdown in new bank loans to the private sector stemming from tighter credit standards and rising interest rates. The credit impulse (that is, the flow of bank loans to eurozone residents excluding government to GDP) has turned negative, pointing to a slowdown in GDP growth (see chart 5). Monetary policy--through higher interest rates and reduction in bank liquidity--is already dampening domestic demand, which should help bring down core inflation. What's more, the restrictive impact of monetary policy will strengthen over the next 12 months. We estimate that it takes up to 10 quarters for housing demand and prices to fully reflect higher interest rates (see "European Housing Prices: A Sticky, Gradual Decline," published Jan. 11, 2023). Gradual and lagged effects of monetary policy tightening are the main reason we expect the recovery in 2024 to be subdued, because periods of positive interest rates in real terms are always associated with low GDP and investment growth (see chart 6).

Chart 5


Chart 6


Production Might Weaken In Second-Half 2023

A key factor in the European economy's solid performance over 2022 was industrial production catching up on backlogged orders that had accumulated during the pandemic. This boost in production benefitted GDP, exports, and employment. Thanks to easing supply chain bottlenecks, including port congestion and semiconductor shortages, European industry was able to raise production to an all-time high last year (see "Economic Outlook Eurozone Q1 2023: Reality Check", published Nov. 28, 2022), and current order levels indicate that it still has five months of assured production. Alongside lower prices for industrial and energy commodities, this should ensure industrial production remains steady until the summer.

While European industry had a strong start to 2023 with production up 0.7% in January, driven by energy-intensive sectors, new orders have decreased significantly. Unless there is a strong rebound in new orders—potentially driven by China's reopening--the upward trend in European production is likely to lose steam in the second half of 2023, with possible implications for the labor market (see chart 7). Fading momentum in industrial production and a slowdown in construction caused by higher interest rates over this year and next lead us to expect a slight increase in the unemployment rate, which we forecast will rise to 7.2% in 2024 from 6.7% in 2022.

Chart 7


Rising Wages And Public Investment Will Prevent A Eurozone Recession

While monetary policy will increasingly dampen domestic demand this year and next, and the production cycle will lose steam, we expect other factors will support the European economy.

First, nominal wage growth is set to accelerate. The number of unemployed per job vacancy is still unusually low (see chart 8). Negotiated wages have increased at a moderate pace (3% at the end of 2022), but marginal wage growth is 6% (see "Marginal Wage Growth In The Eurozone May Be Starting To Cool," published Jan. 18, 2023) and recent wage agreements point to an acceleration toward 5% growth in total pay next year. Higher wages will increase households' purchasing power, even more so as consumer prices are likely to increase at a slowed pace.

Second, governments have taken, or they have already reconducted, measures to shield the consumer from the energy price shock in the form of prices cap and subventions. The Bundesbank estimates that the relief measures on consumer prices could have an effect of -1.9 pps on the headline inflation rate in 2023. In France, a study by INSEE estimates that inflation between the second quarter of 2021 and the second quarter of 2022 would have been 3.1 pps higher without the "tariff shield".

And lastly, NextGen EU (NGEU's) implementation will lift public investment. Money has flown from the European Commission to beneficent countries. They have until 2026 to invest it, which should raise GDP by 0.5% to 0.6% in 2023, and 0.4% in 2024 and 2025, according to the ECB (see "Next Generation EU: A Euro-Area Perspective," in the ECB Economic Bulletin, Issue 1/2022; see also chart 9). These recent estimates place the benefits of NGEU on GDP growth close to the high-impact scenario we projected two years ago (see "Next Generation EU Will Shift European Growth Into A Higher Gear," published April 27, 2021).

NGEU's impact is not only important in terms of growth; its timing also matters. Its start, originally planned for 2021, has been delayed because of multiple exogenous shocks, but the goal remains to have the plan's full amount--mostly the recovery and resilience facility (RRF)--invested by 2026. Public investment efforts will therefore need to focus on the plan's final years as the European economy slows and is at risk of recession. Ultimately, NGEU may end up bringing more countercyclical benefits than expected.

Chart 8


Chart 9


Risks To The Macro-Outlook Still Point To The Downside

Geopolitical developments continue to weigh on the macro-outlook. Otherwise, downward risks relate less than three months ago to a possible resumption of the energy crisis. Gas inventories in Germany are about two-thirds full as of mid-March, which is three times the average of the past three years at the end of winter. This suggests that the marginal effort to refill inventories in preparation for the next winter should not be insurmountable (see "S&P Global Ratings Cuts 2023 European, U.S., And Canadian Gas Price Assumptions on Lower Demand," published Feb. 23, 2023).

On the other hand, the downside risks associated with an unwarranted and disorderly tightening of global financing conditions are clearly on the rise, as evidenced by the recent market turmoil (see chart 10). This risk will continue to strengthen as real long-term yields move from negative to positive, especially in 2024.

Chart 10


That said, should financial stability be ensured, risks to our economic outlook could also be on the upside. Disinflation could be quicker than thought, as pent-up demand wanes. The unemployment rate may not rise this year, because job vacancies are still high. Stronger external demand from China's reopening (for example, on tourism and the European industry) is possible. The contribution of public investment to GDP may turn out to be stronger than expected if the implementation of the NGEU plan catches up with its original schedule. The largest recipient countries, such as Spain and Italy, would particularly benefit.

Our forecasts were developed during a period of high market volatility and significant policy changes, and therefore have wider-than-normal confidence bands.

S&P Global Ratings European Economic Forecasts (March 2023)
Eurozone Germany France Italy Spain Netherlands Belgium Switzerland U.K.
2021 5.3 2.6 6.8 7.0 5.5 4.9 6.1 4.2 7.6
2022 3.5 1.8 2.6 3.9 5.5 4.5 3.1 2.1 4.0
2023 0.3 0.0 0.4 0.4 1.1 0.9 0.5 0.6 (0.5)
2024 1.0 0.9 1.2 1.0 1.6 1.3 1.4 1.2 1.5
2025 1.7 1.8 1.6 1.4 2.3 1.8 1.8 1.7 1.8
2026 1.6 1.7 1.4 1.4 2.2 1.9 1.3 1.2 1.6
CPI inflation
2021 2.6 3.2 2.1 1.9 3.0 2.8 3.2 0.6 2.6
2022 8.4 8.7 5.9 8.7 8.4 11.7 10.4 2.9 9.1
2023 5.9 6.7 5.4 6.5 4.6 4.8 4.6 2.5 5.8
2024 2.7 2.9 2.3 2.3 3.2 3.4 2.6 1.5 1.4
2025 2.0 2.0 2.0 2.0 1.7 2.3 1.3 1.5 1.1
2026 1.9 1.6 2.1 2.0 2.0 2.3 1.8 1.6 1.7
Unemployment rate
2021 7.7 3.6 7.9 9.5 14.8 4.2 6.3 5.1 4.5
2022 6.7 3.0 7.3 8.1 12.9 3.5 5.5 4.3 3.7
2023 6.9 3.2 7.6 8.2 13.0 3.9 5.9 4.2 4.3
2024 7.2 3.2 7.9 8.2 13.2 4.0 6.0 4.2 4.5
2025 7.0 3.1 7.9 8.0 12.9 3.8 5.9 4.0 4.2
2026 6.8 3.0 7.6 7.8 12.6 3.7 5.7 4.0 4.0
10-year government bond (yearly average)
2021 0.1 (0.3) (0.1) 0.8 0.4 (0.2) 0.0 (0.2) 0.7
2022 1.8 1.2 1.6 3.2 2.2 1.4 1.7 0.8 2.3
2023 3.4 2.8 3.3 4.7 4.0 3.3 3.4 1.6 3.5
2024 3.7 3.1 3.6 5.0 4.3 3.3 3.7 2.1 3.4
2025 3.5 2.8 3.3 4.8 4.1 3.1 3.4 1.9 3.3
2026 3.4 2.7 3.2 4.7 3.8 3.0 3.3 1.8 3.3
Eurozone U.K. Switzerland
Exchange rates USD per euro USD per GBP Euro per GBP CHF per USD CHF per euro
2021 1.2 1.4 1.2 0.9 1.1
2022 1.0 1.2 1.2 1.0 1.0
2023 1.1 1.2 1.1 0.9 1.0
2024 1.1 1.3 1.2 0.9 1.0
2025 1.2 1.4 1.2 0.9 1.1
2026 1.2 1.4 1.2 1.0 1.1
Eurozone (ECB) U.K. (BoE) Switzerland (SNB)
Policy rates (end of year) Deposit rate Refi rate Bank rate
2021 (0.5) 0.0 0.3 (0.8)
2022 2.0 2.5 3.5 1.0
2023 3.5 4.0 4.3 1.8
2024 3.0 3.5 2.9 1.3
2025 2.0 2.5 2.5 1.0
2026 2.0 2.5 2.5 1.0
Source: S&P Global Ratings Research.

This report does not constitute a rating action.

EMEA Chief Economist:Sylvain Broyer, Frankfurt + 49 693 399 9156;
Economist:Aude Guez, Frankfurt 6933999163;

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