Euro area: Back in the fast lane

After a contraction of -0.3% q/q in the first quarter, euro area GDP expanded by a strong2.0% q/q in Q2 21, confirming that the economy has now firmly arrived on the road to recovery. That said, in contrast to the US and China, euro area GDP remains still some 3% below its pre-pandemic level. Business and consumers surveys still paint an upbeat picture during July, with the euro area services recovery seemingly accelerating during Q3and unemployment has fallen back below 7.7% in June (from a peak of 8.6% last year). However, bumps on the road could still create setbacks: supply chain bottlenecks remain widespread in the manufacturing sector and have started to weigh on production levels despite full order books. The continued spreading of the delta variant also poses a headwind that could hit the tourism, travel, and hospitality sectors (although we do not expect renewed lockdowns). A key question will be how the economic expansion continues in 2022 when the government’s emergency measures are gradually scaled back and higher inflation (see below) is starting to weigh on consumer real disposable incomes.

As part of its strategic review, the ECB introduced a new monetary framework, with an asymmetric 2% inflation target. ECB will aim for inflation to fluctuate around the 2% target, but the implementation will be more flexible compared to Fed’s Average Inflation Targeting (AIT), which explicitly requires making up for any past inflation misses(read more in ECB Research -Strategic Review: Striving for symmetry. ECB’s first meeting since the new strategy took effect was mostly about aligning its forward guidance on rates to the review outcome. Policy rates are now expected to remain at their present or lower levels until ECB sees inflation reaching 2% well ahead of the end of its projection horizon and durably for the rest of the projection horizon, and that this is also confirmed by underlying inflation. Essentially, ECB wants to observe realized inflation printing closer to/at the target earlier in the forecast horizon (currently until 2023) compared to the previous medium-term orientation. In our view, it is more of a change in wording rather than substance, as the ECB failed to also back up its new inflation ambitions with new monetary policy tools(see also ECB Research: Stepping up on inflation ambitions, but not on tools.

Inflation surprised on the upside in July, with German inflation surging above 3% (highest since 2008) and also euro area HICP inflation printing at 2.2%, formally above the ECB’s new target. Energy prices remain an important driver, but technical base effects related to Germany’s temporary VAT cut in H2 20 were the main culprit behind the observed inflation surge. We expect to see some high core inflation rates of 1.3-1.4% over the next 6 months due to the VAT effects, giving the hawks in the ECB GoverningCouncilsome ammunition to push for an end to crisis-fighting tools (read PEPP) sooner rather than later. However, with the turn of the year, we expect inflation pressures to subside again (read more in Research Euro Area -Mind the inflation gap. This should ensure continued accommodative monetary policy stance from ECB, especially as the criteria for interest rate increases have been raised with the new framework.

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