ECB will maintain expansionary course

The ECB Governing Council meets next week. At the last meeting in September, it was made clear that the big decisions would not be taken until the December meeting. These will be about the level of monthly securities purchases under the PEPP program during the first quarter of 2022 and, more importantly, how securities purchases will continue after March 2022. PEPP will then most likely be phased out and we expect the ECB's second purchase program (APP) to be increased and redefined.

Thus, there will be no relevant decisions at the upcoming meeting. The focus will therefore be on assessing developments since the last meeting in September. Since then, it has become clear that the supply shortages are likely to be deeper than previously thought and electricity and gas prices have risen massively. Both have an inflationary effect, through higher prices, as well as a price-dampening effect, as the economy could suffer. It will therefore be interesting to see how the ECB weighs up these factors.

In our view, the sharp rise in energy prices in particular has the potential to dampen economic growth in the Eurozone. Companies will come under pressure and households could cut back their spending in other areas. However, there are significant differences in the speed of price pass-through between Eurozone countries. So the impact will ultimately depend on how long prices stay how high.

In sum, there should be no indication from the ECB next week that it will tighten monetary policy, despite very high inflation rates that are likely to continue rising until the end of the year. Instead, the ECB should emphasize the need for continued strong monetary policy support. The noticeable rise in yields on the bond market during the last few weeks is an additional argument for a continued very loose monetary policy.

EZ – Will inflation continue to rise in October?

Next week, a first flash estimate of inflation in October will be published. In September, inflation rose to 3.4% y/y, due to continued upward pressure from energy prices as well as core inflation. Due to pandemic distortions, a mean of inflation over the last 12 months provides a more solid picture of the underlying trend. At 1.4% y/y, this mean value is currently well below the current inflation value after the negative inflation values from the fall of the previous year are also included in this calculation.

Due in particular to the ongoing upward pressure from energy prices, we expect headline inflation to continue to rise slightly in October. By contrast, core inflation should stabilize at around 2%. We expect headline inflation in the Eurozone to reach its preliminary peak in 4Q, due mainly to the expiry of base effects that distorted core inflation upward in 4Q. However, the further development of energy prices is currently the biggest risk factor to the inflation outlook. We provided background on the triggers of the recent rise in energy prices in the October 1 Weekly Outlook. From January 2022, we expect headline inflation in the Eurozone to decline gradually. We forecast an average inflation rate of 2.2% in 2021 and a slight decline to 1.8% in 2022. However, due to an acute energy shortage as well as ongoing supply chain problems, the risks to this forecast are tilted to the upside.

From a monetary policy perspective, core inflation (inflation-adjusted for energy and food prices) remains in focus. Due to distortions caused by the pandemic, it is also useful here to calculate an average value of core inflation over the past 12 months. This average value of core inflation is 0.9% in September, well below the ECB's price stability target of 2%. Wage developments and thus the recovery of the labor market will be important for core inflation. Depending on the momentum of the labor market recovery, we do not expect sustained wage pressure to exert upward pressure on core inflation until 2023, at the earliest.

EZ – How high was the growth in 3Q?

Next week, a first flash estimate of Eurozone GDP growth in 3Q will be published. In 2Q, the Eurozone economy achieved GDP growth of +2.2% in the previous quarter, thanks to the gradual lifting of corona-related restrictive measures. Private consumption made an above-average contribution to the strong recovery in 2Q. At the country level, Spain and Italy recorded the highest growth rates.

As the corona infection rate was kept under control in 3Q, we expect continued growth in the Eurozone for that quarter. However, we expect a slight decline in growth momentum compared with 2Q. For the current 4Q, historically high energy prices and supply chain issues are the main risk factors for growth. Energy price pressure is weighing on industry profitability; this has already led to initial production cutbacks. We, therefore, expect energy prices to have a dampening effect on industrial production in the winter half-year. In addition, rising household spending on electricity and natural gas will have a dampening effect on private consumption in the coming months. The forward markets do not expect the situation to ease sustainably until the second quarter of 2022.

In our view, the energy issue will remain of considerable importance for the Eurozone's growth outlook in the coming years. This is because the European economy's planned shift away from fossil fuels will lead to far-reaching changes. From an economic perspective, consumption will suffer in the short to medium term at the expense of investment, because the cost of energy will initially rise as a result of the transformation process of the energy system; for example, by extending taxes on CO2. This will put a strain on households' monthly budgets, although policymakers plan to ease the burden on low-income households, in particular. In contrast, the expansion of renewable energy sources and spending on energy efficiency will increase investment activity.

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