Euro area macro monitor: Caught in the stagflation trap

Stagflation remains the big euro area theme, as inflation pressures intensified, while consumers and firms grew more cautious on the outlook during March. The first data releases after Russia’s invasion of Ukraine made for an ugly reading. ZEW expectations, Ifo business climate, investor and consumer confidence all plunged to levels last seen during the pandemic. That said, other indicators such as the PMIs presented a less bleak picture. The truth probably lies somewhere in between, i.e. a marked growth slowdown, but not necessarily yet a euro area recession. Consumers’ reaction will be crucial for the economic fallout. Unemployment expectations have risen during March, while the willingness to spend has abated in light of high uncertainty, which suggest a slowdown in private consumption growth lies ahead, but elevated levels of savings from the pandemic also provide some buffer for consumption in our view.

The manufacturing sector remains especially exposed to renewed supply bottlenecks and Russia's request for gas payments in roubles increases the risk of a halt in energy flows. Germany, Austria and Italy continue to reject a Russian energy embargo, arguing that the economic consequences are too severe, but pressure on the EU is rising to step up its sanctions response and divisions among member states have become ever more apparent. As we outlined in Research Russia - EU embargo on Russian energy could be a game-changer, 23 March, an embargo on Russian energy would be among the most effective ways to pressure the Russian economy. A sudden stop for energy imports, would, however push European energy prices even higher and likely lead to power outages especially for energy-intensive industries. HICP and core inflation already rose to new record highs of 7.5% and 3.0% during March and with cost-push inflation still working its way through pricing chains, we doubt that we have seen the inflation peak yet.

EU governments have tried to limit the economic fallout through a range of support measures for households and firms (i.e. fuel rebates, tax cuts, subsidies to low income households and incentives for energy saving measures, see overview next page). ECB estimates that additional fiscal measures announced in the euro area since the invasion amount to ca. 0.4% of GDP, a smaller fiscal stimulus as seen during the Covid-19 pandemic. However, we see scope for measures to be stepped up in line with growing recession risks, not least amid growing calls to prolong the exemption of EU fiscal rules beyond 2023.

Stagflation presents a policy dilemma for ECB, but at the March meeting the Governing Council nevertheless decided to accelerate the pace of policy normalisation, with faster QE tapering in Q2 and net purchases to end in Q3 22, paving the way for a potential first rake hike as early as September this year, as markets are currently pricing. We continue to expect a 25bp only by December, but with inflation continuing to surprise on the upside, the balance of risks lies towards a faster policy tightening. Especially the development of wage growth remains an important variable to follow in that respect (read more in Euro inflation notes - The wage conundrum, 1 April).

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