Euro area macro monitor: Chilling prospects

Imminent recession fears abated somewhat during November, as sentiment rebounded from subdued levels. Record low unemployment, EUR 600bn of fiscal support and a drop in energy prices from their autumn peaks all helped to lighten the mood of consumers and firms. So has Europe’s crisis ended before it even started? We do not think so. The current economic ‘strength’ is largely a holdover from the past. Manufacturing output continues to receive tailwind from high order backlogs and easing supply constraints. Households still benefit from EUR 800bn of ‘excess’ savings accumulated during the pandemic and government intervention that mitigates the energy shock.

However, cracks have started to appear. Retail sales declined 1.8% m/m in real terms during October, the biggest fall since December 2021. Households face headwinds not only from higher energy bills, but also rising interest rates. The energy crisis is far from over and government subsidies vary significantly across EU countries, as agreement on an EU-wide gas price cap remains elusive. An Ifo survey showed that 75% of German manufacturers have cut back on gas usage without curtailing production, however, 40% also said that more energy savings will necessitate production cuts. Overall, we think a double dip recession is a real risk in the euro area (see Big Picture Euro area - Double dip recession, 28 November) and challenging times lie ahead especially for Germany’s economy (see Big Picture Germany - 'Zeitenwende', 28 November).

On the face of it, the November flash HICP figures brought a welcome decline in headline inflation from 10.6% to 10.0%. However, with core inflation holding steady at 5.0%, the evidence for a similar peak in underlying inflation pressures was less clearcut. Firms continue to pass-on higher input costs to consumers and in spite of an approaching recession, we expect this process of cost-push inflation to extend into 2023. We forecast euro area HICP inflation to average 7.2% in 2023 and 2.9% in 2024, while core inflation will return to the ECB's target only in H2 24 (read more in Euro inflation notes - A 'sticky' problem, 30 November). For ECB, the stabilization in core inflation paired with the weakening growth outlook might be just enough evidence to slow the hiking pace to 50bp in December. However, we expect it to continue guiding for further rate hikes ahead, paired with a reduction of the balance sheet (QT), as 'stickily' high core inflation could remain a concern for ECB for some time yet.

The European Commission presented a first blueprint how to reform EU fiscal rules, which foresees individual member states getting a bigger say in their debt reduction plans, with extra time granted for justified investments and structural reforms, while also strengthening enforcement. We think the proposal is a step to a right direction, but we do not expect the new rules to reduce risks relating to public finances any time soon and some countries like Germany are sceptical about the reform (read more in EU fiscal rules - An evolution rather than a revolution, 21 November). US-EU trade relation have also seen a deterioration in recent weeks, after the adoption of the US Inflation Reduction Act. Gaining a leading position in the green transition race remains key for escaping the current 'stagflationary' dynamics that have captured Europe. Hence, the stakes for the EU to assert its position are higher than in previous transatlantic trade spats (read more in Euro macro notes - Transatlantic ties are in for a chill, 16 November).

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