December brought a noticeable weakening in the macro momentum, as the euro area economy is battling with the triple headwinds of new COVID-19 restrictions, ongoing supply bottlenecks and real household income erosion. With Omicron becoming the dominant variant, many European countries have introduced new restrictions, especially on non-vaccinated citizens, but have so far largely refrained from strict measures such as full-scale lockdowns. While new hospital admissions are increasing again, they remain below levels seen in previous waves. Still, services activity took a noticeable hit from the tighter Omicron containment measures hitting tourism and recreation. Consumer confidence also cooled and fell back below pre-pandemic levels. Rays of light still come from the manufacturing side with tentative signs of easing bottlenecks and shortening delivery times. But overall business surveys suggest economic activity broadly stagnated at the end of Q4 and uncertainty remains high in light of Omicron risks and its impact on supply chains and consumer spending.

Europe’s energy crisis showed signs of calming after natural gas prices have come down some 50% since the late December peak, but it is too early to call it over in our view. Euro area HICP inflation reached another record high of 5.0% in December, as particularly food prices added further to the huge energy contribution and core inflation remained elevated at 2.6%. We forecast headline inflation at 3.2% this year and 1.5% in 2023. Business surveys also point to an easing of cost-push pressures ahead. However, upside risks still stem from the reversal of discretionary fiscal measures, Omicron disruptions, Russia tensions and ongoing green transition efforts. In order to ease green transition challenges, the EU Commission proposed to give the green label now also to nuclear energy and natural gas in its long-awaited taxonomy for sustainable finance, which has received fierce criticism from some EU member states such as Germany, Austria and Luxembourg.

In light of continued inflation upside surprises, ECB initiated the first cautious steps towards policy normalization at the December meeting. In line with the global tightening trend, ECB decided to phase out its PEPP program in March and continue its normal QE program at a slightly higher purchase pace during Q2 and Q3 22, while also leaving the door open for a rate hike in 2023. This will crucially depend on how wages are developing. Although the inflation outlook was significantly revised up for 2022 and 2023, ECB still foresees HICP inflation moderating to 1.8% at the end of the forecast horizon. This seems still too low for ECB to be comfortable with initiating first-rate hike discussions at the current stage, but President Lagarde stressed that ECB will remain data-dependent and adapt its outlook and policy guidance if upside risks to inflation appear. Should the envisioned pick-up in wage growth materialize, we could see a rate hike coming in late 2023, but overall we continue to expect a much more cautious policy normalization approach from ECB than e.g. the Fed.

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