Euro area: Soft landing – cautious ECB

Moderation recently, but still solid growth

While growth is expected to accelerate to 2.1% in 2018, according to our projections, well above its potential growth rates, we expect a soft landing in 2019 of 1.7% and 2020 of 1.6% (forecasts are broadly unchanged from December's Big Picture although here we include our 2020 forecast). The expansion will be driven primarily by domestic demand (private consumption and investments). In Q1 18, the euro area economy expanded by 0.4% from the previous quarter, likely to have been driven by domestic demand but with less support from net exports. Although temporary factors have been at play, we also see increasing arguments for why the recent moderation is more than just a soft-patch and more permanent factors are at play, in particular capacity constraints such as a shortage of skilled labour.

The combination of low borrowing costs and continuing employment gains means that we are still positive on the outlook for private consumption in the euro area. However, US protectionism/ trade war intentions have hampered confidence. Some weakness spilling over via the trade channel in coming quarters is also possible. Import growth rates are expected to slow marginally, but still grow to record high levels, driven by stronger domestic demand. This means that the contribution from net exports to GDP growth will turn negative form 2019. For 2019 and 2020, we expect GDP growth to moderate to 1.7% and 1.6% respectively, staying well above potential growth, which the European Commission (EC) estimates at 1.5%. Hence, the output gap is expected to turn positive this year, supported by a continued fall in the unemployment rate from its current level of 8.5% to 8.4% by end-2018 and 7.9% by end-2019.

However, uncertainties regarding the slack in the labour market are high. The broader unemployment measure, the so-called U6, indicates that there is still a fair amount of slack in the labour market. The EC estimates NAIRU at 8.3% in 2018. We expect the unemployment rate to fall below the NAIRU in late 2018/early 2019, meaning that wage growth will stay muted despite the recent modest acceleration in certain jurisdictions.

The political landscape in Europe has changed recently. In particular, there are concerns about Italy remaining the most fragile among the big eurozone countries due to a combination of banking sector weaknesses, a high public debt burden combined with a weak growth outlook and political risks. The appointment of a populist government between Five Star Movement and League has brought Italian risks back into the spotlight. Their policy programme, which envisions a big fiscal expansion in clear violation of EU budget rules, has spooked financial markets given Italy's high public debt burden. Although we see the risk of a pro-longed stand-off between the populist government and the EU, our base case remains that it will eventually abide by EU rules. We assess the risk of Italy exiting the single currency as very low, not only due to constitutional hurdles, but also because a majority of the population is still in favour of the euro (see also Italian Election Monitor, 1 June 2018).

At the same time, calls for deeper EU integration led by France's President Emmanuel Macron have been met with opposition from Germany's more reluctant stance. The main differences in view related mainly to increased risk sharing (France's view) and the risk reduction view (Germany's view). The EU summit in late June has long been the key event for embarking on further integration; however, we expect only cosmetic initiatives, in particular given the strong resistance from Germany.

The ECB ‘will cross the bridge when it gets there'

In March 2018, the ECB took its latest step in gradually removing its very accommodative monetary policy stance, when it removed its QE flexibility of being ready to scale up the purchase volume again. That means that the ECB's purchases programme will continue at least until September at EUR- 30bn/month, a purchase rate it commenced in January 2018. We expect a further reduction in the purchase rate in Q4 18 to EUR15bn/month, before the last bond under the government bond purchase programme is bought by the end of the year. Overall, we expect the ECB to adopt a cautious stance on normalising monetary policy in which it will be reactive and not proactive in removing its stimuli measures. While any discussion of the first rate hike is premature in the ECB's view, we expect the first 20bp rate hike in the deposit rate to come in December 2019. See also, Not on Draghi's watch, 20 April 2018. Markets have started speculating on this, in particular given the uncertainty prevailing about the size of the hike. We reflected on this in 10bp, 20bp or ...? ECB in uncharted waters, 20 March 2018, although the ECB will only communicate on this at a relatively late stage.

The ECB's reinvestment policies will gain more importance in its guidance going forward. With reinvestments set to average around EUR10bn/month over the next year, the accommodative monetary policy stance will be ensured. This also supports the ECB's very conscious approach to a gradual normalisation. The ECB seems content with moderately higher yields, but the pace of a potential sharp rise in yields is a concern to it. We believe the ECB is too optimistic on its growth outlook, where the March staff projections pointed to 2.4% in March. With the recent moderation in both soft and hard data, we expect the ECB to revise this figure down closer to our estimate of 2.1%. See Research: Global business cycle is moving lower, 19 April 2018.

While price stability, according to the ECB's definition, is headline inflation ‘below but close to 2%', the key inflation metric to assess is the core inflation, i.e. inflation excluding the volatile food and energy prices, as the ECB also wants a self-sustained inflation path. However, with core inflation only reaching 1.5% by the end of next year, from its current level of around 1%, there is still some way to go. Wage growth in certain jurisdictions will provide some upward pressure on core inflation in particular in 2019. However, at the same time, slack in other parts of the euro area will restrict core inflation from rising markedly in the near future.

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