Eurozone Economic Outlook: Does Monetary Tightening Lie Ahead?

Executive Summary

The economic expansion in the Eurozone is firmly underway, with real GDP increasing 2.7 percent in Q4 year over year. Although a breakdown of the GDP data into its underlying demand components is not yet available, monthly economic data suggest that the expansion is strengthening and likely self-sustaining. In this report, we highlight the solid growth seen across multiple sectors of the Eurozone economy at present, as well as discuss the European Central Bank’s (ECB) transition towards policy normalization and eventual tightening.

Although the economic data have been indicative of increasingly self-sustaining growth, inflation in the Eurozone remains benign. CPI inflation fell significantly from 2012-2015, causing the ECB to cut policy rates and implement a quantitative easing (QE) program. As inflation slowly begins to pick up and growth remains solid, the Governing Council is now tasked with ending its QE program and eventually beginning to hike rates. We look for the ECB to gradually begin to raise rates in H1-2019 by first hiking its deposit rate, while keeping the overnight interbank rate and two-week refinancing rate unchanged. In the midst of a slow path toward policy normalization, our currency strategy team looks for the euro to appreciate against the dollar as the greenback weakens over the coming quarters and the ECB gradually begins to tighten. Although growth is increasingly broadbased, we also acknowledge several risks to our outlook, including political uncertainties in Germany and Italy or the potential for another sovereign debt crisis like the one seen in 2010-2012. That said, we see these risks as largely manageable at present, and look for real GDP to increase 2.2 percent in 2018 and 2.0 percent in 2019.

Q4 GDP Growth Supportive of Broad-Based Expansion

Preliminary data that were released today showed that real GDP in the Eurozone rose 0.6 percent (2.3 percent on an annualized basis) in Q4-2017 relative to the previous quarter (Figure 1). On a year-ago basis, Q4 growth matched consensus estimates at 2.7 percent, and the Q3 data were also revised upward to 2.8 percent year over year.

The breakdown of the Q4 GDP data into its underlying demand components will not be available until February 14, but monthly economic indicators and disaggregated data from past quarters reveal the solid nature of the expansion at present. Consumer spending as measured by real retail sales remains solid in Q4. Real retail sales rose 0.1 percent (not annualized) through the first two months of Q4 relative to Q3, and they were up 2.7 percent in November on a year-ago basis (Figure 2). Businesses are hiring—employment was up 1.7 percent in Q3 relative to the same quarter in 2016—and higher employment is creating more disposable income which is supporting consumer spending. The unemployment rate in the Eurozone currently stands at 8.7 percent (Figure 3). Although this rate is elevated relative to its low in 2007, it has receded significantly over the past five years from its record high of 12 percent. Low inflation—the overall CPI is up just 1.4 percent—is also supportive of growth in real income (Figure 4).

But real PCE is not the only area of spending that is growing in the euro area at present. Solid growth in the rest of the world is boosting real exports of goods and services. Real exports for the first two months of Q4 were up 0.5 percent relative to Q3, and on a year-ago basis are up more than 5 percent. We do not have any direct monthly indicators for capital expenditures or government spending; however, the disaggregated data available from the Q3 GDP report support the expansion currently in place. Real investment spending was up 4.2 percent year over year in Q3, and real government expenditures grew 1.1 percent. These increases in spending across the spectrum are a good sign because real GDP growth that is broad-based tends to be self-sustaining, everything else equal.

Indeed, we forecast that real GDP in the Eurozone, which grew 2.5 percent in 2017, the strongest annual rate since 2007, will expand another 2.2 percent this year and 2.0 percent in 2019. Because these forecasted growth rates exceed estimates of long-term potential growth rates in most Eurozone countries, the unemployment rate in the euro area should continue to recede in the next two years.

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