At its 10 March meeting, the ECB paved the way for raising its key deposit rate, although the timing of the first rate increase remained uncertain at the time: the odds of a September move had declined compared to a few weeks ago and July was excluded, which left December. The wait-and-see approach still seemed appropriate given the increasing downside risks to growth, aggravated by the current inflationary shock, the war in Ukraine and China’s zero-Covid strategy. Yet economic data reported in the meantime, as well as the hawkish tone of several ECB members, seems to have accelerated the tempo. Concerning data, it is the combination of high inflation, a weak euro and relatively resilient growth that has moved forward the lift-off date.
The sharp rise in energy prices since April 2021 has been the main driving force behind the current surge in Eurozone inflation. The outbreak of war in Ukraine on 24 February accentuated this trend, sending the energy component of the harmonised index of consumer prices (HICP) up 44.4% y/y in March 2022. Faced with this situation, the governments of the four main Eurozone economies under review in this article have acted to try to buffer the shock on economic players, and notably on household purchasing power, via direct subsidies, tax cuts, price regulations and measures to boost nominal incomes
At first glance, higher inflation seems like good news for governments. After all, inflation erodes the real value of debt and lowers the public debt/GDP ratio through a higher nominal GDP. However, the impact of inflation on public finances depends on whether higher inflation was anticipated by financial markets and on its expected persistence. Both factors would influence the borrowing cost and hence the dynamics of the debt ratio through the difference between this cost and nominal GDP growth. Public finances should benefit from having a central bank that is credible in its ability to keep inflation expectations well anchored and is not afraid of tightening policy when inflation has moved well above target
In the space of just a few months, growth prospects in the eurozone have deteriorated markedly. So much so that the risk of a recession is looming this year. Between our growth forecast from early 2021 – when it peaked at 5.5% – and our current scenario, drawn up in mid-March 2022, expected growth has been about halved; we now expect a figure of 2.8%. As recently as November 2021, we were still forecasting 4.2%. This figure of 2.8% still looks very high, as it is well above the long-term trend rate of 1.6% per year on average between 1996 and 2019. However, it relies on an exceptionally high growth carry-over of 2.1% in Q1 2022 and, for the subsequent quarters, on projected weak but positive growth
At first glance, the significant depreciation of the euro looks like a blessing for the ECB. Via its mechanical effect on import prices, it should remove any remaining doubt about the necessity of hiking the deposit rate. However, upon closer inspection, there is concern that the weaker euro, through its effect on inflation and hence households’ purchasing power, will weigh on growth. This would warrant a cautious approach in terms of policy tightening. On balance, a deposit rate hike in the second half of the year looks like a certainty, but the real question is about the scale and timing of subsequent rate increase. This will depend on how the inflation outlook develops.
Growth in outstanding bank loans to NFCs decelerated in March 2022 (4.2%, from 4.5% in February) for the first time since September 2021 (by way of comparison, real year-on-year GDP growth was 5% in Q1 2022, from 4.7% in Q4 2021 according to Eurostat’s preliminary estimate, masking a slowdown on a quarterly basis, +0,2% q/q in Q1 2022 against +0,3% q/q in Q4 2021). Because of a substantial comparison effect (between March and August 2021, the virtual cessation of new guaranteed loans to NFCs and a first wave of loan repayments put the brakes on growth in lending), the impulse of credit to NFCs (reflecting the change, over a year, of the annual growth in outstanding loans) continued to improve – whilst remaining negative – to -1.0% in March 2022, from -2.6% in February.
The outstanding amounts of loans and advances that are still subject to banking support measures, introduced in response to the Covid-19 pandemic[1], continues to decrease in the eurozone. It was EUR444 billion in the fourth quarter of 2021, or 3.1% of total loans, from EUR494 billion, 3.5% of the total, in the third quarter of 2021. This decrease related nearly exclusively to loans subject to moratoria compliant with the European Banking Authority guidelines[2], for which preferential prudential treatment came to an end on 31 December 2021. The outstanding amounts of loans subject to public guarantee schemes and loans subject to forbearance measures almost stabilised in the fourth quarter of 2021, at EUR438 billion
The war in Ukraine compounds the ECB’s task of balancing the fight against inflationary risks with the need to support growth. At the monetary policy meeting on 10 March, inflation was the predominant concern and the central bank announced that net securities purchases under the Asset Purchase Programme (APP) would probably end in Q3. This paves the way for the first increase in the key deposit rate, although the timing of the move is still highly uncertain. The inflationary shock is spreading while growth faces ever greater threats. Even so, pre-existing cyclical momentum, excess savings, investment needs and fiscal support measures should all help ease the risk of stagflation.
An exceptionally high number of Eurozone companies plan to raise selling prices. It is unlikely that, at this stage, unit labour cost growth would already be a key driver. Rising input costs and strong demand are playing a crucial role, whereby well-filled order books make it easier for companies to increase their prices. Selling price expectations of euro area companies are much higher than what would be expected based on their historical relationship with input prices and order book levels. It seems that when more companies are raising prices, others will be inclined to do the same. This broad-based nature of the increase of inflation could slow down the reaction of inflation to slower demand growth.
A priori, rising inflation and inflation expectations, reflecting robust growth in demand and economic activity, should boost household spending by reducing real interest rates. Today’s situation is different. In many advanced economies, inflation is exceptionally high and to a considerable degree explained by negative supply shocks. In the EU and the euro area, household confidence recorded a big drop in March. Although unemployment expectations have increased, the main reason seems to be concern about high and rising inflation. Eurozone consumer confidence measures provide information about spending up to three quarters into the future. Given their recent decline, one should expect below-average consumer spending growth over the coming months
Eurostat’s flash estimate puts eurozone inflation for March at 7.5% y/y, representing another very substantial increase (up 1.6 points on the February figure). Inflation continues to be driven mainly by energy prices – the energy component contributed 4.9 percentage points to this figure, thus explaining 65% of the total – but the other components (food, manufactured goods, services) are also seeing increases and each contributed around one point. Thus, inflation is getting more widespread and all eurozone countries have been affected by its recent acceleration, albeit to varying degrees.
Since its launch, the ECB’s asset purchase programme has had, through various transmission channels, a significant impact on financial markets, activity and inflation. In recent months, doubts about the positive effects of additional purchases and concerns about possible negative consequences have increased. Against this background, the ECB has cut the link between the timing of the end of net asset purchases and the rate lift-off. This is a welcome decision that increases the governing council’s optionality. The new staff macroeconomic projections remind us of the pervasive uncertainty we are facing. In such an environment, monetary policy can be nothing else than data-dependent.
Abundant job creations in the Eurozone helped bring down the unemployment rate to a historically low level in 2021, but this has also led to hiring difficulties and labour shortages. Labour shortages seem to be having the most restrictive impact in Germany (in all sectors), given the already low unemployment rate. They seem to be weakest in Italy where the job market is less dynamic, and this hierarchy was confirmed regardless of the sector. In France, labour market tensions are the highest in the construction, and comparatively less important in the manufacturing and services sectors. Production constraints due to labour shortages have reached a record high in the services sector, especially in Germany
First of all, we will pay particular attention to the extent of the upward revision of the European Central Bank's inflation projections. We expect major revisions given the latest developments and the most recent inflation figures, which continue to rise (headline inflation hit 5.8% y/y in February, according to the Eurostat flash estimate, and core inflation was 2.7% y/y).
The war in Ukraine influences the euro area economy through different channels: increased uncertainty, financial market volatility, reduced exports, higher prices for oil, gas and certain other commodities. Although the economic channels of transmission are clear, the size of the impact is not. Counterfactual analysis of last year’s jump in oil and gas prices provides a reference point but the geopolitical nature of the economic shock reduces the reliability of model-based estimates. Moreover, the other transmission channels should also have an impact on growth. Finally, there is a genuine concern that, the longer the crisis lasts, the bigger the economic consequences because eventually, months of elevated uncertainty would end up weighing heavily on household and business confidence.
Investor behaviour is strongly influenced by stylised facts, i.e. the historical relationship between economic variables and financial markets. When Bund yields increase, the spread of certain sovereign issuers tends to widen. This positive correlation will be perpetuated when enough investors believe that the historical relationship continues to hold. This was again illustrated in recent weeks by the significant widening of certain sovereign spreads in reaction to the rise in Bund yields. It creates a challenge for governments, due to higher borrowing costs, but also for the ECB, because of its influence on monetary transmission. This explains the ECB’s insistence on the flexibility offered by the PEPP reinvestments.
Based on Christine Lagarde’s latest press conference, it is clear that the ECB’s Governing Council view on the inflation outlook has evolved quite significantly. Since the December meeting, upside risks to inflation have increased, raising unanimous concern within the Council. Financial markets interpreted this as a signal that the first rate hike might come earlier than previously expected and bond yields moved significantly higher. The ECB’s forward guidance, which can also be considered as a description of its reaction function, suggests a rule-based approach to setting interest rates with clear conditions in terms of inflation outlook and recent price developments. In reality, a lot of judgment will be used as well
Against the background of economic recovery (real year-on-year GDP growth of 14.4% in Q2 2021, followed by 3.9% in Q3 and 4.6% in Q4 according to Eurostat’s preliminary estimate), outstanding bank loans to non-financial companies (NFCs) and households continued to accelerate in the eurozone between May and December 2021. Although substantial comparison effects mean that the figure is still in negative territory, its impulse (measuring the variation in annual growth in outstanding loans over one year) improved to -0.6% in December 2021.
Economic newsflow was particularly rich last week. The first important items, looking in the rear-view mirror, were the first growth estimates for Q4 2021 in France, Germany and Spain. Performances were mixed, between the 0.7% q/q contraction in Germany, further strong growth of 2% q/q in Spain and, between these two, growth of 0.7% q/q in France.
The resurgence of the Covid-19 pandemic and the emergence of the new Omicron variant make the ECB’s task even harder. Although growth should hold at a high level, it is expected to ease, and this trend could worsen, at least in the short term. Meanwhile inflation continues to soar, while becoming more broadbased, and the risk in the coming months is on the upside. Faced with greater uncertainty, the ECB is arguing in favour of patience and constancy while saying it is ready to act in any direction. According to our scenario, which is somewhat optimistic in terms of growth and calls for persistent inflation, the ECB would end its Pandemic Emergency Purchase Programme (PEPP) in March 2022 and begin raising its key deposit rate in mid-2023.
The ECB’s meeting on 16 December is highly anticipated, primarily for the central bank’s new growth and inflation forecasts. When it comes to growth, the ECB’s September forecast was for annual average growth of 5% in 2021, 4.6% in 2022 and 2.1% in 2023. It could leave its 2021 forecast unchanged, with the positive figures for Q3 offset by a less positive view of Q4, due to the effect of supply constraints, inflationary pressures and a resurgence of the pandemic. Growth in 2022 will be weakened by the same factors. The scale of the forecast downward revision will indicate the level of the ECB’s concerns. It will also be interesting to see whether any growth ‘lost’ in 2022 will be shifted, in part at least, into a higher forecast for 2023.
In September 2021 a slight acceleration in lending to eurozone non-financial companies (NFCs), which rose 2.1% y/y from 1.9% in June, interrupted the deterioration of the credit impulse (which reflects the year-on-year change in outstanding loans). However, this remained negative (-1.4% in September, from -1.9% in June) due to a high basi of comparison.
Companies in the euro area report record-high levels of labour shortages. These are partly cyclical in nature but structural factors also play a role. Last year’s annual investment survey of the European Investment Bank shows that the availability of staff with the right skills is the second most important factor weighing on long-term investment decisions in the EU. Structural labour shortages can weigh on potential GDP growth through its impact on capital formation, innovation and productivity. Economic and, in particular, education policy including vocational training and lifelong learning schemes will have to make sure that, going forward, the available skills, both in quantity and quality, fit the evolving needs.
According to our Pulse, the Eurozone’s cyclical situation has deteriorated over the past three months (the blue area is smaller than the area within the dotted lines). Hard data have dropped sharply but the decline in business climate surveys has been much milder. This difference is due to statistical distortions. For retail sales and production, the sharp decline in growth rates in year-on-year terms since May reflects a normalisation after the previous 3-month average was inflated by very favourable base effects in March and April.
In the euro area, business surveys report record-high staff shortages. They represent a headwind to growth and raise the possibility of faster wage growth and a pick-up in inflation. Thus far, growth of negotiated wages has been subdued but, given its historical relationship with labour market bottlenecks, an acceleration seems likely. Despite the difficulties of companies in filling vacancies, labour market slack has remained above pre-pandemic levels. This situation should improve in the coming months but whether this eases labour market tensions depends on companies’ hiring intentions. Based on recent surveys, these should remain elevated.
