Eurozone: will there be a growth outage this winter?

It seems highly likely that for the eurozone, 2023 will bring an easing in inflation, a contraction in GDP and a peak in the ECB’s policy rates. The uncertainties lie in the scale of disinflation and of the recession, and in the level and timing of the peak in rates. According to our forecasts, the fall in inflation will be rapid on the surface (with headline inflation dropping from around 10% y/y in Q4 2022 to 3% in Q4 2023), but this will mask a slower fall in core inflation, which we expect to remain above 2% in a year’s time, from 5% at present. In the face of this persistent inflation, we expect the ECB to hike its deposit rate by 100bp, to 3%, by the end of Q1 2023 and then maintain this restrictive level throughout the year, despite the recession. The recession, meanwhile, is expected to be shallow and short-lived, thanks in particular to fiscal support and the resilience of the labour market, which both allows and justifies the ECB’s restrictive approach.

RECESSION LOOKS INEVITABLE...

Although eurozone growth provided another positive surprise in Q3 (up 0.3% q/q, taking the growth carry-over to 3.4%) and thus dodged the expected contraction, repeating this performance in the current quarter, and also the next two, is a tougher task. A recession is not a certainty, but we believe it is inevitable. Although consumer confidence saw some small signs of improvement in October and November, it remains depressed.

The deterioration in business climate surveys remains relatively well contained, but in absolute terms are still pointing towards a contraction in activity (Chart 2). Above all, we are expecting that their decline will continue as we have not yet seen the full effects of the inflationary shock, the energy crisis and monetary tightening.

...BUT IT COULD BE SHALLOW AND SHORT

A severe and prolonged recession can not be ruled out given the unprecedented accumulation and scale of the shocks listed above. But for the time being we believe that the most likely scenario is a shallow and short-lived recession. Thus we expect GDP to contract by -0.4% q/q in Q4 2022, then -0.5% in Q1 2023 and -0.2% in Q2 2023 before a modest recovery in the second half. In annual average terms, we expect GDP growth of 3.2% in 2022, followed by a contraction of -0.5% in 2023 and then a recovery to 1.3% in 2024.

The first of the factors containing the expected recession is the substantial fiscal support introduced at the national and European levels (Chart 3).

In the short term, economic activity should continue to be supported by the continued catching up from the pandemic in sectors where this is not yet complete, although this effect is not far from reaching its end. The easing of supply chain difficulties, allowing the order backlog to be addressed, is another factor in supporting the economy. More broadly, the extra savings built up by households during lockdown periods and the relatively good financial situation of businesses at the beginning of 2022 aresignificant shock absorbers: households and companies have had something of a buffer to absorb the current shocks and this will remain the case, albeit to a lesser extent as the shocks have started to eat into these reserves.

The scale and urgency of investment needs, particularly in the areas of digital technology and the energy transition, are another source of substantial support to growth, although these could be limited by hiring and skills constraints and less favourable financing conditions. This wave of green investment could help in a soft landing for the economy similar to that seen in the second half of the 1990s, when investment in new information and communications technologies contributed to a soft landing for the US economy.