Over the past year, the relative contribution of the food component has a little more than doubled, while the one of the energy component has declined by 10 points. Another indicator of diffusion is that in May, as in April, about 70% of the components of the HICP and core inflation index had increased by more than 2% y/y. Alternative measures of core inflation (super core, median and the trimmed mean) range from 4% to 7% y/y, which also shows the extent of the problem. Unsurprisingly, inflation expectations are also rising, albeit moderately for the moment.
Yet the economic news is not all bad. The business climate in industry, services and construction has not deteriorated much up through May, the most recent data point. Business climate indexes are holding at high levels, which is consistent with strong growth. The retail business climate and consumer confidence, which are more exposed to the inflationary shock, declined sharply in March and April, but this trend did not get any worse in May. The signals from the job market are still reassuring: the unemployment rate is low and stable, hiring difficulties remain very high as well as hiring intentions, and household fears of unemployment stay low. It is also worth reiterating that there are major sources of growth: post Covid-19 catch-up effect, surplus savings, investment needs and fiscal support measures.
Even so, growth is expected to slow down more sharply in the months ahead. After +0.6% q/q in Q1 2022 (a figure inflated by the 0.4-point contribution of the surge in Irish GDP, which rose nearly 11% q/q), we expect Eurozone GDP to contract by -0.2% q/q in Q2, followed by barely positive growth in Q3 (+0.1% q/q) before rebounding more strongly in Q4 (+0.5% q/q), buoyed by the above-mentioned support factors and the expected easing of the inflationary shock and supply chain disruptions. This rebound should extend into 2023. In 2022, we are forecasting average annual growth of 2.5%, which might seem high (thanks to the carry-over of 2.5% in Q1 2022) but is actually low (considering the 1% y/y growth forecast for Q4 2022).
Current forecasts of average annual growth (not only ours, but those of other international institutions) also stand out for what seems like stagflation: inflation will be much higher than real growth in 2022 and 2023, before normalising somewhat as of 2024. The difference with a scenario of true stagflation, however, lies in the unemployment rate, which is not expected to rise very much.
Under this environment, the ECB confirmed that on 1 July it would end its net asset purchases via the Asset Purchase Programme (APP). The central bank is also preparing to begin raising its key rates, with Ms Lagarde announcing a 25bp increase in the deposit rate on 21 July. We cannot exclude a bigger move. We are then looking for two 50bp rate hikes in September and October, followed by three 25bp rate hikes in December, February and March. Two final 25bp rate increases in June and September 2023 would complete this cycle, bringing the deposit rate to 2%, within our estimated range for the neutral rate (1.5-2.5% for the nominal rate; -0.5% to +0.5% for the real rate). At this level, the ECB’s monetary policy would not be restrictive. A new tool is also being prepared to combat the unwarranted widening of spreads within the Eurozone, in order not to interfere with the normalisation and smooth transmission of monetary policy.
Our scenario, like the ECB’s, calls for a soft landing of the economy, with growth slowing down (under the impact of the inflationary shock and orchestrated via monetary normalisation) in a controlled manner (thanks to the support factors mentioned above), albeit sufficiently to ease inflation. Lower inflation, in turn, should help ease the downward pressure on growth. We see the current inflationary shock as intrinsically disinflationary and not a source of stagflation.
