Slow Disinflation Implies That Low Growth And High Interest Rates Are Here To Stay, And That QT Could Accelerate
We maintain our GDP growth forecasts for the eurozone economy. We still expect growth to soften considerably to 0.6% this year from 3.4% in 2022 and barely accelerate next year (0.9%), before potentially returning to an annual increase of 1.5% in 2025-2026. This baseline assumes no new external shocks, especially in terms of geopolitics, external trade and commodity prices. It also expects the labor market to remain quite resilient and European Central Bank (ECB) policy rates to remain unchanged until the second half of next year.
Yet, the geographic composition of growth is slightly different from our previous exercise. We have revised downwards our growth forecasts for 2023 and 2024 in countries that are heavily dependent on external trade and where the domestic real estate market is correcting rapidly, such as Germany and the Netherlands. We have revised upwards our growth forecasts, particularly for 2023, for countries where disinflation is faster and the labor market is more resilient than we expected, such as Spain and Belgium.
Otherwise, the baseline narrative has largely materialized. The slowdown is here to stay, as post-pandemic tailwinds fade and as high inflation and rising interest rates significantly curb demand; tailwinds include companies hoarding labor and processing order backlogs and tourism demand normalizing. While the first normal tourist season since 2019 is supportive in Q3-2023, the risk for the eurozone economy to slide into a shallow recession later on, at the turn to next year, remains elevated.
The labor market, which was slowing but still strong in Q2, will be decisive for growth prospects next year. Its tightness and resilience are the main reasons why we do not expect a more pronounced slowdown, since accelerating wages combined with slowing inflation ease income constraints for households. An increase in real disposable income should mitigate the dampening effects of rising interest rates on demand by 2024, and even exceed them by 2025. Should the labor market weaken more than expected, we may have to revise our baseline downwards.
Our inflation forecast for 2023 has been revised markedly downwards (to 5.6% from 5.8%) due to a faster-than-expected fall in energy prices in the second quarter, albeit unevenly across countries. We confirm our forecast of 2.7% for inflation next year and believe it will not return to the 2% target until the second half of 2025. The recent surge in oil prices and the removal of government subsidies on domestic energy prices in some countries will translate into slower disinflation from now on.
While first-round effects fade, second-round effects persist. Growth in unit labor costs accelerated to 6.3% in Q2. Even if headline inflation has already halved from peak, at 5.3% in August versus 10.6% in October 2022, price stability is still a long way off. We estimate that prices for two-thirds of the consumer basket continue to rise at a rate of over 4% per annum
Against this backdrop of slow and limited disinflation, we believe that the ECB is not yet done normalizing its monetary policy. Interest rates may have reached their peak (at 4% for the deposit rate), as the ECB signaled at its September press conference, but it will take some time for the ECB to start cutting rates again. What’s more, we believe that the ECB has further work to do on the quantitative tightening (QT) front and the way it supplies banks with liquidity (see “What An Acceleration of Quantitative Tightening Could Mean for Eurozone Banks,” published Sept. 13, 2023).
If inflation does indeed exceed the target for another two years, as the ECB staff expects, we believe the current passive form of QT could give way to a more active form; passive QT involves extinguishing bank reserves by letting bonds held by the ECB mature, whereas active QT involve the ECB starting to sell bonds on the market. We expect discussions about QT and bank reserves to be put to the ECB Governing Council towards the end of the year. Some upward pressure on bond yields would then be likely, as quantitative easing (QE) led the term premium on benchmark yields to compress by almost 100bps, but it is not certain that the impact of an active QT on bond market yields would simply be that of QE in reverse. As regards policy rates, the current reaction function communicated by the ECB does not suggest that it will start cutting them before H2-2024.
The Growth Slowdown Is Here
The eurozone economy has barely expanded over the last three quarters. GDP grew by a modest 0.1% quarter on quarter in the second quarter, after -0.1% and +0.1% respectively in the previous two quarters. As in the first three months of the year, consumer spending stagnated, and net exports contracted during the months of spring. Only an increase in inventories and public consumption prevented GDP from contracting in Q2 (see chart 2).
Business confidence deteriorated further over the summer months, undermining any chance of a strong GDP rebound in the third quarter. The European Commission’s economic sentiment indicator has dropped over the last four months, to 6 points below its long-term average in August. The service purchasing managers’ index (PMI) has entered contractionary territory (47.9 in August), following the manufacturing PMI, which has been in this region since the end of last year (43.5 in August).
The slowdown of the manufacturing sector is more pronounced in Germany than elsewhere in large European economies (see chart 3). German industrial production is contracting, as energy-intensive production, especially that of the chemical industry, has been partly offshored since domestic gas prices soared. What’s more, Chinese competition in the automotive sector is intensifying. As a result, capacity utilization in the German industry is at 82.9% in Q3, one percentage point below average for the first time in 2.5 years.
Subdued sentiment is visible across the board: consumer confidence did not develop much better than business confidence, as disinflation takes time before lifting real wage growth above zero. For now, income growth has just caught up with prices.
The reasons for the slowdown in Europe are the same as we already highlighted in our previous publication (see “Economic Outlook Eurozone Q3 2023: Short-Term Pain, Medium-Term Gain,” published June 26, 2023). In addition to the purely cyclical downturn caused by the end of restocking and the processing of order books, European production faces a competitive shock from energy costs. This puts it at a severe disadvantage compared with the U.S. (as a percentage of GDP, energy imports to the eurozone are still 4% higher than U.S. imports of energy).
High inflation is eating into household incomes. Rapidly rising interest rates translate into a growing preference for saving rather than spending money. The housing market has entered a sustained correction phase (see “European Housing Markets: Sustained Correction Ahead,” published July 20, 2023). All these factors should maintain their grip on the European economy well into 2024. That said, inflation should then have receded sufficiently for real disposable income to rise again, making the second half of next year more promising than the next six months.
Disinflation Is Faster In Some Countries Than Others
Inflation has not fallen significantly over the last three months, settling at 5.3% in August and interrupting a sustained disinflation since last November. The reasons for the halt in disinflation lie in the rise in gasoline prices and the removal of energy price subsidies in some countries. It is perhaps more encouraging to see that core inflation seems to have passed its peak, also standing at 5.3% in August, compared with 5.7% in March.
Disinflation is, however, far from uniform across the euro zone. Spain leads the disinflation process (see chart 4). These differences are not only due to the price of domestic energies and government measures to protect the consumer. They also stem from the labor market, with unit labor costs rising less in Spain than in Germany.
The Orientation Of The Labor Market Will Be Decisive For 2024
Once again, the labor market proved more resilient than we thought over the past quarter. Eurozone employment rose twice as much as GDP in Q2 (+0.2% QoQ for employment, +0.1% for GDP). The unemployment rate continues to fall, reaching 6.4% for the eurozone in July. Unemployment fell more in economies such as Greece and Spain, which benefited from their first normal tourist season since the pandemic. Job vacancies in the eurozone still represent 3% of the active population, close to the record peak of 3.2%.
That said, signs are mounting that the European labor market may have reached a turning point. Tightness is receding somewhat, and the hiring momentum is slowly fading according to real time data on job postings. And wage growth, while not abating, seems to be plateauing at 5%. What’s more, labor productivity is slightly above the pre-pandemic level but now below the long-term growth trend. Unit labor costs have soared. In this context it is worth noting that the labor market cycle goes hand in hand with the profit cycle (see chart 5). For these reasons, we continue to expect unemployment to edge up in the coming quarters.
Our baseline scenario forecasts a gradual slowdown in the European labor market in 2024. Gradual in terms of rising unemployment and decelerating wage growth, given that labor market tightness persists. With inflation set to continue moderating, a gradual slowdown in the labor market will not prevent real disposable income from picking up next year, easing income constraints for households and supporting consumption (see chart 6). Consumer spending should be a driver of GDP growth next year and prevent the eurozone economy from falling into recession. Conversely, a more pronounced slowdown in the labor market could push the economy into recession.
No Loss Of Global Market Share Yet, But External Trade Is Less Profitable Than Before
Net exports have not contributed much to eurozone growth over the past quarters, and the question arises as to whether higher energy costs at European factories, trade sanctions against Russia, growing wariness of trade dependency vis-à-vis China have caused the eurozone to lose global market shares. This is an important issue, given that extra-Economic and Monetary Union (EMU) exports represent 21% of eurozone GDP. Comparatively, total exports represent less than 15% of U.S. GDP and 18% of China and Japan’s GDP, according to data from Organization for Economic Cooperation and Development (OECD). The eurozone’s trade with the rest of the world provides more than half of its current account surplus (3.3% of GDP on average between 2015 and 2020), making it one of the world’s leading exporters of capital, alongside China and Japan.
Trade data suggest that the slowdown in eurozone exports is largely in sync with the global trade cycle, which has come to a halt in 2023 after it grew more than world GDP during the COVID recovery (see chart 7). This is therefore not suggesting that the eurozone is losing share in world trade. On the other hand, eurozone trade with the rest of the world (i.e., vis-à-vis. Extra-EMU countries) remains less profitable than before. The current account balance has not totally recovered from the energy price shock that has been caused by the stop in Russian gas imports, as the total trade surplus has not yet returned to pre-war levels (see chart 8).
ECB Rate Plateau Could Be Longer Than In Previous Rate Cycles
The ECB opted in an apparently close decision for a dovish hike at its September meeting; we were in the camp of a hawkish pause. The governing council decided to raise the three key interest rates by 25 bps to 4% for the deposit rate and 4.5% for the repo rate. It also signaled that interest rates are now at a level that should be sufficiently restrictive to bring back inflation to target over the medium term, if “maintained for a sufficiently long duration.”
We believe that 12 months could be a sufficiently long duration, based on the new ECB projections and the ECB explicit reaction function. The ECB said that it will look at the combined three elements of (1) the inflation and economic outlook; (2) dynamics in core inflation; and (3) the strength of monetary policy transmission, to decide over rates in the future.
We do not expect the ECB to start cutting the policy rates before H2 2024. The scope and the speed of future cuts will largely depend on how the three elements of the reaction function develop. We have shown in our previous publication that the transmission of monetary policy to demand via the banking channel is swifter than in the past; for instance, observing the unprecedented shift from sight deposits to term deposits (see “Economic Outlook Eurozone Q3 2023: Short-Term Pain, Medium-Term Gain,” published June 26, 2023). On the other hand, we believe that core inflation will remain sticky, not returning to 2% before 2025.
Also, the fact that financial buffers remain in the private sector points to a longer pause before the next interest rates cuts than previous tightening cycles. European non-financial corporates still have close to 12% of cash and equivalent in total assets, that is two percentage points above the pre-pandemic average trend. Households’ cash savings accumulated during the pandemic have diminished, but they also remain above trend.
It’s hard to know how long the rate plateau could last, given that the ECB is only in its third cycle of monetary tightening since it began operating in 1999. In 2001, the ECB had to start cutting rates seven months after they had peaked. In 2008, the ECB had to cut rates just four months after the last hike, although this came after rates had been held at a plateau of 3% for 13 months (see chart 9).
Normalization Of Monetary Policy Is Not Over Once Policy Rates Have Peaked
Given that inflation will remain above target for another two years, we believe that the ECB’s monetary policy could continue to normalize once rates have peaked. This includes reducing excess reserves deposited by banks with the ECB on the liabilities side, and reducing the amount of bonds held by the ECB as part of its two quantitative easing portfolios on the assets side of its balance sheet, i.e., QT.
We understand that some central bankers may find benefits in returning to the pre-financial crisis world of scarce reserves and lean balance sheets (see “Getting Up From The Floor,” by Claudio Borio of the Bank for International Settlements, published as SUERF policy note no. 311 in May 2023). We expect such discussions to come to the governing council around the end of the year.
Admittedly, the optimal level of excess reserves in a post-QE world remains largely uncertain (see “Complete Fed Balance Sheet Normalization Is Still Years Away,” published Aug. 26, 2021). According to recent research by David Lopez-Salido and Annette Vissing-Jorgensen presented at the ECB forum on central banking in Sintra, Portugal, banks’ demand for reserves largely depends on a trade-off between the costs of holding reserves (the money market rate) and their remuneration (the deposit facility rate, plus a convenience yield), as well as the level of deposits (see “Reserve Demand, Interest Rate Control and Quantitative Tightening,” published by the Federal Reserve Board on Feb. 27, 2023).
By our estimates, the demand function proposed in the paper fits well with actual reserves. We therefore use this function to estimate the reserves that banks would likely want to hold given their current level of deposits and under normal liquidity conditions. Under these parameters, we estimate that European banks would probably be willing to hold reserves of around €1.7 trillion. This is around €2 trillion less than at present (see chart 10). This estimate should be seen as a landing zone to be reached gradually rather than an immediate target (for details of our estimates, see “What An Acceleration of Quantitative Tightening Could Mean For Eurozone Banks,” published Sept. 13, 2023).
Relatedly, the reduction in excess reserves on the liability side of the ECB balance sheet supposes the same reduction on the asset side. Given that €600 billion in targeted longer-term refinancing operations (TLTROs) are set to mature until the end of 2024, the reduction of excess reserves by around €2 trillion should occur by a €1.4 trillion reduction in bonds that the ECB holds under its two QE programs. As of August 2023, the ECB still holds close to €5 trillion of bonds, mostly of it under its asset purchase programs (€3.3 trillion) and the rest under its pandemic emergency purchase program (PEPP; €1.7 trillion).
Around 1.4 trillion of bonds are set to mature by the end of 2026, meaning that the size of the ECB balance sheet could land in our estimated zone in 3.5 years, just by letting its two portfolios mature. This would be the continuation of the current policy of passive quantitative tightening. However, if the ECB feels it needs to reduce these amounts sooner than the end of 2026, it will have to sell bonds actively. This would be active quantitative tightening. The form of reduction (active or passive QT) chosen by the ECB will largely depend on inflation trends.
QT is likely to exert some upwards pressures on bond yields. For example, the rise in excess reserves has coincided with a fall in the term premium on benchmark yields of nearly 100 bps since the launch of quantitative easing at the end of 2014. We can also observe that the term premium has risen slightly since banks began repaying TLTROs from December 2022, extinguishing reserves (see chart 11). However, there are good reasons to believe that QT does not affect bond yields just like QE in reverse.
ECB board member Isabel Schnabel, who is in charge of markets, sees at least three reasons for this: (1) QT does not give as strong a signal on future interest rates as QE; (2) QT might be more gradual than the QE build-up in assets; and (3) QT is likely to happen in a different market environment (i.e., not during a crisis). The inverted yield curve currently points to a lack of safe assets (see the speech by Ms. Schnabel: “Quantitative Tightening: Rationale And Market Impact,” March 2, 2023). In any case, the actual impact of QT on bond yields remains difficult to predict.
Risks To Our Baseline Scenario Are The Downside
Risks to our baseline relate further to geopolitics. A longer duration and escalation of the conflict in Ukraine could test the resilience of the European economy even more. Downwards risks involve unwarranted and disorderly tightening of global financing conditions, with central banks approaching peak rates and potentially accelerating QT. In this context, we continue to closely monitor European real estate markets. Downwards risks also relate to trade policies, for instance vis-à-vis China. Last but not least, since this is for us the main endogenous risk to our baseline, the unemployment rate could rise more than expected due to the sharp rise in unit labor costs that weigh on corporate profits.
But it’s more likely, in our view, that low growth and high interest rates are here to stay.
| S&P Global Ratings European Economic Forecasts (September 2023) | |||||||||
|---|---|---|---|---|---|---|---|---|---|
| (%) | Eurozone | Germany | France | Italy | Spain | Netherlands | Belgium | Switzerland | U.K. |
| GDP | |||||||||
| 2021 | 5.6 | 3.1 | 6.4 | 7 | 5.5 | 6.2 | 6.3 | 4.2 | 7.6 |
| 2022 | 3.4 | 1.9 | 2.5 | 3.8 | 5.5 | 4.4 | 3.2 | 2.1 | 4.1 |
| 2023 | 0.6 | -0.2 | 0.8 | 0.9 | 2.1 | 0.5 | 1 | 0.6 | 0.3 |
| 2024 | 0.9 | 0.6 | 0.9 | 0.7 | 1.6 | 0.9 | 1.2 | 1.2 | 0.5 |
| 2025 | 1.5 | 1.4 | 1.5 | 1.3 | 2.2 | 1.5 | 1.8 | 1.4 | 1.5 |
| 2026 | 1.5 | 1.4 | 1.4 | 1.3 | 2.2 | 1.7 | 1.4 | 1.5 | 1.6 |
| CPI inflation | |||||||||
| 2021 | 2.6 | 3.2 | 2.1 | 1.9 | 3 | 2.8 | 3.2 | 0.6 | 2.6 |
| 2022 | 8.4 | 8.7 | 5.9 | 8.7 | 8.3 | 11.6 | 10.3 | 2.8 | 9.1 |
| 2023 | 5.6 | 6.3 | 5.6 | 6.3 | 3.5 | 4.9 | 3.2 | 2.3 | 7.5 |
| 2024 | 2.7 | 2.8 | 2.6 | 2.3 | 2.6 | 3.1 | 2.5 | 1.6 | 2.5 |
| 2025 | 2.0 | 2 | 1.9 | 2.1 | 1.9 | 2.2 | 1.9 | 1.5 | 2 |
| 2026 | 1.8 | 1.6 | 1.7 | 2 | 1.9 | 2 | 1.9 | 1.4 | 2 |
| Unemployment rate | |||||||||
| 2021 | 7.6 | 3.6 | 7.9 | 9.5 | 14.8 | 4.2 | 6.3 | 5.1 | 4.5 |
| 2022 | 6.7 | 3.1 | 7.3 | 8.1 | 12.9 | 3.5 | 5.6 | 4.3 | 3.7 |
| 2023 | 6.4 | 2.9 | 7.3 | 7.7 | 12.1 | 3.6 | 5.6 | 4 | 4.3 |
| 2024 | 6.5 | 3 | 7.5 | 7.9 | 12.1 | 3.7 | 5.6 | 4 | 4.7 |
| 2025 | 6.5 | 3 | 7.5 | 8 | 12 | 3.7 | 5.6 | 3.9 | 4.4 |
| 2026 | 6.3 | 3.1 | 7.3 | 7.9 | 11.8 | 3.6 | 5.5 | 3.9 | 4.2 |
| 10y government bond (yearly average) | |||||||||
| 2021 | 0.2 | -0.3 | -0.1 | 0.8 | 0.4 | -0.2 | 0 | -0.3 | 0.7 |
| 2022 | 2 | 1.2 | 1.5 | 3.2 | 2.2 | 1.4 | 1.7 | 0.8 | 2.3 |
| 2023 | 3.3 | 2.6 | 3 | 4.3 | 3.6 | 2.9 | 3.2 | 1.2 | 4.1 |
| 2024 | 3.7 | 2.9 | 3.3 | 4.7 | 4 | 3.2 | 3.5 | 1.4 | 4 |
| 2025 | 3.5 | 2.7 | 3.1 | 4.5 | 3.8 | 2.9 | 3.3 | 1.5 | 3.4 |
| 2026 | 3.3 | 2.6 | 3 | 4.4 | 3.5 | 2.8 | 3.2 | 1.6 | 3.3 |
| Eurozone | U.K. | Switzerland | |||||||
| Exchange rates | US$ per Euro | US$ per GBP | Euro per GBP | CHF per US$ | CHF per Euro | ||||
| 2021 | 1.18 | 1.38 | 1.16 | 0.91 | 1.08 | ||||
| 2022 | 1.05 | 1.23 | 1.17 | 0.96 | 1 | ||||
| 2023 | 1.09 | 1.24 | 1.13 | 0.9 | 0.98 | ||||
| 2024 | 1.11 | 1.27 | 1.15 | 0.91 | 1.01 | ||||
| 2025 | 1.16 | 1.36 | 1.18 | 0.92 | 1.06 | ||||
| 2026 | 1.18 | 1.38 | 1.17 | 0.93 | 1.09 | ||||
| Eurozone (ECB) | U.K. | Switzerland (SNB) | |||||||
| Policy rates (end of year) | Deposit rate | Refi rate | Bank rate | ||||||
| 2021 | -0.50 | 0.00 | 0.25 | -0.75 | |||||
| 2022 | 2.00 | 2.50 | 3.5 | 1.00 | |||||
| 2023 | 4 | 4.5 | 5.5 | 2.00 | |||||
| 2024 | 3.25 | 3.75 | 4.5 | 1.25 | |||||
| 2025 | 2 | 2.5 | 2.6 | 1.00 | |||||
| 2026 | 2 | 2.5 | 2.5 | 1.00 | |||||
Related Research
- What An Acceleration Of Quantitative Tightening Could Mean For Eurozone Banks, Sept. 13, 2023
- Complete Fed Balance Sheet Normalization Is Still Years Away, Aug. 26, 2021
- European Housing Markets: Sustained Correction Ahead, July 20, 2023
- Economic Outlook Eurozone Q3 2023: Short-Term Pain, Medium-Term Gain, June 26, 2023
External Research
- Claudio Borio of the Bank for International Settlements: Getting Up From The Floor, May 2023
- ECB’s Isabel Schnabel speech: Quantitative Tightening: Rationale And Market Impact, March 2, 2023
- Federal Reserve Board: Reserve Demand, Interest Rate Control and Quantitative Tightening, Feb. 27, 2023
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