Eurozone on Edge: Can the ECB Tame Inflation Without Derailing Growth?
Euro Area economy faces challenges amid recovery, war in Ukraine, and global slowdown. ECB's policy shift and EU fiscal framework crucial for sustainable recovery.
Thursday, 15 August, Week 33
Euro Area Macroeconomic Report: A Balancing Act Between Growth and Inflation
This report provides a comprehensive analysis of the Euro Area's current macroeconomic landscape, covering fiscal and monetary policy, key economic indicators, and the overall economic outlook. The report is structured to provide insights into the near term (five-day outlook), short term (five-week outlook), mid-term (five-month outlook), and long term (five-year outlook). This structure allows traders to understand the potential impacts of macroeconomic developments on the forex market across different time horizons.
The Euro Area, a monetary union of 20 European countries using the euro, is navigating a complex economic environment. While recovering from the COVID-19 pandemic, the bloc faces challenges from the ongoing war in Ukraine, high inflation, and a global economic slowdown. The European Central Bank (ECB) has begun raising interest rates to combat inflation, while governments grapple with balancing fiscal support with sustainability. Geopolitical tensions, particularly the war in Ukraine and the Middle East conflict, add further uncertainty to the economic outlook.
Navigating Fiscal Policy in a Turbulent Landscape
The Euro Area's fiscal policy is currently focused on balancing the need for continued economic support with the imperative of ensuring long-term fiscal sustainability. The recent surge in inflation, driven by energy price shocks and supply chain disruptions, has complicated this balancing act, forcing governments to implement measures to mitigate the impact on households and businesses while also addressing underlying fiscal imbalances.
The most recent fiscal policy changes have involved the withdrawal of pandemic-related support measures, offset by the introduction of new measures to address the energy crisis and support Ukrainian refugees. However, the data shows that the new energy support measures were larger than the withdrawal of COVID support. Over the past six months, the focus has shifted from pandemic recovery to mitigating the economic fallout from the war in Ukraine and the energy price shock. This has led to a significant increase in government spending on energy support measures, though these are expected to be temporary. Over the past five years, the most significant fiscal policy change has been the implementation of the Next Generation EU (NGEU) program, which aims to support economic recovery and resilience through large-scale investments. The NGEU program has the potential to significantly impact the Euro Area's long-term growth prospects, but its success will depend on the effective implementation of the planned reforms and investments.
Fiscal policy expectations for the short and mid-term remain uncertain. The direction of fiscal policy will depend on the evolution of the energy crisis, the war in Ukraine, and the overall economic outlook. The implementation of the reformed EU fiscal framework, which emphasises national ownership of medium-term budgetary plans, will also play a crucial role in shaping fiscal policy in the coming years.
Key Economic Indicators: Signs of Recovery Amidst Uncertainty
Key economic indicators in the Euro Area are currently reflecting a mixed picture of recovery and uncertainty. While economic growth has been robust, inflation remains elevated, and the labour market, though strong, is showing signs of slowing momentum. The geopolitical environment, particularly the war in Ukraine and the Middle East conflict, continues to weigh on business and consumer confidence.
Recent changes in key economic indicators show a mixed picture. GDP growth has been positive but is slowing, inflation remains above the ECB's target, and the unemployment rate, though recently increasing, is still relatively low historically. Over the past six months, the most significant changes have been the surge in inflation and the tightening of financial conditions due to the ECB's monetary policy tightening. Over the past five years, the most significant changes have been the economic fallout from the COVID-19 pandemic and the subsequent recovery, as well as the recent energy crisis and its impact on inflation and growth. The Euro Area's heavy reliance on Russian energy imports has made it particularly vulnerable to the energy price shock, highlighting the need for diversification of energy sources and a transition to renewable energy.
In the short term, key economic indicators are expected to reflect continued economic growth, albeit at a slower pace, and a gradual decline in inflation. The labour market is expected to remain strong, with the unemployment rate stabilising. In the mid-term, the outlook for key economic indicators will depend on the success of the ECB's monetary policy in bringing inflation back to target, the evolution of the war in Ukraine, and the implementation of the reformed EU fiscal framework. The outcome of these factors will have significant implications for the Euro's exchange rate and the attractiveness of Euro Area assets to foreign investors.
ECB Monetary Policy
The ECB's monetary policy is currently focused on balancing the need to control inflation with the imperative of supporting economic growth. The ECB has started to raise interest rates, but the pace and extent of future tightening will depend on the evolution of inflation and the resilience of the economic recovery.
The most recent monetary policy change was the ECB's decision to keep interest rates unchanged in July 2024, following a rate cut in June. Over the past six months, the ECB has transitioned from an accommodative monetary policy stance to a more neutral stance, with one rate cut. The ECB's future policy decisions will be data-dependent, taking into account the evolving inflation outlook, economic growth prospects, and the impact of its policy measures on financial conditions.
In the short term, the ECB's monetary policy stance is expected to remain data-dependent, with the central bank closely monitoring the evolution of inflation and economic growth. Markets are currently pricing in further rate cuts, not hikes, in the coming months. In the mid-term, the outlook for monetary policy will depend on the success of the ECB's measures in bringing inflation back to target and the resilience of the economic recovery. The ECB's communication and forward guidance will be crucial for managing market expectations and ensuring a smooth transition to a more normalised monetary policy stance.
Macroeconomic Outlook: Navigating Uncertainty and Risks
The Euro Area's macroeconomic outlook is characterised by a balancing act between continued economic recovery and the risks posed by high inflation, geopolitical tensions, and a global economic slowdown. The ECB's shift to restrictive monetary policy is expected to dampen inflation but may also weigh on economic growth.
The short-term macroeconomic outlook is for continued economic growth, albeit at a slower pace. The ECB's June 2024 staff macroeconomic projections forecast annual average real GDP growth of 0.9% in 2024, strengthening to 1.4% in 2025 and 1.6% in 2026. Headline HICP inflation is projected to decline from 5.4% in 2023 to 2.5% in 2024, 2.2% in 2025 and 1.9% in 2026. The mid-term macroeconomic outlook is more uncertain, with the risks tilted to the downside. The evolution of the war in Ukraine, the success of the ECB's monetary policy in bringing inflation back to target, and the implementation of the reformed EU fiscal framework will be key factors shaping the mid-term outlook. The potential for further geopolitical shocks, such as an escalation of the Middle East conflict, adds further uncertainty to the macroeconomic outlook.
Economic Indicators: Tracking the Path Ahead
Economic Growth:
GDP Growth Rate QoQ: The Euro Area GDP expanded 0.3% on quarter in Q2 2024, matching the upwardly revised Q1 growth rate. In the short term, GDP growth is expected to remain positive but moderate. In the mid-term, the outlook for GDP growth will depend on the evolution of inflation, the war in Ukraine, and the implementation of the reformed EU fiscal framework.
Industrial Production MoM: Industrial Production in the Euro Area decreased 0.10 percent in June of 2024 over the previous month. In the short term, industrial production is expected to remain subdued, reflecting ongoing weakness in the manufacturing sector. In the mid-term, the outlook for industrial production will depend on the strength of the economic recovery and the evolution of global supply chain disruptions.
Price Changes (Inflation):
Inflation Rate YoY: Inflation Rate in the Euro Area increased to 2.60 percent in July from 2.50 percent in June of 2024. In the short term, the path of inflation is uncertain. In the mid-term, the outlook for inflation will depend on the success of the ECB's monetary policy in bringing it back to target and the evolution of wage growth.
Core Inflation Rate YoY: The annual core inflation rate in the Euro Area, excluding volatile items such as energy, food, alcohol & tobacco, remained steady at 2.9% in July 2024. In the short term, core inflation is expected to remain elevated, reflecting persistent price pressures in the services sector. In the mid-term, the outlook for core inflation will depend on the evolution of wage growth and the persistence of second-round effects from past inflation.
Labour:
Unemployment Rate: Germany's seasonally adjusted jobless rate stood at 6% in July 2024. In the short term, the unemployment rate is expected to stabilise as the labour market remains strong. In the mid-term, the outlook for the unemployment rate will depend on the strength of the economic recovery and the pace of job creation.
Employment Change QoQ: The number of employed persons increased by 0.2% in both the euro area and the EU in the second quarter of 2024, compared with the previous quarter. In the short term, employment growth is expected to moderate as the labour market tightens. In the mid-term, the outlook for employment growth will depend on the strength of the economic recovery and the pace of job creation.
Housing:
Housing Starts: Data on housing starts in the Euro Area is not readily available. However, the construction sector is expected to remain weak in the short term, reflecting ongoing challenges from high interest rates and supply chain disruptions. In the mid-term, the outlook for the construction sector will depend on the strength of the economic recovery and the availability of financing.
Business Confidence:
Ifo Business Climate Index: Business Confidence in Germany decreased to 87 points in July from 88.60 points in June of 2024. In the short term, business confidence is expected to remain subdued, reflecting ongoing uncertainty about the economic outlook and the direction of monetary policies. In the mid-term, the outlook for business confidence will depend on the strength of the economic recovery and the evolution of geopolitical tensions.
ZEW Economic Sentiment Index: ZEW Economic Sentiment Index in Germany decreased to 19.20 points in August from 41.80 points in July of 2024. In the short term, economic sentiment is expected to remain weak, reflecting ongoing concerns about the economic outlook and the direction of monetary policies. In the mid-term, the outlook for economic sentiment will depend on the strength of the economic recovery and the evolution of geopolitical tensions.
Consumer Sentiment:
Consumer Confidence: The consumer confidence indicator in the Euro Area rose by 1 percentage point from the previous month to -13 in July 2024, the highest level since February 2022 and matching preliminary estimates. In the short term, consumer confidence is expected to improve gradually as inflation eases and the labour market remains strong. In the mid-term, the outlook for consumer confidence will depend on the strength of the economic recovery and the evolution of real incomes.
GfK Consumer Climate: The GfK Consumer Climate Indicator for Germany climbed to -18.4 heading into August 2024 from a marginally revised -21.6 in the previous period. In the short term, consumer sentiment is expected to improve gradually as inflation eases and the labour market remains strong. In the mid-term, the outlook for consumer sentiment will depend on the strength of the economic recovery and the evolution of real incomes.
Trade:
Balance of Trade: Germany recorded a trade surplus of 20.40 EUR Billion in June of 2024. In the short term, the trade surplus is expected to narrow as exports moderate and imports recover. In the mid-term, the outlook for the trade balance will depend on the strength of the global economy and the competitiveness of Euro Area exports.
Exports: Exports from Germany dropped by 3.4% month-over-month to a six-month low of EUR 127.7 billion in June 2024. In the short term, exports are expected to remain subdued, reflecting ongoing weakness in global demand. In the mid-term, the outlook for exports will depend on the strength of the global economic recovery and the competitiveness of Euro Area exports.
Conclusion: A Cautious Path Forward
The Euro Area economy is at a critical juncture, facing a complex interplay of positive and negative forces. While the recovery from the COVID-19 pandemic continues, the war in Ukraine, high inflation, and a global economic slowdown pose significant challenges. The ECB's shift to a more neutral monetary policy stance and the implementation of the reformed EU fiscal framework will be crucial for navigating these challenges and ensuring a sustainable recovery. The near-term outlook remains uncertain, with the potential for further volatility in financial markets as investors assess the evolving macroeconomic landscape.
Sources
European Central Bank
Eurostat
Federal Statistical Office, Germany
INSEE, France
Centre for European Economic Research (ZEW)
S&P Global
GfK Group
Ministère de l'Économie et des Finances, France
Trading Economics
Newsquawk
Financial Juice
Stratfor