Euro Area: Facing Headwinds Amid Political and Fiscal Uncertainties
Sunday, 30 June, Week 26: The Euro Area is navigating a complex economic landscape, marked by subdued growth, persistent inflation, and significant political and fiscal uncertainties. While inflation has shown signs of easing, it remains above the ECB's 2% target, and underlying price pressures are still evident. The ECB's recent interest rate cut, while widely anticipated, underscores the central bank's cautious approach to supporting a fragile economic recovery while maintaining its commitment to price stability. Adding to the complexity are the French parliamentary elections taking place today, the outcome of which could have implications for fiscal policy and economic reforms. Fiscal challenges across the bloc, including rising debt levels and the need for consolidation, further complicate the macroeconomic landscape. This report examines the key trends shaping the Euro Area's economic trajectory and explores the potential headwinds and tailwinds that lie ahead, providing insights valuable to forex traders navigating the euro's path.
Fiscal Policy
The Euro Area's fiscal policy is transitioning from an expansionary stance adopted during the energy crisis and pandemic to a period of tightening. This shift is primarily driven by the withdrawal of energy and inflation support measures, leaving governments to grapple with the challenge of balancing fiscal consolidation with the need to support a still-fragile economic recovery.
The withdrawal of support measures has already led to a significant tightening of the fiscal stance in 2024. This is projected to continue in 2025 and 2026, albeit at a more moderate pace. The tightening is primarily driven by a scaling down of remaining energy support, slower growth in subsidies and other fiscal transfers, and some revenue-side measures. However, these effects are expected to be partially offset by limited increases in government investment, particularly those related to the Next Generation EU (NGEU) program, which aims to boost long-term growth and resilience.
The Euro Area's budget balance is projected to improve over the coming years. However, based on current projections, it is not expected to fall below 3% of GDP within the projected timeframe. The debt-to-GDP ratio is projected to broadly stabilise over the projection horizon, as continuous (though declining) primary deficits and positive deficit-debt adjustments are compensated by favourable (negative) interest rate-growth differentials.
The tightening fiscal stance is likely to have a restraining effect on economic growth in the near term. However, it is also expected to contribute to a more sustainable fiscal position in the medium to long term. The impact of the tightening will depend on the specific measures implemented by individual countries and the overall economic environment.
Looking ahead to the next five weeks, the focus will be on the implementation of national budgets and the progress of fiscal consolidation efforts. The European Commission will be closely monitoring the fiscal situation in member states and may issue recommendations for further adjustments if necessary.
Economics
The Euro Area economy is showing signs of recovery, with positive growth recorded in the first quarter of 2024. However, the pace of growth remains subdued, and the outlook is clouded by persistent inflation and uncertainties stemming from geopolitical events and the global economic slowdown.
Economic Growth
The Euro Area economy grew by 0.3% in the first quarter of 2024, following a decline of 0.1% in the fourth quarter of 2023. The recovery was driven by a boost from net trade, following a temporary decline in the previous quarter. The unusually mild winter also temporarily supported housing investment in some countries. Looking ahead, the ECB projects economic growth to pick up to 0.9% in 2024, 1.4% in 2025 and 1.6% in 2026. However, these projections are subject to significant uncertainty.
Labour
The Euro Area labour market remains a bright spot, with employment increasing by 0.3% in the first quarter of 2024. The unemployment rate hit a fresh record low of 6.4% in April 2024. This suggests that the labour market is tightening, which could lead to upward pressure on wages. However, the pace of employment growth is expected to slow in comparison with recent years, as cyclical factors that have supported employment more than usual over the recent past gradually fade away.
Price Changes
Headline inflation in the Euro Area increased to 2.6% in May 2024 from 2.4% in each of the previous two months. Prices rebounded for energy (0.3% vs -0.6%) and rose faster for services (4.1% vs 3.7%) but slowed for food, alcohol and tobacco (2.6% vs 2.8%) and non-energy industrial goods (0.7% vs 0.9%). The largest upward contribution came from the services sector. The ECB recently revised its inflation forecasts higher and now sees headline inflation averaging 2.5% in 2024, 2.2% in 2025 and 1.9% in 2026.
Trade
The Euro Area posted a trade surplus of €15 billion in April 2024. Imports increased by 1.8% to €232.5 billion, while exports surged by 14% to €247.6 billion. In January to April, the surplus was €72.8 billion, compared with a €20.5 billion deficit last year. This suggests that the Euro Area's external position is improving, which could provide some support for the euro.
Monetary Policy
The ECB's monetary policy stance is currently accommodative, with interest rates at historically low levels. The central bank has been gradually withdrawing its monetary stimulus in recent months, but it remains committed to supporting the economic recovery. The ECB's June monetary policy meeting saw the central bank lower its three key interest rates by 25 basis points. The main refinancing operations rate was lowered to 4.25%, the deposit facility rate to 3.75%, and the marginal lending rate to 4.5%. The ECB also confirmed that it will reduce the Eurosystem’s holdings of securities under the pandemic emergency purchase programme (PEPP) by €7.5 billion per month on average over the second half of the year.
The ECB's monetary policy is likely to remain accommodative in the near term, as the central bank seeks to balance the need to support the economic recovery with the need to keep inflation under control. The ECB will be closely monitoring economic developments and will adjust its policy stance as necessary.
In the next five weeks, the focus will be on the ECB's July monetary policy meeting. Forex traders will be closely watching for any signals from the ECB regarding its future policy intentions.
Geopolitics and Market Themes
French Parliamentary Elections
France is holding the second round of its parliamentary elections today. The results of the election and the formation of the new government will be closely watched by forex traders for any potential implications for fiscal policy, economic reforms, and the euro exchange rate.
War in Ukraine
The ongoing war in Ukraine continues to weigh on the Euro Area economy. The conflict has disrupted supply chains, pushed up energy prices, and increased uncertainty. The war is also likely to have a negative impact on consumer and business confidence. The euro has been negatively impacted by the war, as investors have sought safe-haven assets such as the US dollar.
Geopolitical Tensions in the Middle East
The recent escalation of geopolitical tensions in the Middle East is another risk to the Euro Area economy. The conflict has the potential to disrupt oil supplies and push up energy prices. It could also lead to increased uncertainty and volatility in financial markets.
OTHER NEWS
Global Economic Slowdown: The global economy is showing signs of slowing, with growth forecasts being revised downwards. This could have a negative impact on the Euro Area economy, as it would reduce demand for exports.
US Presidential Election: The US presidential election is scheduled for November 5. The outcome of the election could have a significant impact on the global economy and financial markets.
Conclusion
The Euro Area economy is facing a number of headwinds, including weak growth, persistent inflation, and significant political and fiscal uncertainties. The ECB's monetary policy is likely to remain accommodative in the near term, but the central bank will be closely monitoring economic developments and will adjust its policy stance as necessary. Forex traders should closely monitor economic developments and political events in the Euro Area, as these could have a significant impact on the euro exchange rate.
References
European Central Bank: https://www.ecb.europa.eu/
Eurostat: https://ec.europa.eu/eurostat/
Trading Economics: https://tradingeconomics.com/
Stratfor: https://worldview.stratfor.com/
Reuters: https://www.reuters.com/
Bloomberg: https://www.bloomberg.com/