The pandemic plunged the eurozone into its worst recession on record. Its economy rebounded strongly thanks to a decisive policy response. However, the good run has come to an end.
After a strong performance in the first half of the year, economic weakness is accumulating in the common currency region. The shocks from the Ukraine war on both industrial and consumer activities have become more apparent, setting the economy on a path of lower growth and elevated inflation. Leading indicators and surveys are pointing towards an economy already in downturn, but the eurozone continued to expand in the third quarter against rising expectation of a contraction.
The EU economy remains vulnerable to developments in energy markets. Surging natural gas prices have forced energy-intensive firms to cut production or idle plants, negatively impacting major industrial economies like Germany.
These factors are also pushing inflation up further. Energy and food components have been the biggest contributors to headline inflation, which climbed to record highs as 2022 progressed. That said, eurozone price increases are becoming increasingly broad. Core inflation has risen from 1.9% last September to 5.0% this year, led by sustained price increases across non-energy industrial goods and services.
"The path of energy prices will be critical to the eurozone’s performance in 2023."
The tight labor market in the eurozone is supporting economic activity, and it is also producing higher wage growth. But as in other advanced economies, prices are increasing at a faster rate than wages, eroding the purchasing power of households.
The risk of a wage-price spiral has triggered a faster monetary policy response by the European Central Bank (ECB). The ECB has taken interest rates firmly out of negative territory, and is poised to tighten further. We expect the ECB to conclude its efforts early next year at a terminal rate of 2.50%.
Inflation is poised to descend gradually as supply/demand imbalances and one-off factors start to ease. Much, of course, depends on the path of European energy prices, which remains substantially uncertain. Despite a weak demand outlook, we don’t expect the central bank to resort to easing next year, as inflation will continue to hover above the 2% target.
"Inflation is poised to descend gradually as supply/demand imbalances and one-off factors start to ease."
Fiscal policy in the euro area will remain somewhat stimulative. National energy support measures aimed at cushioning households and businesses are likely to remain in place well into 2023. Given the suspension of the Stability and Growth Pact targets until the end of next year, there will be no real pressure from markets or fiscally prudent member states to reduce debt or deficits meaningfully. That said, governments will have to be mindful of not injecting excessive stimulus, which would only add fuel to the inflation fire.
Overall, we expect the eurozone economy to witness a two quarter recession starting with the fourth quarter of this year. A resilient labor market, moderating inflation and disbursements under the EU Recovery Fund will help the region emerge from the downturn as 2023 progresses. But weaker foreign demand coupled with rising de-globalization currents will weigh on output and exports. Next year’s recovery will be gradual, unlike the V-shaped pattern seen during the pandemic.
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