Eurozone - Underlying inflation not yet easing
Underlying inflation is looking stubbornly firm in the eurozone.
The eurozone economy is clearly slowing, but underlying inflation is not easing yet, with wage growth higher than expected in Q4. We still expect moderate contractions in GDP during the next few quarters, as the impact of interest rate hikes hits the economy
After raising its policy rates by 50bp at the March meeting, the ECB dropped all guidance on future policy moves. It seems likely that the ECB’s bias is still towards further rate hikes, assuming that market tensions and banking sector worries subside
Eurozone GDP growth in 2022Q4 was revised lower, to 0.0% qoq, down from the first estimate of 0.1%. The details showed that private consumption and fixed investment plummeted (-0.9% and -3.6% qoq, respectively), whereas government consumption increased (+0.7% qoq). Net exports contributed positively to growth as well (0.9pps qoq), but this was due to a collapse in imports (-1.9% qoq), with exports broadly stable (+0.1% qoq). We expect GDP to contract moderately during most of 2023. Monetary policy tightening by the main central banks will reduce growth in global trade and eurozone exports, while fixed investment will probably decline as unit labour costs and borrowing costs jump higher. A rising percentage of companies report that financial circumstances are limiting the level of production (see graph below left). However, private consumption could be less negative than we thought in the first months of the year, as wage growth accelerates more than expected (hourly wages rose 5.1% yoy in Q4, up from 3% in Q3). We have revised our forecasts for consumption and GDP growth in Q1 slightly upward and now see GDP contracting by only 0.1% qoq. However, the labour market is expected to deteriorate in the course of the year, with unemployment rising. This should reduce wage growth and private consumption.
Headline inflation has dropped from a peak of 10.6% in October 2022, down to 8.5% in February 2023. The drop was entirely due to falling energy price inflation, with food price inflation and the core inflation rate still trending higher. Looking forward, we continue to see both headline and core inflation falling rapidly later in the year on the back of the decline in wholesale energy and food prices, as well as dissipating supply chain bottlenecks. Core inflation will probably be more sticky than the headline rate in the short-term, but should also ease going forward. The lagged impact of higher energy prices on the prices of goods and services should peter out in the coming months. It seems the only part of inflation that could rise somewhat further is services sector inflation, which could be pushed higher by rising wage costs on the back of the labour shortages that emerged in the sector after the pandemic. However, the economic slowdown is expected to limit overall wage growth, which should also reduce services sector inflation in the course of the year.
At its March meeting, the ECB hiked its key policy rates by 50bp, while dropping all guidance on future policy moves. It seems that the ECB’s bias is still towards further rate hikes, at least if its baseline scenario plays out and financial market tensions continue to ease. Our baseline sees the deposit rate peaking at 3.75% in June, before a rate cut cycle begins in December and continues during 2024.