Leading EU analysts say the area must pull together if it is not to fall further behind the US
The tightest cycle of interest rate hikes in the history of the European Central Bank may have come to an end, or so the market seems to think. The consensus is that there will be no further rate hikes at today's meeting. The ECB tightened by a total of 450 basis points between July 2022 and September 2023, and although the central bank has not announced the end of the rate hike cycle at recent meetings, its statements in recent weeks suggest that there is a strong chance that it has. Indeed, markets are already pricing in sharp rate cuts for 2024.
It is no longer a question of whether the ECB will raise, but how much it will cut next year
Yes, we believe that the ECB is done with raising rates,
Luca Mezzomo, head macroeconomic analyst at Intesa Sanpaolo Group told Portfolio. The expert attributes this to the prolonged impact of central bank tightening (slow interest rate transmission) and weak domestic demand, which is also affecting the labour market in the form of less aggressive wage increases. In addition, all inflation indicators are falling slightly faster than expected.
However, Mezzomo does not expect aggressive interest rate cuts from the ECB in 2024: “monetary policy will only be eased very gradually until the achievement of the inflation target becomes sure, ” he wrote in his reply. Intesa's economist expects the first rate cut in July 2024 and a cumulative rate cut of between 50 and 75 basis points for 2024 as a whole.
Agreeing with the markets Hélène Baudchon, Deputy Chief Economist at BNP Paribas, also thinks we have seen the end of interest rate hikes. However, she also warns that a further rate hike cannot be ruled out yet, given some of the central bank's tough-talking statements, but that the chances of that are slim. The ECB may stop raising rates because of disinflation and stagnating activity, according to the analyst, who adds in her reply :
This opens the door for the first rate cut to be delivered in April 2024.
Baudchon notes that, despite the narrative of persistently high interest rates put forward by the central bank, the “high for long” period would not be that long and would last 7 months according to their base case. At the BNP, they expect continued rate cuts, with a 25 basis point cut every quarter to track the fall in inflation, so the central bank can avoid a rise in the real interest rate. Thus, at the end of next year, the benchmark deposit rate could fall to 3.25% and the refinancing rate to 3.75%, she said.
Carsten Brzeski, chief global macroeconomist at ING in the Netherlands, agrees that the ECB has stopped raising interest rates, but says the rate cuts priced in by markets are excessive. He said that for the 150 basis point rate cut currently priced in by the market to happen, the eurozone would have to fall into a severe recession triggered by an external shock, and stagnation would not be enough. "I see the ECB cutting rates for the first time in June, by 25bp, and then cut in September and December by again 25bp each, bringing the deposit rate to 3.25% by end 2024," he told Portfolio.
End of the high-inflation era
The ECB may end the rate hike cycle because inflation is falling fast, as analysts have pointed out. The consumer price index fell to 2.4% in November this year, a significant drop from last year's peak of double-digit inflation.
Yes, elevated inflation is gone but a short-lived uptick in inflation at the start of the year is still possible,
Brzeski warns in his reply. He said this is because some government measures will expire next year, there may be second-round effects due to pricing practices, and wage pressure is still present. As a result, ING expects inflation to be between 2% and 3% next year.
Luca Mezzomo also said that we can be confident that inflation will not return to 2022 levels and will continue to fall next year. He also said there are upside risks (mainly from energy prices), but weak demand is expected to put downward pressure on wages and prices. In this environment, companies are also finding it harder to pass on cost increases.
Intesa Sanpaolo's analysts expect euro area inflation to drop to 2.3% by March-April next year.
After that, there will be small upward and downward swings, but inflation is not expected to be lower than that even in December 2024, with core inflation (currently still higher than the headline) expected to be around 2.1-2.2% next December.
"The headline print in particular (2.4% y/y) is good news at first glance as it is much less elevated than a few months ago (down 5 percentage points from March 2023) and no longer very far from the 2% target. On that basis, we could argue that elevated inflation is behind us," Hélène Baudchon wrote to Portfolio.
But core inflation is higher, remains high and quite far from the 2% target,
she reminds. In November, annual core inflation was only slightly below 4%. It could be another year before core inflation reaches the central bank's target level, and the road ahead will be bumpy, "made of good news and false hopes", according to the BNP analyst. Therefore, she says,
some caution is still required before stating elevated inflation is gone.
According to the analyst, the risks to inflation are more tilted to the upside due to stubborn inflation in some elements of the consumer basket, still strong wage pressures, and uncertainties about corporate pricing practices (not counting the new energy bills). "In summary, inflation is going the right direction but it is still not at the right level. We have to wait before claiming victory against inflation and giving the all clear," said Baudchon.
Could the European economy rebound next year?
Along with - and not independently of - the fall in inflation, the European economy has come under pressure. The euro area economy has been stagnating for several quarters and the ECB's interest rate hikes may still not be fully felt.
We expect this low-growth period to last at least two more quarters, until Q1 2024,
Baudchon stated.
A mild recovery is only likely to start in the second quarter, when the positive impact of interest rate cuts and falling inflation will begin to take hold in the economy. In addition, a new European Union instrument, the Next Generation EU, could also support growth.
For next year, it will all be about private consumption,
said Brzeski, who believes that as real wages rise, people will save as a precaution - adding, however, that others believe that real wage growth will spur consumption. In addition to consumption, external factors will have a major impact on the outlook for Europe: a soft landing for the US economy, a slowdown in China and geopolitical conflicts will continue to weigh on Eurozone growth. ING's baseline scenario is for the euro area economy to stagnate next year.
As for individual member states, Germany is in a more difficult cyclical situation than the other large eurozone countries (France, Italy and Spain), according to the BNP economist, because its economy is more open, its industry is more energy intensive and it is more dependent on foreign trade with China. According to the analyst, the German economic model faces cyclical and structural challenges, but, as Baudchon put it,
Germany has the capacity to adapt, and no choice but to adapt.
In 2024-2025, Spain is expected to continue to be the best performer of the big-4, followed by Italy, then France, with Germany the laggard. But over the longer-run, to what extent this divergence will close or not remains an open question, according to the analyst.
"Some countries, above all Germany, are hit more by the combination of cyclical headwinds and structural transitions, but no country will remain unharmed. To the opposite, contrary to the early 2000s when Germany was also sick man of Europe but the rest of the eurozone experienced strong growth, Germany’s economic problems will also be the rest of the eurozone’s problems now," Brzeski wrote.
According to Luca Mezzomo, varying exposure to external markets, the different structure of the economy and different fiscal policies could lead to different trajectories despite the common monetary policy, but he says there is no need to worry about this unless there are significant macroeconomic imbalances behind them.
It is sad, however, that some governments have wasted the opportunity to rebalance the budget in this period of low unemployment and high inflation,
Mezzomo added, recalling that the lack of a counter-cyclical fiscal policy means that monetary policy is overburdened and that the downturn is more likely to lead to a pro-cyclical tightening of fiscal policy.
Will the crisis have a lasting impact on Europe?
The COVID-19 crisis caused a deep recession on the continent, but the fiscal and monetary response to it has helped a swift recovery, with 2021 seeing growth numbers on the continent like never before. However, successive external shocks have stalled this growth and the euro area economy is stagnating. The question is: how has potential growth in the euro area evolved in the meantime? Will the continent return to the 1-2% growth rate it was enjoying in the years before the pandemic?
„2021 was exceptional: it was a year of post-pandemic rebound,” Mezzomo points out, adding that according to his assessment, the growth potential of the euro area is probably just above 1%. The energy price shock of 2021-22 could, however, cause some loss of productive capacity in energy-intensive sectors. Energy prices are structurally higher than in previous years, and the energy transition is reducing rather than improving productivity growth, the analyst argues.
According to Brzeski, "the strong fiscal support in 2020 and 2021 masked the ongoing structural transitions. Now that the effect of fiscal support and the normal rebound after the end of the lockdowns has faded away, the eurozone is again facing its structural weaknesses."
Baudchon recalls that the bounce in 2021 (and to a lesser extent in 2022), together with the Russian-Ukrainian war, led to a rise in inflation and, ultimately, monetary tightening. The slowdown in growth in 2022 was partly a natural phenomenon
"All the recent shocks (positive and negative) make it very hard to know what the normal rate of growth is today and how far we are from the potential growth rate," BNP's deputy chief economist warns. Not only these, but also other developments (AI, decarbonisation, ageing, geopolitical fragmentation) make it difficult to estimate how the EU's potential growth has changed.
I would tend to be optimistic and be of the view that the potential growth rate has not been negatively hit by the Covid-19 shock, at least not significantly so,
she wrote in her reply.
When we hear about slow growth in the euro area, it can be particularly worrying in the light of the fact that another major advanced economy, the United States, has consistently grown much faster than the EU average, meaning that Europe's gap with the US is widening.
One reason for this is population growth, which is lower in the EU than in the US, Mezzomo points out. Fiscal policy is also more supportive of demand overseas than in Europe.
But is the EU really falling behind? When you look at per-capita GDP, it is not that clear,
said Mezzomo, adding that the question should also be raised whether growth also increases prosperity. "For instance, the US is lagging behind most EU countries in terms of healthcare performance and life expectancy. OECD data show that people leaving in the US are twice more likely not to have access to proper sanitary treatment than German or Dutch citizens, while spending much more than them on healthcare."
Carsten Brzeski gave a short answer to the question of what Europe could do to avoid falling behind the US: "more European integration, more fiscal support, more intra-European investments in infrastructure, digitalization and education." Hélène Baudchon echoed similar sentiments:
In very general terms, Europe should simplify and strengthen its governance, reduce all the sources of fragmentation and frictions (for instance, finalize at last the Capital Markets Union), in order to be a more integrated economic and political area and unleash all its potential.
Cover photo: Getty Images
