1. Growth across the Euro area has so far held up better than expected since the onset of the war in Ukraine. The ﬂash PMIs surprised notably to the upside in April, with the composite index moving up to a 7-month high. While manufacturing momentum moderated—driven by Germany—growth in services activity picked up, due to a continued post-Omicron bounce. At the same time, energy prices have fallen and Russian gas ﬂows into the Euro area have not deteriorated relative to the end of last year, pointing to less production weakness in gas-reliant industries. We therefore upgraded our area-wide Q1 GDP growth estimate to 0.3% (released April 29) and raised our Q2 nowcast to +0.2%, and therefore no longer look for a contraction in Euro area activity.
2. But we maintain our view that the war will weigh signiﬁcantly on growth this year. On the household side, we expect anaemic consumption growth as ﬁscal support and a sizeable unwind of excess savings built up during the pandemic are insufﬁcient to offset our forecast of a 3% real income squeeze. On the ﬁrm side, investment growth is likely to slow towards the end of the year as both high uncertainty and tighter ﬁnancial conditions act as a drag. Finally, net exports are likely to slow as exports to Russia fall substantially, while lower energy imports from Russia are likely to be largely substituted by energy imports from elsewhere. We therefore downgraded our H2 activity forecast and now look for growth of 2.6% in 2022 (vs 2.8% consensus) and 1.9% in 2023 (vs 2.4% consensus), and thus maintain our below-consensus forecast. A ban on Russian gas remains an important downside risk to our updated forecasts, especially for Germany and Italy.
3. French President Macron was re-elected in the run-off election against far-right candidate Le Pen, outperforming the latest opinion polls. We expect President Macron to embark on a moderate ﬁscal consolidation path from 2023 and continue his reformist agenda, including the labour market and pension reforms. That said, the extent to which he can push these reforms will depend importantly on the June parliamentary elections, where Macron’s party is likely to gain a narrower majority than in 2017. At the EU level, we expect President Macron to support further ﬁscal support, including an EU-wide ﬁscal response to the energy crisis and a reform of the ﬁscal rules. Although EU institutional progress takes time, the strongly pro-EU leadership trio of President Macron, Chancellor Scholz and Prime Minister Draghi points to further ﬁscal integration ahead.
4. Meanwhile, inﬂation measures have continued to surprise to the upside across Europe, as headline HICP inﬂation hit 7.4% in March and is running in double digits in a number of smaller Euro area economies. Moreover, pipeline indicators have continued to ﬁrm, including an all-time low unemployment rate (at 6.8% in February), very strong producer prices (with the core PPI up 13.9% in March in Germany, the highest reading since records began in the 1960s) and surging ﬁrms’ input costs (including further gains in PMI output prices). While our forecast for April ﬂash headline inﬂation is below consensus (released April 29), we maintain our view that the peak in Euro area inﬂation is yet to come in the summer
5. Given continued cost-push pressures and limited evidence of a sustained demand hit, recent ECB commentary has emphasised rising concerns, with a number of Governing Council members ﬂagging the possibility of an earlier end to QE and the ﬁrst hike in July. We therefore now look for the ﬁrst 25bp hike in July, followed by rate rises in September and December. We expect the Governing Council to decide at the June meeting to ﬁnish APP at the end of Q2, although the ECB could conclude QE ahead of its meeting in July. Given the earlier start, we now see more urgency to normalise and we look for an additional hike in 2023Q3 with four further rate increases next year (March, June, September and December) to an unrevised terminal rate of 1.25%. While a sharper slowdown in growth or renewed sovereign stresses could lead to a slower policy normalisation, clearer signs of second-round effects could require a faster exit.
6. Evidence on second-round effects remains ambiguous, however. On the one hand measures of inﬂation expectations have moved up further in recent weeks, with European inﬂation swaps converging towards US levels and long-run inﬂation expectations in the ECB’s Survey of Professional Forecasters (SPF) now slightly above 2%. On the other hand, indicators of wage growth have not moved up yet, with our area-wide wage tracker still around 2%, in sharp contrast to the US and the UK. Continued labour market improvement, ﬁrming wage surveys (such as input prices in the services PMIs) and the incoming minimum wage increases all point to a gradual ﬁrming of pay growth ahead. But the wage growth data are noisy and released with a long lag, creating uncertainty around the speed at which pay pressures are building. The emergence of clear second-round effects would likely prompt the ECB to hike into restrictive territory and requires careful monitoring.
7. The UK activity outlook has weakened signiﬁcantly given stubbornly high inﬂation, rising interest rates and falling consumer conﬁdence. Headline CPI hit 7% in March (the highest rate since 1992) and looks set to climb further to 9.5% in October (after a temporary headline peak of 9.2%yoy in April). Given the sharp drag on real household incomes, we downgraded our UK growth forecast to 3.9% for this year and 1.2% for next year, below the 1.6% consensus for 2023. While the growth outlook is expected to soften notably, we do not look for a UK recession in our baseline forecast. The principal reason is that the stock of excess household savings of around £170 billion (or 7% of GDP) should provide a signiﬁcant cushion to the real income hit, allowing the savings rate to run below its equilibrium level for some time.
8. The BoE therefore faces a delicate balancing act. On the one hand, the MPC needs to tighten sufﬁciently to cool the labour market, rein in high inﬂation and limit the risk of a de-anchoring of inﬂation expectations. External MPC member Mann, for example, noted last week that she is considering whether interest rates need to rise by more than a quarter point in May, raising the prospect of one (or more) 50bp votes at next week’s meeting. On the other hand, BoE ofﬁcials are mindful of avoiding a policy overtightening, as the economy is already likely to slow notably on the back of the
cost-of-living shock. Governor Bailey argued on Thursday that the MPC remains in tightening mode but faces a “narrow path” to balance these risks. We think this narrow path is consistent with back-to-back 25bp hikes until August, followed by asset sales and a slowdown in the pace of hikes. But signs of growth resilience and further increases in long-term inﬂation expectations skew the risks towards a faster pace in coming months.