European Views: A Faster ECB Exit

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.