Global Economic Outlook: Hawk-Eyed

Eurozone

• • A recession was expected towards the end of 2022 as the eurozone households grappled with high energy and food prices that stretched their budgets. Indeed, the eurozone economy endured a mild winter retreat. Gross domestic product (GDP) contracted 0.1% quarter over quarter in both the first quarter of this year and the last three months of 2022. Thanks to the cost of living crisis, household consumption pulled down GDP growth by 0.1 percentage points, after a larger 0.4 percentage point drag in the last quarter of 2022.
    • After a positive start to the second quarter, incoming data and surveys are pointing toward weak economic momentum. The euro area industrial sector is suffering from weak orders. A softer global economic backdrop will weigh on export performance. Investments will be adversely impacted by higher interest rates.
    • Thriving labor markets should steady consumer spending. This, coupled with lower inflation, will likely result in a modest but fragile recovery in the second half of 2023.
  • In a welcome reprieve, eurozone inflation surprised to the downside in May, with relief coming from components other than energy. The year-over-year change in the overall consumer price index decelerated by almost a full percentage point to 6.1%. The core measure (excluding energy, food, alcohol & tobacco) decelerated three-tenths to 5.3% year over year as prices of both services and non-energy industrial goods fell in May. This news provides some hope that underlying price pressures could be easing.
    • The worst phase of price increases is likely in the past for Europe, but meaningful improvements in inflation from here will be harder to achieve. As the energy shock unwinds and supply chains normalize, wage growth has become the central influence on recent inflation developments.

• The European Central Bank (ECB) has responded to the surge in inflation by embarking on the fastest tightening cycle in its history. Although core inflation decelerated last month, one data point doesn’t make a trend, and underlying price pressures are still elevated. This justifies a hawkish tone from the ECB. Officials signaled that more tightening will likely be required amid strong labor market and wage dynamics. A hike in September, which seemed highly unlikely prior to this month’s meeting, is now a real possibility.
  • We now expect the ECB to hike by 25 basis points at its next two meetings in July and September, taking the peak deposit rate to 4.00%. The risk of overtightening is present, as the impact from past increases in interest rates has yet to fully feed through to the real economy. This is perhaps the only factor that could force the ECB to pause the current cycle next month.
• With Europe's gas crisis diminished and budget rules set to become binding again in 2024, fiscal policy will soon become a drag on growth. However, some European governments remain under pressure to provide support to cap rising prices and protect purchasing power. But there is limited scope for further assistance, given rising government interest payments.
  • Europe will also have to find room in national budgets to address climate change, defense, and technology transition. Debate is active on how these investments will count against debt and deficit targets.

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