OECD Economic Outlook, Volume 2023 Issue 2

Luxembourg

GDP will shrink by about 1.1% in 2023, driven down by a deep contraction of the key financial services sector, before rising by 1.4% in 2024 and 3.1% in 2025, supported by monetary policy easing. The unemployment rate will keep increasing up to the end of next year. Headline inflation will rebound at the beginning of next year, due to base effects and wage indexation, before declining towards 2% in 2025.

Fiscal policy is supporting household incomes through the generous unemployment insurance system and energy support measures, but energy support should be unwound as the economy recovers over 2024-25. The indexation of wages to headline inflation has preserved real wages but risks undermining firm productivity. The government should address long-term fiscal pressures stemming from the pension system and work disincentives due to the joint taxation of couples.

Activity has contracted

Activity contracted sharply at the end of 2022 and has remained weak this year, primarily reflecting the impact of tighter financial conditions on Luxembourg’s large financial services sector. Business surveys and hard economic indicators point to a further deterioration in the second half of 2023. The housing market is undergoing a correction and credit is shrinking due to tighter lending conditions. The ongoing slowdown is weakening the labour market. While headline inflation eased in early 2023, it has recently increased due to the indexation of wages to inflation.

Luxembourg: Activity and economic growth indicators

1Services.

Source: Statec; and OECD Economic Outlook 114 database.

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Luxembourg: Demand, output and prices

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Expectations of tight-for-long monetary policy have prolonged the decline in global bond prices, negatively affecting Luxembourg’s key mutual fund industry. Activity in key trading partners has been slowing, while growth in global trade has almost halted. Rising stress in global financial markets, due to geopolitical tensions, may add further pressures. Spillovers from global energy markets to households have been largely contained due to energy price caps.

Fiscal policy will turn restrictive next year

Euro area monetary policy will remain tight in the short term, before easing gradually over 2025. Fiscal policy support in 2024 will come from measures legislated last year and broadly extended into next year. These include energy price caps for households, the indexation of the personal income tax brackets, subsidies for disadvantaged households and energy-intensive firms, and cuts in employers’ social security contributions. These measures support incomes, and aim at keeping inflationary pressures in check to limit the extent of the automatic wage indexations to inflation, but disincentivise energy savings. Most of the measures are due to expire in 2024 and are assumed to not be renewed. The budget deficit will widen to 2.6% of GDP in 2023 and 2.9% in 2024, before improving to 1.9% in 2025 as the fiscal stance is tightened and the economy recovers.

Activity will recover robustly over 2024-25

The economy will contract further in the second half of this year, dragged down by weak exports on the back of tight financial conditions and slowing global trade, with GDP declining by 1.1% in the year as a whole. Activity will remain subdued in the early part of next year before picking up gradually, driven by the recovery of the key financial services sector, which will benefit from the onset of monetary policy easing in the major economies. GDP growth will be about 1.4% in 2024 and increase to 3.1% in 2025, supported by the continued pick up in exports and the recovery of the construction sector. Yearly headline inflation will rise in the early part of next year due to base effects, as the effect of energy price caps will fade, to then gradually decrease to just above 2% around end-2025. Core inflation will prove stickier, due to past and future rounds of wage indexation. The unemployment rate will rise to 6.2% by the end of 2024, due to the contraction of labour-intensive sectors such as retail trade, hospitality, and construction, and remain around 6% throughout 2025, lagging the economic recovery. An earlier-than-expected recovery in financial asset prices may provide an unexpected boost in activity, while a deeper‑than‑anticipated housing market correction may dent household wealth and lead to higher precautionary savings.

The government should focus on embedding resilience

Phasing out discretionary fiscal policy measures as the economy recovers will be important to limit the build-up of the public debt, which is projected to increase from about 24½ per cent of GDP in 2022 to about 28½ per cent in 2025. Reforming the pension system is needed to manage long-term fiscal sustainability pressures, as age-related spending is set to rise by over 4 percentage points of GDP from now until 2050 under current policies. Weakening the link between inflation in imported energy goods and wage re‑indexation would promote a more balanced burden sharing of negative supply side shocks between workers and firms, thus preserving firm competitiveness without the need for government interventions. Addressing work disincentives from the joint taxation of couples would help to further reduce gender gaps in the labour market and improve growth prospects.