OECD Economic Outlook, Volume 2023 Issue 1

Euro area

GDP growth is projected to slow to 0.9% in 2023 and then gradually strengthen to 1.5% in 2024. Private consumption will be supported by strong labour markets, but higher costs of financing and uncertainty will weigh on private investment. The tight labour market will continue to fuel wage growth in 2023, before wages start gradually easing in 2024. Lower energy and food prices will help reduce headline inflation in 2023, but core inflation will remain elevated. Risks remain tilted to the downside as another spike in energy prices could reignite the energy crisis, and restrictive monetary policy could expose existing financial sector vulnerabilities.

Persistent inflation, declining incomes and elevated uncertainty following recent turmoil in the banking sector call for coordinated and resolute policy actions. Fiscal measures adopted during the energy crisis need to be gradually withdrawn to rein in public debt and avoid providing fiscal stimulus at a time of high inflation. Monetary conditions need to remain tight to durably lower inflation.

Persistent core inflation and elevated uncertainty are weighing on the outlook

GDP growth in the first quarter of 2023 was 0.1% quarter on quarter. Uncertainty remains elevated and the signals from forward-looking indicators of sentiment are mixed. Improvements in output Purchasing Managers’ Indices have moderated in the second quarter of 2023, as strong service sector growth contrasted with weakening demand for goods. Stronger activity levels are also reflected in robust job creation and solid employment growth. At the same time, consumer and, to a lesser extent, business confidence remain well below their long-term averages. Headline inflation has continued to moderate, to 6.1% in May from its peak of 10.6% last October, but core inflation has increased further. Underlying inflation remains broad-based geographically and across consumption items, although inflation dispersion has recently stabilised. Inflation expectations have increased even at longer‑term horizons. Bank lending has moderated across euro area countries, reflecting weaker supply and demand of credit. Declining real incomes have been partly protected by fiscal measures that compensate for higher energy prices, albeit at the cost of weakening the incentives to reduce energy consumption. Labour markets remain tight, with the euro area seasonally adjusted unemployment rate at 6.5% in April 2023, and rising wage growth and increasing wage demands in many countries.

Euro area: Labour market and inflation indicators

1. Data refer to the euro area including 20 member countries.

2. Age group 15 and over.

3. Dispersion measures refer to the individual euro area countries.

Source: OECD Short-term Labour Statistics database; Eurostat Harmonised index of consumer prices (HICP) database; and OECD calculations.

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Euro area: Demand, output and prices

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Euro area: Fiscal and monetary indicators

Source: OECD Economic Outlook 113 database.

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Recent US banking sector turmoil did not spill over directly into the euro area. However, market strains led to a large fall in bank equity prices, increasing the cost of capital. The economic fallout in the euro area from Russia’s war of aggression against Ukraine has been contained. Direct trade with Russia is low and has been reduced further by the ban on Russian seaborn crude and oil imports. The energy crisis has abated, reflecting both stronger supply, such as the inflows of liquified natural gas into Europe, and reduced demand driven by a steep drop in consumption, partly due to mild weather conditions during the winter. At the same time, in the most energy-intensive industries, high prices have led to production cuts or curtailments. Loans to energy-intensive firms have, since Russia’s invasion of Ukraine, seen higher probabilities of default than loans to other firms. The war in Ukraine also continues to have substantial effects on the euro area economy through persisting supply chain disruptions and elevated costs for some agricultural commodities. EU countries are providing temporary protection to about 4 million Ukrainian refugees. To help Member States meet related costs, the EU has made available EUR 27 billion (0.23% of euro area GDP) from the cohesion and pandemic recovery funds.

Macroeconomic policies need to be tightened further to reduce inflation

While starkly different across countries in the euro area, the fiscal stance is projected to remain restrictive for the euro area as a whole in 2023 and even more so in 2024. Fiscal support to cushion the impact of high energy costs in 2022 was high and mostly untargeted, amounting to more than 2% of GDP in some euro area countries. A gradual withdrawal of support, with income support targeted only on vulnerable households, is particularly important to curb the deterioration of public finances and provide the needed macroeconomic policy tightening. In addition, the war in Ukraine has triggered a rise in military spending and investments to secure energy supply in many countries, which need to be delivered without overstimulating the economy.

The ECB has continued to tighten monetary policy, but further policy rate increases are needed to durably reduce the underlying inflationary pressures that are pushing up core inflation. A period of below-trend growth is likely to be needed to help lower resource pressures, including the short‑term effects of additional public expenditure associated with the Next Generation EU (NGEU) programme. The main refinancing rate is projected to rise to 4.25% in the third quarter of 2023 and to remain unchanged through the rest of the projection period.

Growth will rebound in 2024 as real incomes gradually recover

Quarterly growth is projected to slow in 2023, driven by still-elevated energy and commodity prices, continuing supply bottlenecks and tighter financing conditions. Despite robust wage growth, consumer price inflation of 5.8% in 2023 will mean negligible growth of real disposable income and weigh on private consumption. Investment will be held back by high uncertainty and tighter financing conditions, although additional spending of just below 1% of GDP a year under the NGEU programme will moderate the slowdown. Headline inflation is projected to moderate perceptibly in 2023, with declining energy prices and subdued domestic growth helping to contain price and cost pressures. Core inflation, however, is projected to still remain above the ECB inflation target at the end of 2024.

The risks to the projections are to the downside. The energy crisis may be rekindled by higher demand for liquified natural gas by China or unintended effects of Western sanctions on Russian oil, especially close to or during the next winter. Trade related tensions remain a concern. Further fragmentation of global supply chains and barriers to trade would weigh on external demand in the euro area and contribute to inflationary pressures. Financial stability risks are also increasing. Strains from tighter monetary policy could intensify, especially among nonbank financial intermediaries. A much tighter monetary policy could also heighten the risk of a recession. On the upside, a durable conclusion of the war in Ukraine could alleviate upward pressure on energy and food prices. A stronger recovery in China could also add to external demand.

Expanding productive capacity and supporting the green transition

The war in Ukraine has strengthened the link between the twin goals of energy security and climate change mitigation. An effective disbursement of the Next Generation EU funds will help accelerate both the diversification of energy supplies and the green transition. Careful design and monitoring at the EU level would help to maximise effectiveness of such policies, while ensuring a level playing field. Fiscal measures to cushion the impact of high energy prices should be gradually withdrawn to preserve incentives to reduce energy consumption and limit adverse effects on debt sustainability. Investment in clean energy and energy infrastructure will need to increase substantially by 2030. A clear policy framework to support early‑stage green investment should combine price signals with regulatory and fiscal tools at the European level. Continued monetary policy tightening should be complemented, as needed, by macroprudential policy and the use of targeted instruments to address vulnerabilities in the financial sector.