OECD Economic Outlook, Volume 2023 Issue 1

Luxembourg

GDP growth is projected to slow to 0.8% in 2023 from 1.6% in 2022 before picking up to 2% in 2024. Measured activity in the key financial and insurance services sector is weakening, and tightening financial conditions are slowing private investment. Domestic consumption will sustain activity in 2023 and 2024, and a partial recovery in net exports and investment will boost growth in 2024. Risks are tilted to the downside, as the looming housing market correction might have a larger-than-expected impact on private consumption. Measured activity is highly sensitive to financial market prices and developments.

While some mild fiscal expansion might be warranted to sustain consumption in the short term, energy-related support should be phased out and the fiscal stance tightened as the economy recovers. Looking ahead, reforming the pension system to ensure long-term fiscal sustainability should be a priority. A reform of the wage indexation system to restrict indexation to non-energy price inflation should also be considered. Family policies to bring the working time of women more in line with that of men should be strengthened.

2022 ended with a sharp contraction

GDP shrank by over 3% in the fourth quarter of 2022. The slowdown was broad-based. However, key high-frequency indicators, such as retail sales and industrial production, show a possible rebound in domestic activities in the early part of this year. Headline consumer price inflation decreased substantially in the first months of 2023, to below 3% in April 2023, the lowest in the European Union. After growing more than 90% since 2015, residential property prices started to decline at the end of 2022. The labour market has so far proved resilient, with the unemployment rate staying below 5% over recent months.

Luxembourg: Inflation and housing indicators

Source: OECD Economic Outlook 113 database; and OECD Analytical House Prices database.

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Luxembourg: Demand, output and prices

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Weakness in global financial markets in 2022 hit Luxembourg’s mutual fund industry, contributing to a pronounced slowdown in the financial and insurance services sector in the last quarter of last year. Turmoil in the banking sector in some OECD countries in 2023 does not seem to have spread to Luxembourg so far. Global energy prices rose sharply in 2022 but their recent reversion towards historical averages has contributed to disinflation.

Generous fiscal policy support measures are being extended

Financial conditions are expected to keep tightening as a result of euro area monetary policy and are contributing to the correction in the housing market. In accordance with the social partners, the government legislated a fiscal support package last year, worth about 3% of GDP over 2022-23. The package helps the economy deal with the energy price shock and keeps inflationary pressures in check to limit the extent of the automatic wage indexation to inflation. It includes capping gas and electricity prices for all households, distributing subsidies to disadvantaged households and energy-intensive firms, and a one-year cut of the value added tax (VAT) rate. A new agreement was reached in March 2023 to extend most measures to 2024. In addition, the government announced the indexation of the personal income tax brackets to inflation in fiscal year 2024 as well as a generous one-year personal income tax credit for 2023. These measures will result in a significant easing of the fiscal stance, with the budget balance expected to change from 0.2% of GDP in 2022 to a deficit of almost 2½ per cent of GDP in 2023.

Growth will slow substantially in 2023 before picking up in 2024

GDP growth is projected to slow to 0.8% in 2023. Tighter euro area and global financial conditions will reduce the volume of cross-border financial activities and increase borrowing costs, dragging down net exports and private investment. Activity will be supported by healthy domestic consumption helped by rising disposable real incomes, on the back of three rounds of wage indexation and expansionary fiscal policy. Growth will pick up to 2% in 2024, benefitting from a modest recovery in exports and private investment and continued robust growth of domestic consumption. The unemployment rate will tick upwards, reaching over 5½ per cent in the first half of 2024. Headline inflation will decrease in 2023, due to the reduction in energy prices and the VAT rate cut, before rising slightly in 2024 due to the expiration of the VAT rate cut and wage pressures. Core inflation will increase in 2023, due to wage indexation, before easing in 2024. A larger-than-expected housing market correction represents a significant downside risk.

The government should focus on embedding resilience

The government should scale back energy-related fiscal support while energy prices are in line with their historical averages and look to strengthen the fiscal balance. If energy and food prices spike again, support should be extended only to vulnerable households inadequately covered by the general social protection system. Looking ahead, addressing long-term fiscal pressures from the pension system due to ageing is a key priority. A reform of the wage indexation system to restrict indexation to non-energy price inflation would help to manage external price shocks. While Luxembourg has managed to close the gender wage gap, family policies, such as the harmonisation of paternity and maternity leave, should be introduced to attract more women into the labour market and bring their average working time more in line with that of men.