OECD Economic Outlook, Volume 2023 Issue 2

Euro area

GDP growth is projected to slow to 0.6% in 2023 before strengthening gradually to 0.9% in 2024 and 1.5% in 2025. Private consumption will be supported by tight labour markets and increasing real incomes as inflation recedes. At the same time, higher costs of financing and uncertainty will weigh on private investment. Wage growth is projected to ease only gradually over the projection period. Employment bottlenecks in services will keep core inflation elevated until mid-2025, despite ongoing reductions in headline inflation.

Persistent core inflation, the rising impact of higher interest rates on the real economy and uncertainty associated with increasing geopolitical risks call for coordinated macroeconomic policies. Prudent fiscal policy is needed to rebuild fiscal space, while the European fiscal rules should be refocused on debt sustainability and multiannual expenditure plans. Monetary conditions need to remain tight to ensure continued disinflation.

Tight financing conditions and geopolitical uncertainty weigh on the outlook

GDP declined by 0.1% quarter on quarter in the third quarter of 2023. Uncertainty has increased further with the worsening geopolitical situation. Forward-looking indicators of sentiment and confidence have deteriorated. Improvements in the composite Purchasing Managers’ Indices dissipated in the third quarter of 2023, as manufacturing production continued to decline while confidence as well as output in services weakened. Headline inflation continued to moderate, from 5.2% in August to 2.9% in October. Similarly, core inflation decreased to 4.2% in October. However, underlying inflation remains sticky with services rising by more than 4% in annual terms. Market-based inflation expectations have stabilised above the 2% target even at longer-term horizons. Bank lending to firms and households has continued to weaken amid higher lending rates, lower loan demand and tighter credit standards. At the same time, the labour market has remained tight, with the job vacancy rate just marginally below its recent peak. The euro area seasonally adjusted unemployment rate stood at 6.5% in September 2023, with labour shortages reflected in above-average wage growth in many countries.

Euro area: Labour market and inflation indicators

1. The job vacancy rate measures the proportion of total posts that are vacant, expressed as the ratio of the number of job vacancies to the number of occupied posts plus the number of job vacancies.

Source: OECD Labour Statistics database; Eurostat Job vacancy statistics database; Eurostat Harmonised index of consumer prices (HICP) database; and LSEG.

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Euro area: Demand, output and prices

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Euro area: Fiscal and monetary indicators

Source: LSEG; and OECD Economic Outlook 114 database.

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The increase in US sovereign bond yields in recent months and higher inflation risk premia demanded by investors have increased yields on many euro area sovereign bonds. Against the backdrop of falling equity prices, stock prices of euro area banks increased, outperforming their US counterparts, and lowering the cost of new capital. The economic fallout in the euro area from Russia’s war of aggression against Ukraine has been moderate. Direct trade with Russia is low and has been reduced further through multiple rounds of EU-coordinated sanctions. European firms have been resilient during the energy crisis, partly due to strongly reduced demand for energy. Co-ordinated policies have also helped to increase resilience: liquefied natural gas import capacity has been expanded and is well-supplied, with the EU meeting its 90% gas storage target in August, well ahead of the November deadline. Accelerated deployment of renewables has also helped to lower dependence on gas. At the same time, output in the most energy-intensive industries has declined, weighing on growth, and leading to calls for subsidies to national industries that could potentially undermine the EU Single Market. EU countries have recently extended the temporary protection accorded to more than 4 million Ukrainian refugees until March 2025. To help Member States meet the costs of hosting refugees, the EU has made available EUR 21 billion (0.18% of euro area GDP) from the cohesion and pandemic recovery funds.

Ongoing public investment will help finance the green transition

Comprised of starkly different positions across countries, the euro area fiscal stance is projected to remain restrictive in 2024 and 2025, with cumulative tightening amounting to 1¼% of GDP. Fiscal support to cushion the impact of high energy costs is projected to be withdrawn gradually during 2024. Ensuring that income support is targeted on vulnerable households and avoiding a subsidy race between countries is essential to prevent the deterioration of public finances and provide the needed macroeconomic policy tightening. At the same time, the war in Ukraine has led to an ongoing increase in military spending, and the Next Generation EU (NGEU) programme has triggered investments to secure energy supply and accelerate the green transition of about 1% of euro area GDP per year. This spending needs to be delivered effectively.

The ECB has continued to tighten monetary policy, bringing the deposit rate to 4% and the rate on main refinancing operations to 4.5%, both at historic highs. Policy rates are projected to stay at this level into 2025, to durably reduce the underlying inflationary pressures that are keeping core inflation elevated. A period of below-trend growth will help lower resource pressures, including from buoyant labour markets and the short-term effects of additional public expenditure associated with the NGEU programme. Public investment is estimated to increase by as much as 2.5% of GDP until the end of the NGEU programme in 2026, crowding in private investment amounting to 5% of GDP. The main refinancing rate is projected to remain unchanged until the second quarter of 2025 and then gradually decrease to 4% at the end of the projection period.

Growth will strengthen in 2024 as domestic demand picks up

Quarterly growth is projected to remain weak in the near term, amid tightening financial conditions, rebounding energy and commodity prices, and elevated uncertainty. Despite robust wage growth, consumer price inflation of 5.5% in 2023 will continue to weigh on incomes and private consumption. However, real disposable incomes will recover as disinflation continues over the projection period. Investment will be held back by higher uncertainty and tight financing conditions, although additional spending under the NGEU programme will partly offset this. Headline inflation is projected to moderate further, to 2.9% in 2024 and 2.3% in 2025, with weak domestic demand growth helping to contain price and cost pressures. Core inflation is also projected to decline, albeit at a slower pace, returning to the ECB inflation target by the end of 2025.

The risks to the projections are to the downside. Energy prices may rebound on the back of elevated geopolitical uncertainty, especially during the upcoming winter months. Trade tensions may deteriorate further and could weigh on external demand and rekindle inflationary pressures. Financial stability risks remain elevated, as the effects of higher interest rates could trigger losses from defaulting loans and real estate exposures. Moreover, interest rates may need to stay high for longer than expected, or even rise further, heightening the risk of a recession and the exposure of financial sector vulnerabilities, particularly among non-bank financial intermediaries. On the upside, a stronger decline in elevated household saving rates could support private consumption. In addition, a durable reduction of geopolitical uncertainty could alleviate upward pressure on energy and commodity prices, and a stronger recovery in China could help lift external demand.

Macroeconomic policies need to stay the course to reduce inflation

The investment needs associated with improvements in energy security and decarbonisation policies are substantial. At the same time, prudent fiscal policy is needed to support ongoing monetary policy tightening and to continue rebuilding fiscal space. Effective disbursement of the Next Generation EU funds will help expand productive capacity in the medium term, but requires careful design and monitoring at the EU level. To avoid harmful subsidy races and ensure a level playing field, state-aid rules should not be relaxed further, and existing budgetary resources should be re-directed towards support for green R&D, innovation and early-stage support coordinated at the EU level. The monetary policy stance should remain restrictive, complemented, as needed, by macroprudential policy and the use of targeted instruments to address vulnerabilities in the financial sector.