Euro Area Macroeconomic Environment: Conflicting Signals on Recovery Strength
Although leading indicators edged further away from recession territory during February, stagflationary dynamics still dominate the Euro Area macro environment. Soft and hard data continue to send conflicting signals on the strength of the recovery. According to PMIs, the service sector was the main driver for the improvement in activity during February, while manufacturers have yet to see a meaningful boost in orders from the Chinese reopening. Retail spending had a muted start to the year and despite the ongoing recovery in consumer confidence, it seems private consumption is unlikely to return as a major growth driver in Q1 as inflation headwinds remain. Credit and monetary aggregates weakened further and still point to downside risks for the housing market and investment outlook.
In this article, we analyze the current state of the Euro Area macroeconomic environment and highlight the conflicting signals being sent by leading indicators. Despite some signs of improvement, stagflationary dynamics still dominate, and the recovery remains tentative. We examine the role of the service sector in driving growth, as well as the challenges facing manufacturers in the wake of the Chinese reopening. We also explore the muted retail spending and the impact of inflation on private consumption as a growth driver in Q1. Additionally, we discuss the downside risks indicated by credit and monetary aggregates for the housing market and investment outlook. Stay tuned for a comprehensive analysis of the Euro Area macroeconomic environment.
Euro Area Firms Continue Hiring Despite Rising Wage Costs and Uncertain Demand
In February, euro-area firms continued to hire despite rising wage costs and uncertain demand prospects. However, unemployment rates in Spain and Italy started to increase at the beginning of the year. Negotiated wage growth remained modest at 2.9% in Q4 22, similar to Q3 22. But, based on more high-frequency wage measures from job ads, wage growth is closer to 5%, which is not consistent with the ECB’s 2% inflation target. Wage costs are becoming increasingly important in driving underlying inflation pressures. This trend was visible in February, as PMI output prices showed diverging dynamics for manufacturing inflation, which is rapidly falling, and services prices, which are still strong. Although euro area headline inflation eased for a fourth consecutive month to 8.5% in February due to lower energy prices, core inflation hit another record high at 5.6%. While declining input and producer prices suggest a peak in core inflation should not be too far off, elevated selling price expectations for services suggest that ‘stickily’ high core inflation will remain a worry for the ECB, requiring policy rates to stay in restrictive territory for longer.
In light of the continued surprise increases in inflation, we have revised our ECB call and now anticipate a peak policy rate of 4% (deposit rate). Our forecast includes four rate hikes, with increases of 50 basis points in March and May, followed by an additional 25 basis points in both June and July. This analysis is outlined further in our recent report, “ECB Preview – Higher for Longer” published on March 2nd. It’s worth noting that as inflation concerns shift from the US to Europe, market-based inflation expectations on a 10-year horizon in the euro area have surpassed those in the US.
UK and EU Strike Northern Ireland Protocol (NIP) Deal to Avert EU-Border Issue Post-Brexit. Positive Market Reaction Expected as UK Parliament Prepares to Vote
After months of negotiations, the UK and EU have finally agreed on the Northern Ireland Protocol (NIP), a crucial post-Brexit measure to implement an EU border between the Republic of Ireland and Northern Ireland while keeping the British inner market intact. This agreement is a significant step towards averting a possible violation of the 1998 peace agreement.
Although a date for the UK Parliament vote on the NIP deal is yet to be set, it is expected to receive the necessary backing, particularly from Conservative MPs who are faced with the alternative of another potential Conservative government collapse and a continued stalled political process in Northern Ireland. The markets have reacted positively to this development, with the tail risk of an EU-UK trade war fading away.
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