European Macro Outlook: What's in a Number?



is referred to as economic inactivity 1 —the economic inactivity rate in the UK averaged 36.8% as of fourth quarter 2022 versus 35.9% in fourth quarter 2019. This contrasts with 25.2% in the euro area, which is down from 26.1% in fourth quarter 2019. Higher interest rates: the Bank of England (BoE) has raised interest rates faster and higher relative to the European Central Bank (ECB). Since the end of 2021, the BoE increased its policy rate by 390 basis points (bps), while the ECB did so by a lesser 250 bps. The BoE also started raising rates eight months ahead of the ECB. Brexit: Nearly two years after Brexit, economists have reached a consensus that Brexit has and will continue to impact the UK’s economic performance with the economy smaller by as much as 4%, according to the Office for Budget Responsibility.

Rate hikes are expected to weigh on growth more than inflation in 2023. This largely explains growth remaining well below potential 2 , with an expected euro area growth rate of 0.4% year-over-year (YoY) in 2023 and -0.3% YoY in the UK. For reference, the potential GDP growth rate 3 in the euro area is estimated to be around 1.2% and around 0.9% for the UK. The impacts of monetary policy on the real economy are often lagged. According to the ECB, a 100-bps increase in short-term interest rates reduces real output (the output gap as a percentage of GDP) by around 1 pp, with the maximum effect occurring five quarters after the rate hike. Therefore, with rate hikes totalling 350 bps between July 2022 and March 2023, real output is assumed to be 3.5% lower in H2 2023 for the euro area. The BoE started raising rates eight months ahead of the ECB and has since increased rates by 390 bps. With another 50-bps rate hike expected in March, real output is expected to be 4.4% lower than it would have been without rate hikes. The models used by the ECB also suggest a 100 bps rate increase will reduce inflation by 0.3-0.4 pp after five quarters. The current and projected increases in the policy rate are therefore expected to only reduce inflation by 1.5 pp over time. Monetary policy tightening is expected to have limited influence on controlling inflation, as global supply chain disruptions due to the Russia-Ukraine war and lingering pandemic bottlenecks have been driving increases to sustained price levels. In contrast to the U.S., euro area inflation is dominated by energy related price increases, which account for 30% of headline CPI growth. Similarly in the UK, energy accounts for 34% of inflation at present. Europe’s central banks are aiming to reduce additional demand-related inflationary pressures by tightening financial conditions. Inflation has indeed abated from its peak levels recorded in October 2022 for both the UK and euro area, and currently sits at 10.1% and 8.6% (January) YoY, respectively. Despite the recent easing in prices, we expect inflation to remain above target in 2023. The recent agreement among EU member states, which includes a cap on wholesale gas prices if they exceed €180 per megawatt hour for three days running, is a welcome relief. This follows Europe’s benchmark price for natural gas reaching €340 per megawatt hour in August—more than three times the current price and around 17 times the price prior to the pandemic. The cap is temporary and will be in place for a year. Nonetheless, this will help contribute to a more sustained fall in inflation throughout 2023. 2 The level of output which does not generate inflationary or deflationary pressures beyond a central bank’s target. 3 Potential GDP figures refer to OECD estimates.


Source: Cushman & Wakefield Research, Eurostat, Moody’s Analytics *Forecasts refer to C&W Baseline Scenario – January 2023

A Lackluster Recovery The near-term outlook looks brighter than many expected six months ago. This is largely due to the improvement in Europe’s energy picture. Natural gas prices have fallen by 85% from their peak in August 2022 and Brent Crude prices have also come down sharply. Despite the fall in energy prices, inflation remains elevated at 8.6% y/y in the euro area as of January. Moreover, unemployment remains low across most of Europe which is keeping pressure on wages. With inflation still running hot, we expect central banks will continue to tighten policy rates during the winter, before stopping this spring. Terminal rates will settle at 3.5% in the euro area and 4.5% for the UK, provided inflation returns close to target (2%), as expected. Further interest rate hikes could remain a possibility if there are fresh signs that inflation would remain elevated.

1 Economic inactivity refers to people outside the labour force (employed + unemployed).


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