Euro area economic growth surprised on the upside, with stagnant GDP in Q4 2022 and likely modest growth in Q1 2023, quelling previous expectations of an imminent recession. Inflation has passed its peak (10.6% in October 2022) and begun to decelerate, driven by falling energy prices and base effects. In coming quarters, declining inflation will bring some respite to consumers. Real wage growth, after bottoming at -4.9% in Q3 2022, is accelerating and is expected to turn positive in Q4 2023. Despite the banking stress that hit financial markets during March 2023, recent data suggest that financial tensions have so far made little impression on consumers and businesses. Resilient labor markets continue to support consumer income and China’s reopening has contributed to the global demand recovery. As a result, most European economies are expected to avoid GDP contraction in 2023.

Prolonged elevated energy prices and inflation, compounded by monetary policy tightening, will continue to impact household consumption and economic growth. In the baseline scenario, in which we assume that the recent financial sector turmoil is contained, GDP growth in the euro area should decrease from 3.5% in 2022 to 0.7% this year, recovering to 1.3% in 2024 and 1.9% in 2025. Therefore, growth is expected to be slower than the pre-pandemic 2014-19 average of 1.9%. European economies will remain well below pre-Covid trends, pointing to the long-term negative effects of the pandemic and the war in Ukraine.

Despite decline in energy prices, elevated inflation can prove more sticky

Downward inflationary trends could be counterbalanced by a strong and sustained wage growth, which has accelerated in the euro area. The economic slowdown has caused some softening of demand for labor, but labor markets remain much tighter than before the pandemic. Moreover, previous increases in core goods PPI in Europe have been only partially passed on to consumers. Consequently, core goods HICP inflation (excluding volatile energy and food components) may not fall as quickly as some might anticipate due to declining PPI inflation. There is also little sign of abating price pressures in services, though they are no longer intensifying.

The risk of sticky inflation seems to be confirmed by recent data indicating higher than expected core inflation that has not yet peaked in numerous European countries. Underlying price pressures are therefore proving more persistent, particularly with tight labor markets in many economies.

While it is forecasted that inflation in Europe will fall relatively quickly during the course of 2023, in annual average terms, it will remain elevated. In the euro area, inflation will reach 6.1% and some CEE countries, especially Hungary, Czechia, Poland and Slovakia, will continue to see double-digit figures in 2023.

Persistent inflation signals that central bank rates may stay higher for longer

In the euro area, inflation should reach the European Central Bank (ECB) target of 2% in the second half of 2024, but core inflation may remain higher until the second half of 2025. For many EU countries, price growth will remain above central bank targets until 2025 and for some even longer.

The ECB will maintain a data-dependent approach and, due to increased uncertainty over the effects of the recent financial-sector turmoil on credit conditions, will refrain from providing guidance on the future interest rate path. However, given that core inflation in the euro area has recently hit another record and labor markets remain very strong, in EY`s view, for most ECB policymakers further rate hikes will be warranted. It is expected the ECB deposit rate to be raised by another 75bps up to 3.75%.

Following the latest rate increase (by 25bps to the 4.75-5% range), the Fed has turned significantly more dovish as a result of the turmoil in the US banking sector. Still, another 25bps hike in May 2023 seems likely and it is also expected the Bank of England to raise its base rate once more, to a peak of 4.50%.

The 2023 economic outlook has improved, but the balance of risks leans to the downside

Key risk factors:

• Inflation proving more persistent.
• Strong labor market continues to be a major source of upside risks to the inflation outlook.
• Geopolitical tensions, including the war in Ukraine, continue to be a key risk and if they intensify, could lead to more energy and food price spikes (especially if the Black Sea Grain Initiative is not renewed), pushing inflation up.
• China’s reopening, while easing supply bottlenecks and supporting global growth, will add to price pressures through increased demand for energy commodities, especially natural gas.
• Potential harsh weather conditions could exacerbate imbalances in energy markets, particularly ahead of the 2023-24 winter.
• The decision of OPEC+ members on 2 April 2023 to cut oil output only adds to the growing concerns over energy prices and economic outlook.
• The analysis shows that Europe is more vulnerable to a renewed increase in energy prices than other major economies, in particular the US. In the event of another spike in energy costs, the most adversely impacted European economies would include: Romania, Hungary and Czechia.
• The recent turmoil in the banking system, beginning with the failures of some US banks, is a new cause for concern. Financial tensions may make banks even more reticent in lending.
• In the baseline scenario, the banking turmoil will be contained, without significant impact on the European economy. However, volatility in market sentiment could continue. In an alternative scenario, in which is assumed that the current turmoil leads to an additional tightening of credit conditions (a third as large as during the global financial crisis), by 2025 GDP in the euro area would be almost 2% lower than in the baseline.
• Elevated debt levels increase vulnerability, especially of emerging markets and developing economies, to potential financial market turbulences. They also limit the fiscal space to offset new negative shocks and their impact on households and businesses.