Eurozone economic outlook: Good news, but with a disclaimer

We have significantly upgraded our economic growth projections for the eurozone in 2023 from -0.5% to 0.3%. The revision is based on better-than-expected performance in the second half of 2022, as well as an improved outlook for the first half of 2023. We expect the eurozone to enter a technical recession in the first quarter, although we do have to note that it will be a very mild one, given that Q4 growth came in at -0.03%. At the same time, however, we have slightly downgraded our forecast for 2024 from 1.2% to 0.9% as, in our view, medium-term challenges have increased. We also believe that medium-term risks to growth, stemming from geo-economic risks and the higher interest rate environment, are tilted to the downside. Our projections compare to a consensus forecast of 0.4% and 1.2%, respectively.

In early 2022 we were among the first to predict an economic recession for the eurozone based on the energy crisis that was unfolding. Yet energy prices have dropped significantly below previous projections in recent months (see Figure 3) and concerns regarding energy security have largely subsided. Furthermore, the economy has proven to be quite resilient. Despite the unprecedented rise in energy prices in 2022, industrial production is still comparable to pre-Covid levels, as the production of non-energy intensive goods has compensated for a slump in the production of energy-intensive goods. Production was supported by vast backlogs, the ramped up production of vaccines – which has significantly boosted output of the pharmaceutical industry – and government subsidies and tax credits to help industry pay its increased energy bills. Meanwhile, support targeted at households has limited the fall in demand. Furthermore, the blow to consumer spending has been softened by a strong labor market, despite the highest inflation in over 40 years (see Figure 4, and also RaboResearch’s recent EU labor market report). The strong demand for workers (which is even stronger due to labor hoarding) has pulled more workers to the job market, substantially increasing aggregate labor income. At the same, time job security is also higher in a tight labor market, leading to lower precautionary savings.

Energy price forecasts – both our in-house forecast and the forward curve – have also come down substantially, implying that the drag from high energy prices on economic output is expected to be less than assumed earlier. Moreover, new government support measures came into effect this January, while others have been broadened and extended beyond their initial end dates, supporting consumers’ purchasing power in the coming quarters. Furthermore, the reopening of the Chinese economy since December 2022 has improved the trade outlook.

There is a disclaimer however. Government subsidies may support growth, but, depending on the measure, could also lead to higher inflation in the future. Price caps and cuts in energy taxes, for example, are likely to slow inflation in the near term, but may push up prices again when they are lifted. Household income support, in turn, could prove inflationary as it sustains demand for goods and services beyond what would otherwise be expected. Furthermore, due to the improved economic growth outlook we expect (core) inflation to be stickier than initially expected.

All in all, we have lowered our inflation forecast to 5% this year and raised it to 3.1% next year (see Figure 5). We expect it to remain above the European Central Bank’s target for longer, which calls for a higher terminal rate and postpones the prospects of a rate cut as we argued in this report following the ECB’s last monetary policy meeting. Higher interest rates translate into lower growth with a lag, but can have a significant impact, as we explained in our January eurozone economic update. The first signs of a slowdown in credit growth are already here (see Figure 6), which is partly related to the fact that banks have significantly tightened their credit standards for firms and households (see Figure 7). This is the main reason why we have lowered our growth forecast for 2024. At the same time, we do acknowledge that the hit to investment will likely be softened by a quite substantial inflow of public money through NextGenerationEU funds – especially in the periphery – and loosened state aid rules in light of the energy crisis and required energy transition.

Among the biggest five member states, the Netherlands is a notable outlier in our forecasts for 2023. The above-average growth in 2023 can be mainly attributed to an outperformance in the fourth quarter of 2022 and an expected repetition thereof in the first quarter of this year. In late 2022, household consumption grew substantially in the Netherlands, while it contracted for its peers. This can be explained by an increase in the Netherlands of higher-than-required government support to offset the increase in energy bills. As a result, the Dutch economy grew by 0.6% quarter-on-quarter, compared to the eurozone average of 0.1%.

The divergence in (mainly) consumption growth is expected to be repeated in the first quarter of 2023 for several reasons. One reason is strong income support in the Netherlands. For example, minimum wages and allowances for low-income households and households with children increased significantly on January 1. Another reason is that, while the labor market is tight all over Europe, the Dutch labor market tops the list, resulting in relatively higher wage growth. And finally, the cap on retail energy prices that entered into force in January will have a significant impact on inflation. Most other countries also have measures in place to lower prices or cap increases, but the impact on the growth of households’ purchasing power is deemed to be smaller in most cases. Moreover, a price cap in Germany will come into effect later this year.

Given that the fourth quarter of the previous year and the first quarter of the running year carry the most weight in the computation of the annual figure, the Dutch economy’s growth rate in 2023 is likely to be quite a bit higher than the eurozone average.

For a more elaborate analysis we refer you to our monthly outlook.

The Spanish economy is expected to outperform the eurozone in both 2023 and 2024, but mostly so in the latter year. There are three main contributing factors. First, there is still some catch-up potential due to pandemic losses. The relatively large construction sector is still more than 10% smaller than pre-pandemic, for example, and the tourism sector has also not yet fully recovered. Mainly international tourism has remained weaker than pre-pandemic. Furthermore, the important car sector has suffered a lot from pandemic-related supply chain disruptions. Finally, arts and recreation managed to overcome its pandemic losses, but suffered big time toward the end of the year, likely at least partly because of the cost-of-living crisis. Second, relatively more money is flowing in from the EU’s pandemic recovery fund (Recovery and Resilience Facility) than to most of its peers – apart from Italy. And, third, structural growth is expected to be somewhat higher due to, for example, a less rapidly ageing population than in Germany and Italy. Figures 9 and 10 show that the Spanish economy is the only big-5 economy that has not yet recovered its pandemic losses, because domestic demand has stayed behind.

It will take time before the higher costs of inputs, mainly energy, will have been passed through to other goods and services.