ECB to keep policy tight despite recession

The euro-zone economy is set to perform much worse than consensus forecasts suggest over the next two years, with a recession looking likely. That is mainly because monetary policy and bank lending conditions are tightening. We expect household consumption to decline because, after accounting for rising interest expenditure, disposable incomes will fall. Moreover, the low level of consumer confidence suggests that the saving rate will rise. Investment looks sure to fall too, led by a sharp downturn in the construction sector. Meanwhile, headline inflation will decline sharply as the contribution from past increases in energy and food drop out of the year-on-year rate. But core inflation will come down much more slowly, not least because there will continue to be little or no spare capacity in the labour market. Assuming that the recent turmoil in the banking sector does not escalate, the ECB will raise interest rates further and keep them high for longer than is currently discounted in the markets. That said, once it starts to cut interest rates in 2024, we suspect that it will move faster than most expect.