Euro-zone inflation looks set to rise sharply in the coming months as energy inflation shoots up and core inflation edges higher. Indeed, the PMI surveys suggest that manufacturing input prices are rising at their fastest pace in nearly a decade, which reflects movements in oil prices as well as a long list of input shortages, from steel to semiconductors. While the PMIs imply that firms aren’t fully passing those cost increases onto customers, some price increases seem likely. What’s more, when lockdowns are lifted, clothing and holiday prices – which fell particularly sharply last year – should rebound too. We think that all of this will drive headline inflation above 2% in the second half of the year. But since most of these effects should be temporary, we expect inflation to drop back to around 1% in 2022.
- Euro-zone inflation looks set to rise sharply in the coming months as energy inflation shoots up and core inflation edges higher. Indeed, the PMI surveys suggest that manufacturing input prices are rising at their fastest pace in nearly a decade, which reflects movements in oil prices as well as a long list of input shortages, from steel to semiconductors. While the PMIs imply that firms aren’t fully passing those cost increases onto customers, some price increases seem likely. (See Chart 1.) What’s more, when lockdowns are lifted, clothing and holiday prices – which fell particularly sharply last year – should rebound too. We think that all of this will drive headline inflation above 2% in the second half of the year. But since most of these effects should be temporary, we expect inflation to drop back to around 1% in 2022.
- Coronavirus indicators show that new cases are starting to rise again.
- Output indicators add to the evidence that economic activity will decline in Q1.
- Consumer indicators show that retail sales dropped sharply in January.
- External indicators point to divergent prospects for goods and services exports.
- Labour market indicators suggest that the unemployment rate will edge up this year.
- Inflation indicators suggest that inflation will rise, largely due to temporary effects.
- Monetary indicators show that lending growth has started to edge down.
- Fiscal indicators reveal that the scale of fiscal support has been smaller in the euro-zone than elsewhere.
- Financial indicators show that the euro-zone has been caught up in the global bond sell-off.
Chart 1: Euro-zone Manufacturing Price Indices
- New daily cases in the euro-zone fell throughout early February (2), largely due to the sharp decline in Spanish cases, following a spike in January (3). However, the number of new cases has begun to creep up more recently, led by worsening situations in Italy and France.
- Containment measures across the region are being extended, with the current measures in place in Germany set to continue with little change until 28th March. The increases in intensive care unit (ICU) occupancy and uptick in test positivity rates, particularly in France and Italy (4 & 5), may prompt a tightening of restrictions in those countries (6).
- Whilst the pace of vaccination has gained ground across the eurozone, total doses administered per person still lags that of the UK and US (7). But despite the plethora of difficulties, there are encouraging signs: extra doses of the Moderna and Pfizer vaccines have been secured, and the J&J vaccine is set for approval by the European Medicines Agency in mid-March. We think that there should comfortably be enough doses to meet the EU goal of vaccinating 70% of adults by the end of September.
Chart 2: Euro-zone Confirmed Infections
Chart 3: New infections in Europe’s Big Four (7-day Ave, per mn pop)
Chart 4: Daily ICU Occupancy
Chart 5: Positivity Rate (%)
Chart 6: Government Stringency Index
Chart 7: Number of Vaccines Doses Administered as of 1st March (% of population)
Sources: Health Ministries, WHO, Google, BBG, Our World in Data, CE
- The latest business surveys and high frequency data suggest the euro-zone economy is likely to have contracted again in Q1. The Composite PMI rose in February, but remained consistent with GDP at best stagnating in the first two months of the year (8). The breakdown reinforced the divergence between industry and services (9), with the latter suffering from tighter restrictions.
- Admittedly, the PMIs suggest that the outlook is brightening for both industry and services. Industrial production has recovered strongly despite the latest lockdowns and the manufacturing output PMI suggests a further improvement is likely (10). Services firms’ expectations of activity over the next 12 months paint a similar picture (11).
- However, even if firms are starting to feel more optimistic about the longer-term outlook, overall economic confidence in all four big euro-zone economies has remained depressed in the early part of this year compared to pre-virus levels (12). And even in Germany, where the economy has been less hard hit by lockdowns, the Ifo business survey is still consistent with GDP contracting in y/y terms (13).
Chart 8: Euro-zone Composite PMI & GDP
Chart 9: EZ Manufacturing Output & Services PMIs
Chart 10: EZ Mfg Output PMI & Industrial Prod.
Chart 11: Services PMI & Services Output
Chart 12: Major EZ Economies’ ESIs
Chart 13: German Ifo Index & GDP
Sources: Refinitiv, Markit, Capital Economics
Output Indicators (cont.)
- High frequency data have their limitations, notably that many indicators are not seasonally adjusted, but the big picture is that while mobility has improved a touch over the past month, it is still well below pre-virus norms in the largest economies. It is also on average weaker than it was in the early part of Q4. (14) And the recent rise in case numbers in France and Italy means the risk is that mobility is limited again.
- Looking in greater detail at mobility, visits to retail and recreational locations remain much more depressed than those to workplaces (15), highlighting the more targeted nature of the current measures. Traffic congestion has increased, although these data have been distorted by bad weather (16). And the stricter limits on international travel in light of new variants is evident in the daily flight departures data (17).
- Further ahead, we expect economic activity to recover towards the end of Q2 and in Q3 as the vaccine rollout allows the lifting of most restrictions (18). Among the major economies, we think Spain has potential to benefit the most. But this will depend heavily on the re-opening of international borders and a month or two’s delay will make a big difference to Spain’s growth prospects this year (19).
Chart 14: CE Mobility Indices
Chart 15: Google Mobility Indices
Chart 16: Traffic Congestion in Selected EZ Capital Cities (% difference from 2019)
Chart 17: Flight Departures (% y/y, 7 day average)
Chart 18: Countries’ GDP Forecasts
Chart 19: Spain Foreign Tourist Expenditure (€mn)
Sources: Google, INE, Destatis, Refinitiv, CE
- COVID-19 containment measures continue to take their toll on consumer spending, but the vaccine rollout means that a recovery is in sight. National GDP data suggest that consumer spending fell by about 3% q/q in Q4 (20). Since then, euro-zone retail sales dropped in January, leaving them 6.7% below their pre-pandemic level (21) and mobility data show that visits to retail centres remained weak in February (22).
- Retail sales account for less than half of total consumption. And other types of spending, particularly social-spending including on restaurants (23) and accommodation, will undoubtedly have remained subdued as virus-related closures remain in force across the bloc. Meanwhile, although car registrations rose in Germany, Italy and Spain in February, they remain well below their level in February 2020.
- Consumer confidence remains subdued (24) and is unlikely to rise significantly before restrictions are eased substantially. But once restrictions are eased, experience from the first wave suggests that consumption will rebound sharply. The biggest scope for a strong rebound in consumption is perhaps in core countries where household disposable income rose over the first three quarters of 2020 (25).
Chart 20: Household Consumption (% q/q)
Chart 21: EZ Retail Sales Volumes (Feb 2020 = 100)
Chart 22: EZ Retail Sales & Daily Mobility
Chart 23: Germany In-person Restaurant Diners (% y/y)
Chart 24: EC Euro-zone Consumer Confidence
Chart 25: Household Disposable Income
Sources: Refinitiv, Eurostat, EC, CE
- Goods exports should continue to recover but services exports, which are reliant on the vaccine rollout, look set to remain subdued. We do not have the breakdown of euro-zone Q4 GDP yet, but timely monthly data suggest that goods exports grew by about 5% q/q (26). The same data point to a similar rise in imports and show that the bloc’s goods trade surplus was back up to its pre-crisis level in December.
- The outlook for goods exports is bright. The new export orders component of the euro-zone Manufacturing PMI rose to nearly 60 in February and points to a healthy increase in goods exports (27), particularly in Germany (28). But services exports are still contracting, and look set to remain subdued (29). Meanwhile, so long as domestic demand remains weak, so will imports.
- The risks for trade are to the downside. A report from Germany’s statistics office suggests EU-UK trade took a leg down in January as new Brexit rules came in force, and still-high shipping costs look set to dampen imports (30). Meanwhile, as travel restrictions are likely to be lifted after domestic ones, we suspect they will be in place throughout Q2, wiping out around half of the tourist seasons in some countries (31).
Chart 26: Good Exports (Values, % 3m/3m)
Chart 27: Manufacturing New Export Orders PMI
Chart 28: Manufacturing PMI – New Export Orders
Chart 29: Services PMI – New Export Orders
Chart 30: Freightos Baltic Container Shipping Index ($)
Chart 31: Travel Services Exports (% of annual GDP)
Sources: Refinitiv, Markit, Capital Economics
- The euro-zone’s unemployment rate held steady at 8.1% in January, even though the number of unemployed people edged up rose for the first time in five months (32). The country-level data showed that in all the major euro-zone economies, the jobless rate barely changed (33). And they remain much lower than their post-2008 peaks.
- That in large part reflects government support for jobs through short-time working. As containment measures have been tightened in recent months, the share of the labour force on these schemes has edged up, particularly in France during the November lockdown (34). We expect short-time working schemes to remain in place for much of this year and to be tapered only gradually, keeping a lid on unemployment.
- That will be just as well given that surveys of firms’ hiring intentions remain consistent with employment broadly stagnating in year-on-year terms (35). And firms reporting that a lack of labour is limiting their production capabilities is still low by pre-virus standards, even in Germany (36). Overall, we expect the euro-zone unemployment rate to rise a touch further in the coming months, before falling back (37).
Chart 32: Euro-zone Unemployment (%)
Chart 33: Countries’ Unemployment Rates (%) (Jan)
Chart 34: Short-Time Workers (% of Labour Force)
Chart 35: EZ Firms’ Hiring Intentions & Employment
Chart 36: Industrial & Services Firms Reporting Labour As A Factor Limiting Production (%)
Chart 37: Euro-zone Unemployment Rate (%)
Sources: Refinitiv, Markit, Capital Economics
- Headline inflation was unchanged in February, at 0.9%, and the core rate dropped to 1.1% (32). This was partly due to a reversal of the rise in non-energy industrial goods inflation in January, which was caused by the cancellation of winter sales this year (particularly affecting clothing and footwear). This component may fall further in the coming months. Meanwhile, services inflation also fell in February (33).
- Inflation jumped at the beginning of the year in all the major economies, but was highest in Germany (34). We expect inflation to increase further in the coming months as a result of rising energy price inflation. The increase in the headline rate will be similar to the rise after the global financial crisis (35).
- Meanwhile, market-based measures of inflation expectations have increased, reflecting changes in global markets including the market for oil (36). Looking ahead, we think the inflation rate will probably rise above the ECB’s near-2% inflation target later this year but will drop back again next year (37). The ECB will therefore look through this increase and leave its policy settings unchanged.
Chart 32: HICP Inflation (%)
Chart 33: Services & Non-Energy Goods Inflation (%)
Chart 34: HICP Inflation (%)
Chart 35: Euro-zone HICP Inflation (%)
Chart 36: 5yr/5yr Swaps & Brent Crude Price
Chart 37: Euro-zone Inflation (%)
Sources: Refinitiv, Capital Economics
- Money and lending growth has edged down recently, with annual growth in lending to the private sector at 4.5% y/y in January, its slowest rate since February 2020 (44). This is partly because firms have been repaying the short-term loans that they took out during the lockdowns of last March (45). Base effects will drag the year-on-year growth rate down sharply in March.
- Meanwhile, consumer credit dropped in January, taking it below its recent low last May. In year-on-year terms, it is falling nearly as sharply as during the region’s debt crisis (46). This reflects the weakness of consumer confidence and spending, as well as the stock of savings left over from last year, which has reduced households’ need to borrow. Some of those savings may have gone towards house purchases; mortgage lending picked up in the second half of last year and interest rates have remained low (47).
- The ECB reduced its asset purchases last week (48), which may have contributed to the sell-off in bond markets. We suspect that it will ramp up its purchases again, if it hasn’t already, to bring yields down. At the pace of purchasing over the past six months or so, it would fall short of the €1.85trn envelope by the end of March (49), so there is scope for it to buy at a faster pace without expanding the envelope.
Chart 44: Bank Lending (% y/y)
Chart 45: Net Flow of Bank Lending to
Chart 46: Consumer Credit
Chart 47: Mortgage Lending & Mortgage Interest Rates
Chart 48: ECB Weekly Asset Purchases (€bn)
Chart 49: Assets Bought Under PEPP (€bn)
Sources: Refinitiv, ECB, Capital Economics
- Fiscal policy will remain highly accommodative this year and next. In 2020, net bond issuance by euro-zone governments totalled nearly €1 trillion (50). Lockdown extensions in some countries and the likely tightening of restrictions elsewhere will keep bond issuance high this year, even if not as high as in 2020. And the ECB will continue to indirectly finance much of this borrowing (51).
- Despite running huge budget deficits, the fiscal stimulus in the euro-zone has been much smaller than in the US (52). Germany has been one of the most generous (53) and comments from the Finance Minister suggest that it will not re-impose the “debt brake” (restricting borrowing to 0.35% of GDP) in 2022. The EU is also set to suspend its fiscal rules again next year.
- Governments need to present plans to the European Commission by April in order to access cash available under the EU Recovery & Resilience Facility (part of the 2021-2027 budget). The funds will be disbursed over several years and peak in 2024 (54). But there are risks that the process is slower; experience shows EU funds are not usually fully absorbed within EU budget timeframes (55).
Chart 50: EZ Net Gov’t Bond Issuance (12m sum €bn)
Chart 51: EZ Net Government Bond Issuance & ECB Bond Purchases (€bn)
Chart 52: Fiscal measures to support aggregate demand in response to the pandemic (% of GDP)
Chart 53: Change in Structural Fiscal Balance
Chart 54: Disbursement of RRF Grants (€bn, ECB Est.)
Chart 55: EU payments to each Country by 2020
Sources: Refinitiv, Eurostat, ECB, EC, CE.
- Euro-zone government bonds have been caught up in the global bond sell-off this year, but their yields have not risen as far as those in the US and UK (56). The increases in yields have been driven by a combination of higher inflation compensation, which is now back to around pre-pandemic levels (57), and higher nominal interest rate expectations (58).
- Investors expect policy rates to remain unchanged over the next two years before starting to rise in 2023, but we think that the ECB will wait longer before tightening. And with policymakers uncomfortable with recent increase in bond yields, we suspect that they will accelerate the pace of their bond purchases to drive them back down over the rest of the year (59).
- Meanwhile, equity prices have levelled off in recent weeks, but if we are right that global growth will pick up significantly later in the year, then we would expect equity prices to resume their rise (60). An improvement in risk appetite would also probably support the euro against the US dollar (61).
Chart 56: Change in 10-year Government
Chart 57: 10-year Inflation Swap
Chart 58: ECB Deposit Rate
Chart 59: 10-year Government Bond Yields (%)
Chart 60: Equity Indices (1st January 2020 = 100)
Chart 61: US Dollars per Euro
Sources: Refinitiv, Capital Economics
Andrew Kenningham, Chief Europe Economist, firstname.lastname@example.org
Jack Allen-Reynolds, Senior Europe Economist, email@example.com
Melanie Debono, Europe Economist, firstname.lastname@example.org
Jessica Hinds, Europe Economist, email@example.com
Oliver Byrne, Research Assistant, firstname.lastname@example.org