European economic outlook: hopes of significant monetary easing dashed

We upgrade our euro area 2024 GDP forecast by 0.4 percentage points (ppt), and by 0.5ppt for the UK, after stronger 1Q24 GDP prints and improving forward-looking surveys. Strengthening of domestic demand will likely sustain the recovery into 2H24. Concerns around inflation will continue as favourable energy base-effects unwind into the year-end and further upside growth surprises could keep core price pressures stickier. In particular, services inflation persists, and numerous cultural and sporting events in Europe this summer will likely contribute to a slow and bumpy disinflation process in certain countries. We maintain our view that the European Central Bank (ECB) will begin cutting interest rates this summer, but we scale back our expectations for rate cuts thereafter, with risks skewed for even later and fewer rate cuts than we expect.

• Growth in Europe was stronger than expected in 1Q24.
• Continued economic momentum hinges on further strengthening of domestic demand.
• Services inflation to cool gradually, keeping core inflation sticky and above headline CPI in Q3.
• We see fewer central bank rate cuts in Europe this year.
• The risk of inflationary EUR depreciation against the USD constraining the ECB is contained in our view as we expect rates to stay in restrictive territory.

Table 1: Key European forecasts

There is more room for confidence to grow and higher real incomes to sustain a domestic-demand driven recovery. 

Figure 1: European Commission Confidence Indicators, average over 1Q24

European GDP growth rates surprised to the upside in the first quarter of this year, with notable rebounds versus 4Q23 in the UK (-0.3% to 0.6% q/q) and Germany (-0.5% to 0.2% q/q), and still very strong momentum in Spain (0.9% q/q in both quarters). As such, we see green shoots of recovery in Europe, and we lift our annual average growth forecasts for the euro area in 2024 by 0.4 ppt to 0.7%, and for the UK by 0.5 ppt to 0.8%, both above consensus. Risks are these forecasts are skewed to the upside. Key drivers so far include stronger external demand from the US and China, the bottoming-out of the contraction in manufacturing, and a faster reaction to a loosening in financial conditions (eg, business investment increased 0.9% in the UK in 1Q24 potentially in anticipation of interest rate cuts). There is still ample scope for further recovery in growth (see Figure 1) to be driven by further strengthening of consumer confidence and spending, fueled by ongoing gains in real incomes. Sporting and cultural events will be an additional boost to GDP in Q3, even though we expect the more visible significant impact will be rather through services inflation (see below). Still, the Paris Olympics, for example, is expected to generate €8.9bn of revenue for the Île-de-France region (surrounding Paris) over the 2018-2034 time period in an intermediate scenario, approximately 0.3% of France's 2023 GDP.¹

Services inflation to cool gradually as nominal wage growth slows, with one-off spectacles in 3Q24 adding short-term upside risks.

Figure 2. Euro area ECB decision-making inflation dashboard, latest values

As the ECB looks to lower interest rates this year, key data signposts to watch are services inflation prints and wage growth. Services inflation in the euro area had remained elevated at 4.0% yoy for five consecutive months before falling to 3.5% in April (see Figure 2). We expect some more cooling in 3Q24 as nominal wage growth slows on lower spot inflation, and as labour market tightness continues to unwind. Even so, the path of disinflation in both services and headline CPI will likely be bumpy with many big-ticket events taking place this summer in Europe: the Paris Olympics, UEFA EURO 2024 in Germany and Taylor Swift's Era's Tour.

Such sporting and cultural events have broader-economy effects by raising price-inelastic demand for, and prices of, services (eg, hotels, restaurants and transport) in countries where the spectacles are held, as well as spillover tourism in neighbouring countries. As one example, the cost of public transport will double in Paris during the Olympics.³ We expect the impact of the events on aggregate euro area services inflation will be temporary and contained, but smaller economies could see greater volatility. As in the case of Sweden last year, for example, when Beyoncé's Renaissance tour contributed to high-than-expected inflation in May.⁴ In addition to services, we also watch energy inflation, which is vulnerable to exogenous shocks amid elevated geopolitical risks and will be subject to adverse base effects into the year-end. This is likely to nudge headline inflation higher again and subsequently further slow the ECB's rate cutting path.

With impact of any decoupling versus the US Fed on inflation likely muted in the near-term.

Figure 3. Fed/ECB policy rate differential and FX dynamics

Stronger economic growth, sticky services inflation and overall caution from central bankers point to fewer interest rate cuts than we previously expected in Europe. We still expect the first ECB cut to come this summer, but to be followed by only two more rate cuts this year, with risks skewed to even fewer rate cuts. This would result in a policy rate differential versus the Fed of 55 basis points (bp) above the long-term average by the year end, up from 40bp currently. In the short term, the EUR/USD exchange rate has historically proved resilient to monetary policy divergence (see Figure 3). Even if the euro weakened further due to the widening interest rate differential, the fact that 60% of EU trade in goods is within the EU region should help dampen the effect of imported inflation.⁵ Empirical estimations find that a 1% currency movement can lead to a 12 bp impact on inflation in the euro area, a typically short-lived and minor effect.⁶ As such, the ECB should be able to start cutting interest rates earlier and by slightly more than the Fed this year without triggering a large increase in inflation.

Both the EU Parliament and UK general elections are now confirmed to take place this summer.⁷ We see risks of them heightening populism and social polarisation. Defence and international competitiveness are likely to dominate the policy priorities of the next EU parliament. In the UK, if the Labour party wins, the size of its potential majority will determine the extent of its "pro-growth, pro-business, pro-stability" policies. However, given limited fiscal room, we believe the next UK government will seek to drive growth through supply-side reforms rather than riskier deficit-financed spending. We could also see reduced friction with the EU and the reopening of negotiations on trade terms.