Eurozone consumers will lead the way
We expect the recovery in the eurozone to be led by a revival of consumer spending. Inflation fell to 2.9% y/y in October, and we expect it to fall further in the coming months. At the same time, labour markets remain tight – at least for now – and nominal wage growth is still close to record highs. Together, this means real wages are likely to begin rising again. They have been falling since mid-2021 but are now expected to begin growing again (see Figure 1, left-hand side). Another positive factor for consumption are the excess savings which households in the euro area accumulated during the pandemic, which they could use if sentiment improves. Stronger private consumption could lead to a resurgence of growth in the euro area, despite tight monetary policy.
The case of Spain is a good example of how rising real wages can support the economy as a whole. In Spain, real wage growth turned positive from March, and this can partly explain the strong performance of Spain, relative to other major European economies. Retail sales in Spain rose 8.2% year-on-year in August, compared with a 2.1% decline in the eurozone. Solid demand also helped keep house prices up, which rose 3.7% y/y in the second quarter, while falling 1.7% in the eurozone and 9.9% in Germany. While the eurozone as a whole contracted by 0.1% q/q in the third quarter, the Spanish economy recorded modest growth of 0.3%.
We forecast an upturn in the eurozone economy beginning in 2024. Initially it will be based on private consumption, with investment contributing from 2025 onwards as business confidence improves (see Figure 1, right-hand side). Government spending will not contribute significantly to growth given the fiscal consolidation in European countries (read more about fiscal policy in the EU here). Inventory build-up is expected to continue to hold back growth. The fall in final demand has pushed up inventories. There remains considerable uncertainty, for example, firms may want to hold higher inventory levels in the 'new normal' of greater perceived supply chain risk and higher interest rates. Finally, net trade is expected to remain neutral; and although eurozone growth will increase from current levels, it will remain lower than world growth. There is a risk exports might disappoint if the eurozone loses international competitiveness.
What could go wrong?
Our three key assumptions for a eurozone recovery:
- Inflation will continue to fall
- Wage growth will remain above 2010-19 averages
- Higher interest rates do not lead to a strong increase in household savings, a collapse in private investment or fiscal risks taking centre stage again
We currently expect inflation to decline gradually and reach the ECB's 2% target by the end of 2024. Inflation will fall on the back of weak economic activity, base effects in energy prices and the unwinding of the supply chain crisis. However, recent developments in the energy market pose a major upside risk to our inflation forecast. With the danger of the Israel-Hamas war escalating to draw in other countries, risks have increased further in recent weeks. Finally, wage growth alone could sustain inflation and set in motion a wage-price spiral in which firms raise prices to pay higher wages. So far, however, wage growth in the eurozone seems to be relatively contained at 4.6%. A period of above-trend wage growth may reflect wages catching up to past inflation and be absorbed by margins, which implicitly rose while inflation exceeded wage growth.
The labour market is the other key factor. A sharp slowdown in the labour market could lead to a slowdown in labour income as employment and wage growth fall. It could also cause households to increase their precautionary savings, reducing consumption further. The eurozone labour market has so far proved remarkably resilient despite economic stagnation. Unemployment in the eurozone remains close to its record low at 6.5%, in part because workers are working fewer hours and companies are hoarding labour as they fear further labour shortages. However, if the economic slowdown continues, at some point companies will begin to lay off employees. While high-frequency and survey data suggest that the labour market is starting to ease and we expect unemployment rates to rise slightly in the coming months, we do not expect a sharp increase in eurozone unemployment.
Finally, standard economic theory suggests that higher interest rates lead to higher savings and thus to a decline in current consumption. Furthermore, if the economic outlook remains weak and the labour market starts to ease, households have even more incentives to increase their savings rate. On the other hand, the household saving rate remains already above its pre-pandemic average in Europe (in contrast to the US), and European households still have substantial savings surpluses. While we expect savings rates to remain high, we expect them to decline gradually over the next few years. This means we do not expect savings to offset the positive impact of real wages on consumption.
