Eurozone has been saved
Cover image by: Jaime Austin
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The alarmingly rapid spread of Omicron continues to shape the economic outlook for the current quarter in the Eurozone. In January, the number of infections reached record highs in many European countries such as France, Germany, Italy, Spain, Belgium, and Austria. In light of this situation and the ongoing supply-chain disruptions as well as rising energy and material prices, a near stagnation of GDP in the last quarter of 2021 and the first quarter of 2022 would not be a surprise. Nevertheless, assuming that the current wave of COVID-19 would be over by springtime, we should see strong growth dynamics from the second quarter onward, thanks to pent-up demand and resumption of industrial production.
The Eurozone witnessed strong economic growth in 2021—provisional figures point to a growth rate of 5.1% (figure 1). This performance largely reflects catch-up growth after the deep slump of 2020, but it is also evidence of a robust recovery in the face of headwinds from interrupted supply chains and recurring waves of COVID-19.
Growth was mainly driven by private consumption, especially in the services sector, which saw reassuring growth in the second and third quarters of 2021 as a result of the relaxing of COVID-19–related mobility restrictions.1 This promising trend, however, came to a halt with the emergence of Omicron in the fourth quarter, which brought with it a fresh cycle of restrictions and voluntary social distancing on the part of consumers. Meanwhile, many industrial sectors, such as automotive and electrical equipment manufacturing, remained negatively impacted throughout the year from global supply chains disruptions, resulting in a paradoxical situation—industrial production decreased, but new orders reached record highs.2
Furthermore, the economic growth across countries in the Eurozone in 2021 was mostly disproportionate (figure 1). France and Italy saw the strongest growth, at more than 6%, while Germany, plagued by a struggling industrial sector, witnessed a lower-than-expected growth of 2.7%. Spain, the European country most severely hit by COVID-19 in 2020, failed to recover its losses due to its high dependence on tourism—it witnessed a growth of 4.9%.
The surge in inflation in 2021 came as a surprise to many economies and businesses all over the world. In the Eurozone, prices started rising from the middle of last year, and in December, the inflation rate stood at 5%.3 This means that inflation will likely shape the macroeconomic agenda in 2022. After decades of low inflation and deflation risks in recent years, the Eurozone now faces rapid and unexpected price increases—highest since the inception of the euro in 1999. Specifically, it was the rise in prices for energy, services, food, and industrial goods that drove inflation in 2021.
However, certain factors have led the European Central Bank (ECB) to believe that the rise in inflation is a temporary phenomenon that will not require an increase in interest rates. First, since inflation rates are calculated by comparing the current price level against the price level a year ago—low prices in 2020 due to low demand and various policy measures to check the economic impact of the pandemic might have distorted the current inflation rate upward. Germany, for example, lowered its value-added tax in 2020, which means the benchmark for calculating inflation rates in 2021 was lower, leading to an artificial price increase. Second, there is reason to assume that energy prices will not rise at the same rate as last year, reflecting expectations that oil demand and supply might reach a balance, although this is hardly a certainty.4 As a consequence, the ECB intends to continue its ultra-loose monetary policy and, unlike the Fed, has ruled out interest rate increases for now. The only change in monetary policy to be expected is a slower pace of the bond-buying program. Nevertheless, in December, as a reaction to current inflation figures, the ECB almost doubled its inflation forecast for 2022 to 3.2%, but it expects a decline in the following years.5
How inflation evolves going forward and, specifically, whether it tapers off in the coming years or not will depend to a large degree on the labor market and wage pressures on inflation and supply chains. Supply-chain interruptions are likely to start ceasing in the second half of 2022. First, because of pent-up demand, consumers will likely shift their expenses to services once economies open again, thus easing pressure on supply chains. Second, there are signs that transportation challenges are abating and will continue to do so over the course of the year.6 Clearly, the key to both these scenarios becoming a reality is that the current wave of COVID-19 is brought under control by spring.
What the recent trends in the labor market lead to is even more uncertain, and as such, labor markets remain one of the most important areas to keep an eye out for in 2022. The strategy to retain jobs through furlough schemes by many countries in the Eurozone proved successful. At 7.2% in December 2021, unemployment is exactly at the same level as in February 2020, that is, before the onset of the pandemic.7 At the same time, labor shortages have reappeared. In Germany, for example, CFOs see labor shortages as the most critical risk to their businesses for the next 12 months, according to the Deloitte CFO survey.8 The picture in many other Eurozone countries is similar.
If labor shortages persist and result in wage rises, inflation pressures could become more structural, further driving prices. While wage pressures have been modest so far, it is to be expected that unions—whose bargaining power is supported by current labor shortages—will likely incorporate current inflation rates into their wage demands for the upcoming bargaining rounds in 2022. The central role of these collective wage-bargaining rounds in many European countries will likely have strong signaling effects even for the nonunionized sectors.
Meanwhile, several Eurozone countries such as France, Belgium, and Portugal increased their minimum wages, partly as a response to the surge in inflation. Most notably, the new government in Germany raised the minimum wage by more than 25% to 12 euros. ING Research, on the back of these trends, expects a rebound of wage growth in the range of 3–3.5%.9The risk of a wage-price spiral and a persistence of inflation pressures are therefore non-negligible.
The risks posed by a possible entrenchment of inflation, longer-than-expected continuation of the current wave of COVID-19, and political developments such as the ongoing tensions at the Ukrainian border need to be closely monitored as these risks have the potential to derail the recovery in the Eurozone.10 However, if these risks do not materialize, the Eurozone could find itself on a dynamic growth path thanks to the presence of several tailwinds in its favor.
First, the investment appetite of European corporates is high, as evidenced from the findings of the autumn edition of the Deloitte European CFO survey.11 Capital spending is thus likely to become an important driver of the recovery. Second, the enormous backlog of orders from 2021 in the industrial sector should lead to a rebound in output once supply chains start to work more seamlessly. Third, and most importantly, consumers are sitting with a substantial excess savings: Eurozone households still have around 350 billion euro of more savings than they had before the crisis, according to calculations from Deloitte Research.12 This money is likely to be spent incrementally once the current wave of COVID-19 begins to tail off. The services sector, in particular, should benefit from the combination of pent-up demand and consumers’ massive spending power. Furthermore, as was the case in 2021, private consumption will continue to be the key driver of growth in 2022.
To sum up, the Eurozone, in the absence of the aforementioned risks, is likely to witness a substantially above-trend economic growth. The growth, however, will be subdued in the first quarter due to the current Omicron-driven wave of COVID-19. In fact, the economy will likely come close to stagnation; in some countries such as Germany, even a technical recession is possible. Nevertheless, we believe that growth should return in the second quarter and accelerate afterward, resulting in a growth rate of a little less than 4% in 2022. GDP, meanwhile, is expected to reach prepandemic levels by the middle of the year.
Cover image by: Jaime Austin