Crises drive European evolution as core inflation persists

Key takeaways

• The European Central Bank’s updated forecasts point to slowing price pressures and 1% GDP growth in 2023
• While working to maintain financial stability, the ECB’s inflation fight continues: core eurozone inflation remains high and wage growth has reached a record
• The EU’s political and fiscal infrastructure evolves through crises that initially appear existential. In the sovereign debt crisis, Covid, and now the Ukraine war, it has proven adaptable
• We expect the euro to appreciate against the US dollar in the months ahead as improving terms of trade and investor inflows support demand for the common currency. We see the EURUSD trading at 1.10 and 1.12 on a three-month and 12-month basis.

Anyone trying to catch a bus in Berlin or walk the pavements of Paris last week might conclude that the European economy is struggling. As inflation hits consumers’ pockets in the region, labour unions are responding with demands for higher wages, or contesting the prospect of working longer before retirement. Yet by some measures, the European economy looks healthy, and its institutions continue to adapt.

At its most recent monetary policy meeting on 16 March, attention was focussed on the European Central Bank persisting with a rise in its main refinancing rate of 50 basis points, to 3.5%. Just days after the collapse of regional US banks including Silicon Valley Bank and amid questions over Credit Suisse Group, the ECB dropped previous wording about the need to raise interest rates “at a steady pace.” Instead, it reiterated a commitment to offer banks liquidity if necessary.

Less noticed were the central bank’s updated forecasts. The ECB said that it sees inflation in the 20-nation eurozone slowing to 5.3% for 2023 and 2.9% in 2024, while gross domestic product (GDP) should improve to reach 1%. Last week these outlooks appeared to get a boost. Data showed consumer price rises in the eurozone slowing to 6.9% in March, compared with a year earlier, thanks largely to falling energy prices. French consumer price inflation decelerated to 6.6% in March, its first slowdown since December 2022 and German prices also decelerated, to 7.4%. In Spain, annualised CPI almost halved in March to 3.3%, from 6% in February.

Core prices keep rising

That story, though, may be misleading. Stripped of volatile measures such as food and declining energy prices, March’s so-called ‘core’ inflation that tracks changes in longer-term, underlying prices for goods and services, rose by 5.7% in the eurozone, compared with a year earlier. Unfortunately for policy makers at the ECB, core inflation is of course a lagging indicator. It is however also consistent with wage growth in the region, which continues to increase. Wage rises reached a record annualised pace of 5.7% in the last three months of 2022. That could increase inflation in the medium term. Salary growth is a key measure for both the ECB and Federal Reserve because wages fuel inflation. It is unlikely that price pressures can ease more meaningfully until wage growth slows, and unemployment rises from its record low of 6.6% in March.

Some of the price rises in Europe, as in the US, are being absorbed by consumers’ accumulated relatively high savings from the pandemic. Household savings in the eurozone dropped from a high of around 25% of disposable income at the start of the pandemic, to 13% in January. That is similar to pre-Covid levels, and compares with a savings rate of 4.7% in the US.

Despite the financial market turbulence of recent weeks, and the fact that developed economies are still experiencing inflation far above their central banks’ average 2% targets, we expect 2023 to be mostly about the process of recovery. Over time, disinflationary forces such as advances in robotics, artificial intelligence, as well as closer regional cooperation and trade, will tend to counter inflationary pressures resulting from resource scarcity and efforts to tackle climate change, shrinking labour forces and increasing costs of production. Nevertheless, it seems most probable that inflation will inevitably be higher than before the pandemic for a number of years.

Evolution through crisis

The European Union is notorious for evolving only through crises. At each crisis, the EU has appeared vulnerable to an existential threat, but in the end, its processes prove adaptable, or emerge reinforced. In just the last decade, the sovereign debt crisis produced Mario Draghi’s “whatever it takes” monetary policy, significantly improving the financial architecture of the eurozone as a ‘lender of last resort’ through the European Stability Mechanism. In 2016, Brexit reminded member states how integral the EU is to their economies. Then, when the pandemic struck in 2020, the bloc’s disjointed public health response began with the Italian government sourcing supplies of medical masks from Russia, but eventually led to a recovery fund that allows the European Commission to issue low-interest debt to support the region’s economies. In the end, the EU even managed to agree a ‘NextGenEU’ package designed to invest in infrastructure and support a transition to cleaner technologies.

The EU’s most urgent economic competition comes from the US ‘Inflation Reduction Act,’ Mujtabe Rahman of Eurasia Group told a recent seminar hosted by Lombard Odier. Thanks to the attraction of the US’s subsidies and tax credits, worth a combined USD 391 billion plus an additional USD 108 billion for healthcare, the Act risks rapidly drawing technologies and investments away from the bloc, Mr Rahman said. In comparison, the EUR 750 billion NextGenEU package is more cumbersome both to administer and disburse, he added. The risk is that the EU’s package is seen as a pandemic response, and so is not repeated, said Enrico Letta, a former Italian prime minister and now president of Brussels-based Jacques Delors Institute, at the same Lombard Odier seminar.

Since Russia’s invasion of Ukraine, the challenge to the bloc has been military, and unusually, external to its own borders, and a catalyst for political evolution, said Mr Letta. He argued in favour of maintaining a multi-speed EU that lets members of the bloc choose to advance on questions around state aid, or security questions for example, while other member states opt out. It remains to be seen whether the EU can learn to proactively address common challenges, he said, or whether it is condemned to only evolving in response to crises. In the short term, the EU’s resilience is challenged by an absence of its traditional leadership from France and Germany, with both distracted by domestic issues. Longer term, the Ukraine invasion has reignited a discussion about EU enlargement, Mr Letta said, and its ‘qualified majority’ voting system will continue to hamper consensus. For the long term, the bloc needs both a core ‘NextGen’ programme as well as a common defence strategy, Mr Letta concluded.