Eurozone - GDP contraction taking shape

Economic data for January-February indicate that eurozone GDP probably contracted slightly in 2023Q1, but also that the composition of growth has changed compared to 2022Q4, when GDP was stable. Data for retail sales and car registrations show that the contraction in private consumption that began in Q4 probably continued in Q1. Next, investment in machinery and equipment probably rebounded in Q1, after it contracted sharply in Q4. This was pre-signalled by a sharp rise in Germany’s orders for capital goods from other eurozone countries. Meanwhile, investment in housing and buildings is expected to continue to contract in Q1. Mild weather probably temporarily stimulated construction activity in Q1, but underlying activity in the sector remains weak, as is also illustrated by the low level of the PMI for the sector. Finally, net exports probably contributed less positively to GDP growth in Q1 than in Q4. We think that exports picked up in Q1, but that imports also strengthened, meaning that, on balance, the impact on GDP growth was limited. The risks to our forecast for Q1 GDP seem tilted to the upside due to the one-off positive impact of China’s post-pandemic rebound. Looking beyond Q1, we expect GDP to continue to contract modestly during most of the year, as the impact of past and upcoming interest rate hikes will continue to build in coming quarters, weighing on domestic demand, global growth and eurozone exports.

Headline inflation has dropped from a peak of 10.6% in October 2022, down to 6.9% in March 2023. The drop was thanks to falling energy price inflation, with food price inflation and core inflation still trending higher. Looking ahead, we expect both headline and core inflation to fall rapidly later in the year on the back of the decline in wholesale energy and food prices, as well as dissipating supply chain bottlenecks. Core inflation will probably be more sticky than the headline rate in the short-term, but should also ease going forward. The lagged impact of higher energy prices on the prices of goods and services should peter out in the coming months. The only part of inflation that could rise somewhat further is services sector inflation, which could be pushed higher by rising wages on the back of the labour shortages that emerged in the sector after the pandemic. However, the economic slowdown is expected to lift unemployment somewhat in the course of the year, which should reduce overall wage growth and also services sector inflation.

At its March meeting, the ECB hiked its key policy rates by 50bp, while dropping all guidance on future policy moves. It seems that the ECB’s bias is still towards further rate hikes, at least if its baseline scenario plays out. Our baseline sees the deposit rate peaking at 3.75%, before a rate cut cycle begins in December and continues during 2024. Our base scenario is for a 50bp hike in May and a 25bp hike in June, but the risks are tilted towards a slowdown to 25bp in May and, subsequently, two more 25bp hikes in June and July.