European economic outlook: fiscal policy and central bank rate cuts in the spotlight as technical recession looms

We keep our euro area GDP growth forecasts unchanged, with the latest 0.1% quarter-on-quarter decline in 3Q GDP growth affirming our outlook of the start of what is likely to be a technical recession through this winter. Divergence in growth rates across the euro area is narrowing as the transmission of higher rates to the real economy builds. We maintain our existing European Central Bank (ECB) call that the central bank is done with its rate hiking cycle, with rate cuts to start in 2Q24 and likely before the Fed. Risks are tilted to more (and earlier) rate cuts if inflation continues to slow faster than originally projected. We also now see the Bank of England (BoE) staying on hold through to year-end and cutting interest rates later in 2024. The ECB and BoE will, however, likely want to monitor first how wage negotiations go around the turn of the year to reconfirm the slowdown in underlying inflation before feeling comfortable to start cutting rates later in 2024. In addition, focus on fiscal policy (and related risks) will be a theme over the coming months.

Key economic forecasts

Sovereign bond yields are off the decade-long highs reached this autumn after the latest encouraging declines in global inflation rates, including in Europe where both headline (latest: 2.4% y/y) and core (latest: 3.6% y/y) CPI inflation have significantly retreated. We flag downside risks to our CPI forecasts, especially for next year. Bond yields will likely remain below the recent highs as growth (see Theme 3) and inflation continue to slow and as interest rate cuts for next year are increasingly priced in. However, we still see bond yields structurally higher than the last decade amid a higher term premium, positive real yields and unwinding of the QE regime. A formal announcement on an early end of the ECB's Pandemic Emergency Purchase Programme runoff is likely in the coming months.

Figure 1. Germany's 10-year yield components 

Whether investment for the future should be exempt from debt rules is top of mind as Germany suspends for 2023 its debt brake for a fourth consecutive year and agreement over EU fiscal rules remains pending. Time will tell whether long-term investment needs overcome pre-pandemic thinking on restraining debt and eventually prompt more fiscal looseness than the last decade. In the meantime, constraints on government spending pose risks to short-term growth. Debt sustainability and EU 2024 parliament elections remain key to watch, especially as the fiscal burden accumulated in response to the COVID-19 and energy crises is compounded by calls for more spending (eg, defence, decarbonisation, decoupling) and higher debt servicing costs from higher interest rates (see Figure 2). Still, we believe the ECB can step in to contain disorderly market moves via the Transmission Protection Instrument to contain fragmentation risk.

Figure 2. Interest expenditure as a % of GDP, yoy % growth

The euro area economy contracted by 0.1% 3Q23, led by weakness in Germany. Growth in the UK was flat. We believe the euro area slowdown that started in 2Q will continue into next year as restrictive policy continues to weigh on the manufacturing and service sectors. Weaker economic activity should reduce demand for labour, and the unemployment rate in many countries is likely to gradually rise, in turn lowering aggregate demand more widely as incomes and confidence fall. We see risk that fiscal policy may underwhelm in Europe as debt concerns rise (eg, that Germany's 2024 Budget is not approved before year-end). As a result, we expect Bloomberg consensus will continue to converge with our more pessimistic growth forecast (see Figure 3).

Figure 3. Euro area GDP forecasts for 2024