European economic outlook: wage growth holds the key to the interest rate cutting cycle

Headline CPI inflation will likely hit the central bank 2% target in both the euro area and UK this year, with some monthly volatility. We lower our 2024 average CPI inflation forecasts by 0.4ppt in the euro area and by 0.9ppt in the UK. Combined with expected stagnant GDP growth, this serves to soften our interest rate outlook. We see the ECB and BoE cutting interest rates from Q2 2024 onwards, and revise down our forecasts for both their year-end policy rates by 75bps each, to 3.0% and 3.75% respectively. We also adjust our 10-year sovereign bond yield forecasts for year-end down below current levels. We do not change our below-consensus 2024 growth outlook amid the lagged impacts of restrictive monetary policy and lower fiscal support. Wage growth is a risk that could keep services inflation high, delaying the cutting cycle. Political risk and central bank uncertainty may create additional bond market volatility. 

• Inflation is on track to hit the 2% central bank targets this year and we lower our 2024 UK and euro area CPI forecasts.
• Policy interest rates will likely begin their descent from Q2 2024 into 2025.
• Labour market loosening underpins our economic outlook and holds the key to rate cuts.
• European parliamentary elections may rock the boat, both in terms of policy priorities and bond markets.

 

We expect the ECB and BoE to begin unwinding the historic policy interest rate hikes of the past two years in the second quarter of this year, cutting by a total of 150bps each this year before reaching the neutral rate in 2025. We lower our year-end 2024 policy rate forecasts by 75bps each as inflation has surprised to the downside in recent months and our expectations for weak growth remain. In the UK, we expect CPI inflation to hit the BoE's 2% target as early as April, as the Ofgem energy price cap resets lower,¹ reducing consumer gas and electricity prices.

Our GDP growth expectations remain below consensus as a further weakening in the European Commission consumer confidence index in January 2024 suggests a more muted and delayed household consumption-led recovery than consensus expects, despite rising real wages. As a result, and according to the simple monetary policy targeting rule that indicates where interest rates should lie to stabilise the economy, we think central banks will not be able to justify such restrictive monetary policy for much longer (see Figure 1).

Figure 1. Euro area Taylor Rule, with SRI growth and inflation forecasts used for Taylor Rule forecasts

However, risks to our outlook are skewed towards a slightly later start to the rate cutting cycle to allow for the release of more wage data (see labour market section below). In such a case, the two central banks may cut later, in larger increments, but we expect our year-end forecast to hold. Uncertainty around the pace and timing of cuts will likely keep bond market volatility elevated this year.

European labour markets will be crucial to determine the path of inflation, growth and interest rates over the coming months. These are showing resilience relative to weak economic activity (e.g. -0.3% q-o-q real GDP growth in Germany in Q4 2023), but lagged effects are still playing out and we anticipate signs of softening in the coming months, strengthening the case for interest rate cuts this year. As job vacancy rates fall and unemployment slowly rises, the bargaining power of workers will likely erode, weighing on economic growth. In turn, we expect wage growth to lose steam, allowing sticky services inflation to ease.

Figure 2. German employment, m-o-m, 000s, and German Ifo Business Climate Index

Wage negotiations in Germany (eg, Germany's construction labour union IG BAU has demanded a pay rise equivalent to 21%, with negotiations due to conclude in March 2024 where it is likely a lower rate will be agreed)² will be revealing. With infrequent wage-setting every ~2years, real incomes have suffered. If workers nevertheless accept lower negotiated pay rates, for example lower than last year's public sector settlement of c.5.5% per year for two years, it will indicate a turning point in, and softening of, the labour market.

Labour market loosening appears further advanced in the UK, where wage negotiations are more frequent and the inflation passthrough is faster, than the euro area. Q-o-q annualised growth in regular UK private sector pay has already fallen to 2.5%, below the ~3% level consistent with the BoE's 2% inflation target.

European Parliamentary elections will take place in June 2024 for the next five-year term. The new Parliament will set Europe's policy priorities and strategic agenda in areas such as energy, transport, industrial policy and immigration. These decisions ultimately shape progress on the key structural trends we see defining the long-term European outlook: what we term the 4Ds, of Decarbonisation, Digitalisation, Demographics and Debt.

Current polls suggest a majority for the centrist grand coalition, but project that the Greens may lose about a quarter of their seats. While Next Generation EU funding will continue to go to Decarbonisation, this shift in power could lead to lower momentum in that area. Given high geopolitical tensions, we anticipate the focus shifting towards Divergence and Defence.

Figure 3. 10y Italian BTP-German bund spread, in days around the last two European Parliament elections (rebased to 100 = election date)

Italian sovereign spreads are likely to be volatile this year, reflecting elevated European political and fragmentation risks (see Figure 3). For example, a shift in the parliamentary mix towards parties at political extremes could create investor unease in bond markets.

Other political events to watch include the UK Labour Party's general election manifesto launch (expected 8 February) ahead of the upcoming UK general election, Portuguese legislative elections (10 March), the UK Spring Budget (15 March), and potential Ukraine presidential elections (31 March).