Euro-area economic recovery faces headwinds amid fiscal and geopolitical uncertainty

Euro-area fiscal policy: A balancing act

The Euro-Area's fiscal policy has been characterised by a gradual withdrawal of pandemic-related support measures, offset by new spending initiatives and the impact of the energy crisis. In March, the European Commission (EC) projected a reduction in the government budget deficit to -3.00 percent of GDP by the end of 2024. However, recent data suggests a potential for fiscal slippage, with several large euro-area countries, including France and Italy, exhibiting rapid expenditure growth. This has led to concerns about the sustainability of public finances and the potential for delays in achieving debt reduction targets. The EC's proposal to delay the recommendations to open EDPs until late autumn, while maintaining the timeline for issuing guidance on how to correct excessive deficits, aims to reconcile the EDP process with the new fiscal framework. However, this decision also highlights the challenges faced by policymakers in balancing the need for fiscal consolidation with the need to support economic growth. Fiscal policy is crucial for maintaining macroeconomic stability, as it influences aggregate demand, interest rates, and exchange rates. A prudent fiscal policy can create buffers for stabilisation at the national level and support the ECB in achieving its price stability mandate. However, the current expansionary fiscal stance, coupled with the uncertainty surrounding the implementation of the reformed framework, poses risks to the euro area's economic outlook.

Euro-area economy: Mixed signals amid global headwinds

The Euro-Area's economic situation has been characterised by mixed signals over the past five months. While economic activity is projected to pick up in 2025, driven by falling inflation, a tight labour market, and sustained real wage growth, downside risks to the outlook persist. The energy crisis, geopolitical tensions, and escalating trade tensions continue to weigh on growth prospects. The German economy contracted in Q2 2024, following growth in Q1, highlighting the uneven nature of the recovery. Looking ahead, the economic situation is expected to evolve in response to global developments, monetary policy decisions, and the implementation of the reformed fiscal framework.

Economic growth:

• Euro Area GDP Growth Rate: Expanded by 0.30% in Q2 2024, following a 0.30% growth in Q1. Projected to be 0.30% by the end of this quarter, with long-term projections of 0.40% in 2025 and 0.30% in 2026.

• Germany GDP Growth Rate: Contracted by 0.10% in Q2 2024, following a 0.2% growth in Q1. Projected to be 0.20% by the end of this quarter, with long-term projections of 0.40% in 2025 and 0.30% in 2026.

• France GDP Growth Rate: Expanded by 0.30% in Q2 2024, the same as in Q1. Projected to be 0.20% by the end of this quarter, with long-term projections of 0.30% in 2025 and 0.40% in 2026.

Price changes (Inflation):

• Euro Area Inflation Rate: Unexpectedly edged up to 2.6% in July 2024 from 2.5% in June. Projected to be 2.20% by the end of this quarter, with a long-term projection of 2.10% in 2025.

• Germany Inflation Rate: Edged up to 2.30% in July from 2.20% in June. Projected to be 2.10% by the end of this quarter, with long-term projections of 2.00% in 2025 and 1.90% in 2026.

• France Inflation Rate: Edged up to 2.30% in July from 2.20% in June. Projected to be 2.30% by the end of this quarter, with long-term projections of 1.90% in 2025 and 1.70% in 2026.

Labour:

• Euro Area Unemployment Rate: Stood at an all-time low of 6.4% in May 2024, unchanged from April.

• Germany Unemployment Rate: Stood at 6% in July 2024, the highest since May 2021.

• France Initial Jobless Claims: Decreased to 18.20 thousand in June 2024 from 40.90 thousand in May 2024.

Business confidence:

• Euro Area Economic Sentiment Indicator: Eased marginally to 95.8 in July 2024 from 95.9 in June.

• Germany Ifo Business Climate Index: Declined for a third consecutive month to 87 in July 2024, the lowest since February.

• France Business Confidence: The manufacturing climate indicator fell to 95.5 in July 2024, down from 98.9 in June.

Consumer sentiment:

• Euro Area Consumer Confidence: Rose by 1 percentage point to -13 in July 2024, the highest level since February 2022.

• Germany GfK Consumer Climate: Climbed to -18.4 heading into August 2024 from -21.6 in July.

• France Consumer Confidence: Rose to 90.8 in July 2024, up from 89.7 in June.

Trade:

• Euro Area Balance of Trade: Posted a trade surplus of €13.9 billion in May 2024, below market expectations of €18 billion.

• Germany Balance of Trade: Rose to EUR 24.9 billion in May 2024 from EUR 22.2 billion in April.

• France Balance of Trade: Widened to €8 billion in May 2024 from €7.5 billion in April.

Outlook for key economic indicators:

The outlook for key economic indicators over the next five weeks and beyond will depend on the interplay of global economic conditions, monetary policy decisions, and fiscal policy developments. The ECB's communication and upcoming data releases on inflation, GDP growth, and labour market conditions will be closely scrutinised by market participants.

ECB at a crossroads: Data dependency reigns supreme

Monetary policy in the Euro-Area has entered a period of data dependency following the ECB's decision to cut interest rates in June 2024. The rate cut, the first since the ECB began its tightening cycle in July 2022, came amid signs of easing core inflation and concerns about the uneven nature of the economic recovery. However, the unexpected acceleration in headline inflation to 2.6% in July from 2.5% in June highlights the challenges faced by the ECB in balancing the need to bring inflation back to its 2% target while also supporting economic activity. The outlook for monetary policy over the next five weeks is uncertain, with the ECB adopting a data-dependent approach. The Governing Council will closely monitor incoming economic data, particularly inflation and growth indicators, to determine the appropriate path for interest rates.

The ECB's July monetary policy statement emphasised the data-dependent nature of its approach: "The Governing Council is not pre-committing to a particular rate path... [and] will continue to follow a data-dependent and meeting-by-meeting approach to determining the appropriate level and duration of restriction."

The ECB's commitment to price stability was also reiterated: "The Governing Council is determined to ensure that inflation returns to its 2% medium-term target in a timely manner."

The ECB's data-dependent approach to monetary policy will be a key factor shaping the euro area's economic outlook in the coming weeks and months. Market participants will closely scrutinise the ECB's communication and upcoming economic data releases for clues about the future path of interest rates.

Euro-area risks: Navigating a turbulent landscape

Risks over the previous five months:

1. "Energy Crisis Deepens" (February 2024 - June 2024):

• Synopsis: The energy crisis, triggered by the war in Ukraine and exacerbated by geopolitical tensions in the Middle East, continued to weigh on the euro area economy, driving up energy prices and fueling inflation.

• Key Developments:
  Russia further reduced natural gas supplies to Europe.
  Oil prices surged to multi-year highs.
  The euro weakened against the dollar, making energy imports more expensive.

2. "French Political Turmoil" (May 2024 - June 2024):

• Synopsis: Political uncertainty in France, following President Macron's decision to dissolve Parliament and call for early legislative elections, raised concerns about policy paralysis and fiscal slippage.

• Key Developments:
  The far-right National Rally made significant gains in the European Parliament elections.
  Macron's centrist alliance lost its absolute majority in the National Assembly.

• French bond yields rose amid concerns about political instability.

3. "Global Trade Tensions Escalate" (June 2024 - July 2024):

• Synopsis: Escalating trade tensions between the United States, the European Union, and China, fueled by disputes over technology and trade imbalances, threatened to disrupt global supply chains and dampen economic growth.

• Key Developments:
  The United States imposed tariffs on Chinese electric vehicles and other strategic goods.
  The European Union announced plans to place tariffs on Chinese EVs.China retaliated with tariffs on US and EU goods.
  Risks over the next five weeks:

1. "Fed Policy Pivot" (August 2024):

• Synopsis: The Federal Reserve's decision on interest rates in August will be a key risk event for the euro area. A more hawkish than expected Fed could strengthen the dollar and weigh on the euro, while also tightening global financial conditions.

2. "Italian Fiscal Concerns" (August 2024 - September 2024):

• Synopsis: Italy's high debt levels and rapid expenditure growth pose a risk to the euro area's fiscal outlook. Delays in implementing necessary fiscal adjustments could lead to renewed concerns about debt sustainability and weigh on investor confidence.

3. "Middle East Tensions" (August 2024 - September 2024):

• Synopsis: The ongoing conflict between Israel and Hamas, coupled with heightened tensions between Israel and Hezbollah, poses a significant geopolitical risk to the euro area. A further escalation of these conflicts could disrupt energy supplies, fuel inflation, and dampen investor confidence.

Conclusion

The Euro-Area's macroeconomic outlook is characterised by a mixed bag of data, persistent inflationary pressures, and heightened geopolitical risks. The implementation of the reformed fiscal framework and the ECB's data-dependent approach to monetary policy will be crucial for shaping the economic landscape in the coming weeks and months. Market participants will closely monitor key economic indicators and policy announcements for clues about the future path of the euro area economy.

Action points:

• Monitor the ECB's monetary policy decisions and communication for signs of a shift in its stance.

• Pay close attention to the implementation of the reformed fiscal framework and the EC's handling of fiscal slippages, particularly in Italy.

• Stay informed about geopolitical developments in the Middle East and their potential impact on the euro area economy.

Key economic events to monitor:

• August 1, 2024 (Thursday, Week 31): Bank of England Monetary Policy Report and Interest Rate Decision.

• August 2, 2024 (Friday, Week 31): US Non-Farm Payrolls Report.

• September 5, 2024 (Thursday, Week 36): ECB Interest Rate Decision.

• September 26, 2024 (Thursday, Week 39): German GfK Consumer Climate.

Sources:

• European Central Bank.

• European Commission.

• Federal Statistical Office (Germany).

• INSEE (France).

• International Monetary Fund.

• Organisation for Economic Co-operation and Development.

• Trading Economics.

• S&P Global.

• IHS Markit.

• CPB Netherlands Bureau for Economic Policy Analysis.

• GfK Group.

• Stratfor.

• Newsquawk.