Euro area: Growth broadens, ECB hikes

Economic activity gained further momentum in September, with the composite PMI rising to 53.1 from 52.0 in August, well above expectations and the highest level in more than three years. The increase was driven by a surprisingly strong services sector, where the PMI rose to 53.0 from 51.6, while manufacturing remained solid at 52.7. Growth in Q2 was predominantly driven by manufacturing, but the September PMIs suggest that momentum is now spilling over to the services sector, which is also boosted by consumer spending. The detailed Q2 GDP breakdown showed a positive surprise in private consumption, which rose 0.3% q/q despite higher energy costs and falling confidence. However, the prolonged period of higher energy costs is a downside risk for private consumption in the near term, but growth looks increasingly broad-based heading into Q4. 

Headline inflation increased to the highest level in three years at 3.8% y/y in September from 3.2% y/y, which was marginally above expectations of 3.7% y/y. The uptick in HICP was driven mainly by energy and food inflation, while underlying inflation pressures remained more muted. Core inflation increased in line with expectations to 2.5% y/y (cons.: 2.5%, prior: 2.4%). We are seeing momentum in core goods picking up slightly due to indirect effects of the energy shock, but the spillovers from the shock to underlying inflation remain relatively small as the chart to the right also shows.

The ECB hiked policy rates by 25bp at the September meeting, with the deposit rate at 2.50%, as expected. The communication, however, came as a hawkish surprise, with the ECB stating that "inflation is set to remain well above target for an extended period", while the new staff projections either kept all forecasts the same or revised up. Together with a focus on energy prices in its reaction function, this led us to revise our call in early September, to expect further tightening form the ECB, although a hike already in October now seems rather unlikely.

France's fiscal outlook has deteriorated further and come into focus again, with public debt reaching an all-time high of 119% of GDP in Q2 and this year's deficit expected at 5.4% of GDP, well above the initial 5.0% target. Market concerns have increased, with the 10Y France-Germany government bond yield spread widening further to around 140bp. Next year's budget is unlikely to bring much improvement. PM Lecornu targets a deficit of 5.0% of GDP in 2027, but his minority government depends on the opposition, which has little incentive to support strong fiscal tightening ahead of the presidential election. We therefore expect the final budget to target a deficit closer to 5.4%.

Download The Full Euro Area Macro Monitor