European Central Bank — Economic Bulletin (Europe, 2023)

Economic Bulletin Issue 2 / 2023 Contents Economic, financial and monetary developments Overview 1 2 3 4 5 6 External environment Economic activity Prices and costs Financial market developments Financing conditions and credit developments Fiscal developments Boxes 1 2 3 4 5 6 7 8 9 What shapes spillovers from US monetary policy shocks to emerging market economies? Oil price developments and Russian oil flows since the EU embargo and G7 price cap Friend-shoring global value chains: a model-based assessment Global value chains and the pandemic: the impact of supply bottlenecks Who foots the bill? The uneven impact of the recent energy price shock Results of the 2022 climate risk stress test of the Eurosystem balance sheet Backcasting real rates and inflation expectations   combining market- based measures with historical data for related variables Liquidity conditions and monetary policy operations from 2 November 2022 to 7 February 2023 Update on euro area fiscal policy responses to the energy crisis and high inflation Article 1 Fiscal policy and high inflation Statistics ECB Economic Bulletin, Issue 2 / 2023   Contents 2 2 8 15 23 32 38 45 48 48 53 59 67 72 79 83 88 94 99 99 S1 1 Economic, financial and monetary developments Overview Inflation is projected to remain too high for too long. Therefore, on 16 March 2023 the Governing Council decided to increase the three key ECB interest rates by 50 basis points, in line with its determination to ensure the timely return of inflation to the 2% medium-term target. The elevated level of uncertainty reinforces the importance of a data-dependent approach to the Governing Council s policy rate decisions, which will be determined by its assessment of the inflation outlook in light of the incoming economic and financial data, the dynamics of underlying inflation, and the strength of monetary policy transmission. The Governing Council also announced that it was monitoring current market tensions closely. It stands ready to respond as necessary to preserve price stability and financial stability in the euro area. The Governing Council said that the euro area banking sector was resilient, with strong capital and liquidity positions. In any case, the ECB s policy toolkit is fully equipped to provide liquidity support to the euro area financial system if needed and to preserve the smooth transmission of monetary policy. The new ECB staff macroeconomic projections were finalised in early March before the recent emergence of financial market tensions. As such, these tensions imply additional uncertainty around the baseline assessments of inflation and growth. Prior to these latest developments, the baseline path for headline inflation had already been revised down, mainly owing to a smaller contribution from energy prices than previously expected. ECB staff now see inflation averaging 5.3% in 2023, 2.9% in 2024 and 2.1% in 2025. At the same time, underlying price pressures remain strong. Inflation excluding energy and food continued to increase in February and ECB staff expect it to average 4.6% in 2023, which is higher than foreseen in the December projections. Subsequently, it is projected to come down to 2.5% in 2024 and 2.2% in 2025, as the upward pressures from past supply shocks and the reopening of the economy fade out and as tighter monetary policy increasingly dampens demand. The baseline projections for growth in 2023 have been revised up to an average of 1.0% as a result of both the decline in energy prices and the economy s greater resilience to the challenging international environment. ECB staff then expect growth to pick up further, to 1.6%, in both 2024 and 2025, underpinned by a robust labour market, improving confidence and a recovery in real incomes. At the same time, the pick-up in growth in 2024 and 2025 is weaker than projected in December, owing to the tightening of monetary policy. ECB Economic Bulletin, Issue 2 / 2023   Economic, financial and monetary developments Overview 2 Economic activity Global economic activity remained subdued at the turn of the year, but near-term prospects have brightened, buoyed by China s economic reopening and the continued resilience of labour markets across advanced economies. The easing of supply constraints continues to underpin global trade and, despite headline inflation declining, underlying price pressures remain strong. Against this backdrop, the global growth outlooks for 2023 and 2024 included in the March 2023 ECB staff macroeconomic projections for the euro area have been revised upwards compared with the December 2022 Eurosystem staff macroeconomic projections. While the reopening of China s economy will support global growth this year, global economic activity remains relatively subdued, with growth rates still below historical averages over the whole projection horizon from 2023 to 2025. Global trade projections have also been revised upwards to reflect China s economic reopening and the further easing of global supply chain constraints. There are growing signs that global consumer price index (CPI) inflation already peaked in 2022, although price pressures in the global economy remain high. Disinflation is being bolstered by waning supply disruptions, falling energy prices and synchronised monetary policy tightening across the world. However, resilient labour markets and strong wage growth, especially in major advanced economies, suggest that underlying inflationary pressures in the global economy remain strong and that the disinflation process will be gradual. The euro area economy stagnated in the fourth quarter of 2022, thus avoiding the previously expected contraction. However, private domestic demand fell sharply. High inflation, prevailing uncertainties and tighter financing conditions dented private consumption and investment, which fell by 0.9% and 3.6% respectively. Under the baseline, the economy looks set to recover over the coming quarters. Industrial production should pick up as supply conditions improve further, confidence continues to recover, and firms work off large order backlogs. Rising wages and falling energy prices will partly offset the loss of purchasing power that many households are experiencing as a result of high inflation. This, in turn, will support consumer spending. Moreover, the labour market remains strong, despite the weakening of economic activity. Employment grew by 0.3% in the fourth quarter of 2022 and the unemployment rate stayed at its historical low of 6.6% in January 2023. With energy supplies becoming more secure, energy prices have eased significantly, confidence has improved and activity should pick up somewhat in the short term. Lower energy prices are now providing some cost relief, particularly for energy- intensive industries, and global supply bottlenecks have largely dispersed. The energy market is expected to continue rebalancing and real incomes are expected to improve. With foreign demand also strengthening, and provided current financial market tensions subside, output growth is expected to rebound as of mid-2023, underpinned by a robust labour market. Nevertheless, the ECB s ongoing policy normalisation and further rate hikes expected by markets will increasingly feed through to the real economy, with additional dampening effects stemming from a recent tightening in credit supply conditions. This, together with the gradual withdrawal of fiscal support and some remaining concerns about risks to the energy ECB Economic Bulletin, Issue 2 / 2023   Economic, financial and monetary developments Overview 3 supply next winter, will weigh on economic growth in the medium term. Overall, annual average real GDP growth is expected to slow to 1.0% in 2023 (from 3.6% in 2022), before rebounding to 1.6% in 2024 and 2025. Compared with the December 2022 Eurosystem staff macroeconomic projections, the outlook for GDP growth has been revised up by 0.5 percentage points for 2023 owing to a carry-over from the positive surprises in the second half of 2022 and an improved short-term outlook. For 2024 and 2025, it has been revised down by 0.3 percentage points and 0.2 percentage points respectively, as the tightening of financing conditions and the recent appreciation of the euro outweigh the positive income and confidence effects of lower inflation. According to ECB staff March 2023 projections, the euro area fiscal outlook is set to improve over the projection horizon. After the significant decline estimated for 2022, the euro area budget deficit is projected to continue to decline somewhat in 2023 and more significantly in 2024 (to 2.4% of GDP), remaining unchanged in 2025. The decline in the budget balance at the end of the projection horizon, compared with 2022, is explained by the improvement in the cyclically adjusted primary balance and by a better cyclical component, while interest payments gradually increase as a share of GDP over the projection horizon. Euro area debt is projected to continue to decline, albeit more slowly after 2022, to slightly below 87% of GDP by 2025. This is mainly on account of negative interest rate-growth differentials, which more than offset the persisting primary deficits. Nevertheless, in 2025, both the deficit and the debt ratios are expected to remain above pre-pandemic levels. Compared with the December projections, the budget balance path has been revised up over 2023-25, albeit only marginally at the end of the projection horizon, while interest payments have increased over 2024-25. The debt ratio has been revised down, reflecting mainly the improvement in the primary balance path. Government support measures to shield the economy from the impact of high energy