European Central Bank — Economic Bulletin (Europe, 2023)

Economic Bulletin Issue 8 / 2023 Contents Economic, financial and monetary developments Overview External environment Economic activity Prices and costs Financial market developments Financing conditions and credit developments Fiscal developments 1 2 3 4 5 6 Boxes 1 2 3 4 5 6 7 8 US Treasury market conditions and global market reactions to US monetary policy Geopolitical risk and oil prices Potential output in times of temporary supply shocks Monetary policy and the recent slowdown in manufacturing and services A primer on measuring household income Liquidity conditions and monetary policy operations from 2 August to 31 October 2023 Net interest income of households and firms Monetary dynamics during the tightening cycle Article 1 Statistics Central bank money settlement of wholesale transactions in the face of technological innovation 2 2 7 13 21 28 34 43 47 47 53 58 64 69 77 83 88 96 96 S1 ECB Economic Bulletin, Issue 8 / 2023   Contents 1 Economic, financial and monetary developments Overview The Governing Council decided at its meeting on 14 December 2023 to keep the three key ECB interest rates unchanged. While inflation has dropped in recent months, it is likely to pick up again temporarily in the near term.1 According to the December 2023 Eurosystem staff macroeconomic projections for the euro area, inflation is expected to decline gradually over the course of 2024, before approaching the Governing Council s 2% target in 2025. Overall, Eurosystem staff expect headline inflation to average 5.4% in 2023, 2.7% in 2024, 2.1% in 2025 and 1.9% in 2026. Compared with the September 2023 ECB staff macroeconomic projections for the euro area, this amounts to a downward revision for 2023 and especially for 2024. Underlying inflation has eased further. But domestic price pressures remain elevated, primarily owing to strong growth in unit labour costs. Eurosystem staff expect inflation excluding energy and food to average 5.0% in 2023, 2.7% in 2024, 2.3% in 2025 and 2.1% in 2026. The past interest rate increases continue to be transmitted forcefully to the economy. Tighter financing conditions are dampening demand, and this is helping to push down inflation. Eurosystem staff expect economic growth to remain subdued in the near term. Beyond that, the economy is expected to recover because of rising real incomes   as people benefit from falling inflation and growing wages   and improving foreign demand. Eurosystem staff therefore see growth picking up from an average of 0.6% for 2023 to 0.8% for 2024, and to 1.5% for both 2025 and 2026. The Governing Council is determined to ensure that inflation returns to its 2% medium-term target in a timely manner. Based on its current assessment, the Governing Council considers that the key ECB interest rates are at levels that, maintained for a sufficiently long duration, will make a substantial contribution to this goal. The Governing Council s future decisions will ensure that its policy rates will be set at sufficiently restrictive levels for as long as necessary. The Governing Council will continue to follow a data-dependent approach to determining the appropriate level and duration of restriction. In particular, its interest rate decisions will be based on 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 key ECB interest rates are the primary tool for setting the monetary policy stance. At its meeting on 14 December 2023, the Governing Council also decided to 1 The cut-off date for data included in this issue of the Economic Bulletin was 13 December 2023. ECB Economic Bulletin, Issue 8 / 2023   Economic, financial and monetary developments Overview 2 advance the normalisation of the Eurosystem s balance sheet. It intends to continue to reinvest, in full, the principal payments from maturing securities purchased under the pandemic emergency purchase programme (PEPP) during the first half of 2024. Over the second half of the year, it intends to reduce the PEPP portfolio by  7.5 billion per month on average. The Governing Council intends to discontinue reinvestments under the PEPP at the end of 2024. Economic activity The euro area economy contracted slightly in the third quarter of 2023, mostly owing to a decline in inventories. Tighter financing conditions and subdued foreign demand are likely to continue weighing on economic activity in the near term. Prospects are especially weak for construction and manufacturing, the two sectors most affected by higher interest rates. Services activity is also set to soften in the coming months. This is due to spillovers from weaker industrial activity, fading effects from the reopening of the economy and the broadening impact of tighter financing conditions. The labour market continues to support the economy. The unemployment rate stood at 6.5% in October and employment grew by 0.2% over the third quarter. At the same time, the weaker economy is dampening the demand for workers, with firms advertising fewer vacancies in recent months. Moreover, even though more people are in work, the total number of hours worked edged down by 0.1% in the third quarter. According to the December 2023 projections, available short-term indicators suggest that economic activity will remain weak in the fourth quarter of 2023. However, growth is expected to strengthen from early 2024 onwards, as real disposable income rises   supported by declining inflation, robust wage growth and resilient employment   and export growth catches up with improvements in foreign demand. The impact of the ECB s monetary policy tightening and adverse credit supply conditions continues to feed through to the economy, affecting the near-term growth outlook. These dampening effects are expected to fade later in the projection horizon, supporting growth. Overall, annual average real GDP growth is expected to slow down from 3.4% in 2022 to 0.6% in 2023, before recovering to 0.8% in 2024 and stabilising at 1.5% in 2025 and 2026. Compared with the September 2023 projections, the outlook for GDP growth has been slightly revised down for 2023-24, on the back of the recent data releases and weak survey data, whereas it is unrevised for 2025. As the energy crisis fades, governments should continue to roll back the related support measures. This is essential to avoid driving up medium-term inflationary pressures, which would otherwise call for even tighter monetary policy. Fiscal policies should be designed to make the euro area economy more productive and to gradually bring down high public debt. Structural reforms and investments to enhance the euro area s supply capacity   which would be supported by the full implementation of the Next Generation EU programme   can help reduce price pressures in the medium term, while supporting the green and digital transitions. To ECB Economic Bulletin, Issue 8 / 2023   Economic, financial and monetary developments Overview 3 that end, it is important to swiftly agree on the reform of the EU s economic governance framework. Moreover, it is imperative that progress towards capital markets union and the completion of banking union be accelerated. Inflation Inflation dropped over October and November 2023, falling to an annual rate of 2.4% in November according to Eurostat s flash release. This decline was broad-based. Energy price inflation fell further and food price inflation also came down, despite remaining relatively high overall. In December 2023 inflation is likely to pick up on account of an upward base effect for the cost of energy. In 2024 Eurosystem staff expect inflation to decline more slowly because of further upward base effects and the phasing-out of past fiscal measures aimed at limiting the repercussions of the energy price shock. Inflation excluding energy and food dropped by almost a full percentage point over October and November 2023, falling to 3.6% in November. This reflects improving supply conditions, the fading effects of the past energy shock and the impact of tighter monetary policy on demand and on the pricing power of firms. The inflation rates for goods and services fell to 2.9% and 4.0% respectively. All measures of underlying inflation declined in October, but domestic price pressures remained elevated, chiefly because of strong wage growth together with falling productivity. Measures of longer-term inflation expectations mostly stand around 2%, with some market-based indicators of inflation compensation declining from elevated levels. According to the December 2023 projections, the expected temporary pick-up in inflation notwithstanding, the underlying disinflationary process is expected to continue. Despite some cooling, the labour market is projected to remain tight which, together with compensation effects from past high inflation, should keep nominal wage growth high. Nevertheless, wage growth is expected to ease over the projection horizon as the upward impacts from inflation compensation gradually fade. Profits expanded notably in 2022, but are set to weaken over the projection horizon and provide a buffer to the pass-through of labour costs. Overall, with medium-term inflation expectations assessed to remain anchored at the ECB s 2% inflation target, headline HICP inflation is expected to decrease from 5.4% in 2023 to an average of 2.7% in 2024, 2.1% in 2025 and 1.9% in 2026. Compared with the September 2023 projections, HICP inflation has been revised down for 2023 and 2024, mainly owing to lower than expected recent data outturns and lower assumptions for energy commodity prices, whereas it is unre