A few more rises in interest rates amid inflation persistence

As interest rates increase in the Euro Area, credit growth has started to slow. Energy prices have fallen but core inflation remains sticky, pointing to further monetary tightening in the coming months.

With the energy crisis fading and the labour market remaining strong, confidence has improved, but we expect economic growth to be increasingly weighed down by rising interest rates.

In our view, downside risks to the growth outlook this year include unexpected stresses in the banking sector, a severe drought in Europe leading to higher food prices, tighter financial conditions than currently envisaged, or an intensification of global geopolitical tensions.

Monetary Tightening Is Having an Impact on Lending Rates

With the European Central Bank (ECB) conducting a comparatively aggressive tightening, the effect on bank lending rates is underway. EA bank lending rates have increased rapidly in recent months, particularly the non-bank financial corporations (NFCs) lending rate, which has reached the highest level since February 2009. Partly as a result, lending flows to corporates and households started to decelerate at the end of 2022. Compared to a year ago, lending growth to NFCs slowed to 5.7% in February 2023, but on a monthly basis lending flows have been contracting for four months already. Annual lending growth to households has slowed less sharply and monthly flows remain positive but these are decelerating. Since the start of its tightening cycle in July 2022, the ECB has raised its rates six times by a cumulative 350 basis points (bps), in a combination of 50pbs and 75bps hikes.

We expect the ECB to raise interest rates further in the coming months, as core inflation remains elevated. The financial market turmoil seen in March has so far proved temporary, diminishing concerns over widespread problems in the banking sector in Europe. This also means that the ongoing tightening is unlikely to be delayed or paused just yet. Although credit to the economy is slowing, the full effect of monetary tightening on the overall economy is yet to be seen. Research shows that changes in monetary policy have a lagged impact on the economy, in some cases by about a year.

The Energy Crisis Has Eased but Core Inflation Has Continued to Rise

As Europe secured gas supplies and reduced energy consumption, and with winter turning out to be mild, the worst of the energy crisis is now behind us. Overall, through energy saving measures, European countries managed to reduce demand for energy in the last months of 2022 in line with the voluntary commitment agreed by the European Union members in July last year. European countries also managed to replace gas from Russia. Although these developments led to a significant increase in energy prices initially, energy price pressures have now subsided markedly.

Headline inflation has fallen in recent months, but food prices and core inflation have continued to increase. The EA Harmonised Index of Consumer Prices (HICP) fell sharply to 6.9% in March 2023, after reaching a peak of 10.6% in October 2022. In the same way as energy prices drove inflation up, energy prices are driving inflation down. The inflation rate has fallen markedly in some countries, including Spain (3.1%), the Netherlands (4.5%), Belgium (4.9%). Inflation in the Baltic countries is also slowing although it remains high, still in double digits. Nevertheless, despite the declining trend in headline inflation, EA core inflation (excluding energy and food prices) has increased further, reaching 7.5% in March.

We expect EA inflation to continue to fall in the coming months, driven by base effects from lower energy prices. We also expect core inflation to remain elevated for some time and to fall more gradually. With energy inflation falling faster than expected, the ECB revised down in March its projection for EA inflation by 1ppt to 5.3% in 2023 and 0.5ppt to 2.9% in 2024. Upward surprises related energy (either oil or gas prices) and food inflation could still materialise leading to price pressures remaining somewhat high for longer.

Despite Improvements in the Near Term We Expect Weak Growth in 2023

Economic activity slowed significantly towards the end of last year, affected by the energy crisis, but the outturn was better than expected. Growth virtually halted in Q4 2022, dragged down by fixed investment and private consumption, which more than offset the positive contribution to growth from net exports and government consumption. Growth would have been worse without fiscal measures to lessen the impact of high inflation.

After a solid performance in the first half of the year, with real GDP growth of 5% Y-o-Y, growth more than halved to 2.2% in the second half. Among the largest EA economies, Spain (with real GDP growth of 3.7%) and the Netherlands (3.5%) outperformed EA growth in H2 2022, while France underperformed with growth of just 0.8%, along with Germany at 1.2% and Italy at 2.0%. For 2022 as a whole, the EA economy grew by 3.6%.

After stagnating in Q4 2022, recent indicators are pointing to some improvement in growth in the near term. Industrial production turned positive in January and February. EA economic sentiment has also improved since December, stabilising just below its long-term average in April 2023. The labour market has remained resilient, with the unemployment rate continuing to fall reaching 6.6% in February 2023. Moreover, falling headline inflation should provide some respite to household purchasing power.

Nevertheless, we expect weak growth in the EA this year, as the effect from higher interest rates takes hold and feeds through the economy. The ECB’s bank lending survey shows that credit standards are expected to tighten and demand for credit is set to fall further in the next months.

Moreover, the withdrawal of government support measures is likely to dampen demand later this year. Reflecting a carry-over effect from last year and a less bleak outlook in the near term, the ECB revised upward in March its growth projections for 2023 to 1.0%. This is still very weak growth. The ECB also revised downward its projection for 2024 to 1.6%.

In our view, downside risks to the outlook have shifted but remain significant. These include unexpected stresses in the banking sector, tighter-than-expected financial conditions, adverse weather conditions or a severe drought in Europe leading to higher food prices and trade disruptions, stickierthan-expected inflation, and an intensification of global geopolitical tensions.

UNITED KINGDOM

The effect from higher interest rates in the UK has been notable already, affecting the housing market and consumption. Tight financial conditions will continue to weigh on growth.

The Bank of England’s (BoE) tightening cycle seems to be approaching its end, although inflation persistence is pointing to yet another interest rate hike in May.

In our view, downside risks to the UK economic outlook in the near term include renewed financial market turmoil, even more persistent inflation, tighter-than-expected financial conditions, and an intensification of global geopolitical tensions.

Lending Rates Have Reached High Levels As Monetary Tightening Has Been Substantial

The BoE seems well ahead in its tightening cycle, having raised Bank Rate in 11 steps over 16 months, from 0.10% in December 2021 to 4.25% in March 2023 - a cumulative increase of 415bps. This substantial tightening has already had some impact on the economy, with additional lagged effects yet to come. The effect has been particularly evident in the UK housing market, along with other factors.

After mortgage rates spiked in October 2023, reflecting financial volatility related to the announcement of the mini budget, mortgage rates have fallen but remain at high levels. Mortgage lending activity has weakened sharply in recent months, while lending to NFCs has also slowed. The average bank lending rate to NFCs on new loans has continued to increase reaching 5.8% in February 2023, indicating how restrictive policy is at the moment.

We view another modest hike in Bank Rate in the near term as likely, in view of the stillhigh domestic inflationary pressures. Financial market stresses like the one seen in March, if contained, are unlikely to lead the BoE to alter its hiking cycle. The BoE has indicated that it is looking closely at the tightness in the labour market, wage growth in the private sector, and services inflation, as the three indications of inflation persistence.

UK Inflation Is Proving Sticky for Now but Expected to Start Falling More Rapidly

After reaching a peak of 11.1% in October 2022, the annual inflation rate has fallen only slightly and remains in double-digits. Inflation came in at 10.1% in March 2023, driven by food price inflation. Core inflation remained at 6.2% for a second consecutive month. Moreover, services inflation stabilised at a still high 6.7%. On the other two indicators of inflation persistence, private sector pay growth also increased in February, while conditions in the labour market remained tight, despite some softening in the demand for labour (job vacancies). Employment continued to grow and the unemployment rate edged up to a still low 3.8% in January.

As base effects come into play, inflation is set to fall from April, one year after a significant increase in the energy price cap took effect. In its central projections, the BoE expects the inflation rate to fall to 3.9% by the end of 2023, declining below target in the medium term.

The Growth Outlook Remains Weak This Year

Growth has been weak recently and this trend is set to continue. Economic activity has been affected by the energy crisis and high inflation as well as industrial action since last year.

Looking ahead, we expect weak growth in the near term, as prices pressures remain high and financial conditions remain tight, both weighing on consumption, while industrial disputes remain ongoing, potentially leading to further industrial action this year, disrupting economic activity.

In our view, renewed financial market turmoil, even more persistent inflation, tighter-than-expected financial conditions, and an intensification of global geopolitical tensions pose the main downside risks to the near-term outlook in the UK.