Overview

Following weak growth in the second and third quarters of 2019, real GDP growth is expected to remain subdued in the near term. Economic sentiment indicators have declined, mainly reflecting the ongoing weakness in global trade in an environment of continued global uncertainties (related to increased protectionism, a potential sharper slowdown in China and a no-deal Brexit). Nevertheless, the most recent indicators on manufacturing show some stabilisation, while sentiment in the construction sector and consumer confidence have exhibited more resilience, and the labour market situation remains favourable. Beyond the near term, the very favourable financing conditions (fostered by the ECB’s highly accommodative monetary policy stance), the assumption of an orderly Brexit and some dissipation of other global uncertainties, the associated gradual recovery in foreign demand and notable fiscal easing should all support a sustained recovery in growth over the medium term. Overall, real GDP growth is projected to decline slightly to 1.1% in 2020, before increasing to 1.4% in 2021 and 2022. Compared with the September 2019 projections, growth has been revised down by 0.1 percentage points in 2020, as the impact of sizeable downward revisions to foreign demand is only partially offset by the impact of more supportive fiscal and monetary policies and an effective depreciation of the euro.

After weakening in 2019, HICP inflation is expected to slow further in 2020, before gradually rising to 1.6% by 2022. The profile for headline inflation in the coming quarters will be heavily affected by base effects in energy inflation. Following a rise at the end of 2019, HICP inflation excluding energy and food is expected to strengthen gradually over the projection horizon. It should be supported by strengthening economic growth, by relatively robust wage growth amid tight labour markets and by recovering profit margins as activity regains pace, aided by, among other things, the recent monetary policy package. Rising non-energy commodity prices should also support underlying inflation. Compared with the September 2019 projection exercise, HICP inflation has been revised upwards for 2020 owing to higher oil prices and revised slightly downwards for 2021 owing to lower external price pressures and weaker developments in wages and profit margins.^[1]

1 Real economy

Real GDP growth in the euro area was 0.2% in the third quarter of 2019, slightly stronger than expected in the September 2019 projections. Domestic demand contributed positively to growth in the third quarter of 2019, whereas net trade and changes in inventories had a slight dampening impact. The moderate growth in exports reflects global headwinds and, in particular, sluggish global activity and foreign demand in the context of elevated global uncertainty. Private consumption growth was resilient in the third quarter and remained the main driver of growth.

Short-term indicators point to subdued growth in the near term. The Economic Sentiment Indicator compiled by the European Commission improved in November, following two months of decline, but remains below the average for the third quarter. Ongoing weakness in global trade and continued high uncertainty (related to global trade disputes, the possibility of a disorderly Brexit and risks of a steeper slowdown in China) weigh on business expectations. This is particularly the case in the manufacturing sector, where sentiment remains well below its longer-term average. By contrast, sentiment in the construction sector, as well as consumer confidence, have continued to exhibit resilience. The Purchasing Managers’ Indices continue to signal divergence across sectors, with manufacturing data remaining far below the growth threshold of 50, albeit stabilising somewhat recently, while the indices related to the services and construction sectors stand above 50. Spillovers from the manufacturing to the services sector have so far been contained and are broadly as expected given the limited exposure of the services sector to the global shocks which have adversely affected manufacturing (see Box 3). Overall, the latest indicators suggest that the weak growth seen in the second and third quarters will continue into the final months of 2019 and early 2020.

Over the medium term the projections assume some dissipation of global headwinds, allowing the fundamental factors supporting the euro area expansion to regain traction (see Chart 1 and Table 1). In particular, the baseline assumes an orderly exit of the United Kingdom from the EU and no further protectionist measures (beyond those already announced), which also reduces the chances of a steep slowdown in China. Thus, the current level of uncertainty will gradually decline, allowing the fundamentals supporting growth to regain traction. Financing conditions are expected to remain very accommodative and the ECB’s monetary policy measures, including the September 2019 monetary policy package, will continue to be transmitted to the economy. More specifically, the technical assumptions imply that nominal interest rates would increase only modestly from their current low levels over the projection horizon. After remaining broadly unchanged in the near term, lending to the non-financial private sector should also strengthen modestly, spurred by an improving macroeconomic environment, very low interest rates and favourable bank lending conditions for both households and non-financial corporations. Lower deleveraging needs and improved debt servicing capacity across sectors and rising profits will also contribute to the dynamism of private expenditure. Growth in private consumption and residential investment should also benefit from relatively robust growth in wages and net worth, as well as from declining unemployment. Euro area exports are expected to benefit from the projected recovery in foreign demand and the recent depreciation of the euro in effective terms. Finally, the fiscal stance is expected to loosen over 2020-2021 and to be broadly neutral in 2022 (see Section 3).

Nevertheless, the fading-out of some tailwinds would lead to a marginally slower growth profile in the course of 2022. Employment growth is expected to slow over the medium term, mostly reflecting increasingly binding labour supply constraints in some countries.

Private consumption growth firmed in the third quarter of 2019 and should moderate slightly over the projection horizon. It increased from 0.2% in the second quarter of 2019 to 0.5% in the third quarter in an environment of resilient consumer confidence and favourable labour market conditions. Looking ahead, the quarterly dynamics of private consumption are expected to be slightly stronger on average in the second half of 2019 than in the first half, partly due to a lagged reaction of consumption to the government measures supporting income in a number of large countries. In 2020 still relatively favourable consumer confidence, expected further declines in unemployment and continued growth of real wages per employee suggest a pick-up in consumption growth, also supported by the positive effects of fiscal loosening in some countries. Consumption growth is expected to moderate slightly in 2021-22, in line with lower real disposable income growth in these two years.

Private consumption growth should be supported by favourable financing conditions and rising net worth. Nominal bank lending rates are projected to decline slightly further in the near term, before stabilising and then increasing modestly in 2021-22. Given that bank lending rates and bank lending volumes to households are projected to increase only moderately in the coming years, gross interest payments are expected to remain at low levels and, therefore, continue to support private consumption. In addition, net worth is projected to increase further in real terms in 2020-2022, spurred by the continued robust valuation gains on real estate holdings. Together with the earlier progress achieved in deleveraging, rising net worth should also provide moderate support to consumption.

Growth in housing investment is expected to continue, albeit at a more moderate pace. Over the short term, confidence indicators for the construction sector suggest a continued, but moderate, expansion of housing investment. Ongoing moderate growth is also suggested by an easing in the number of building permits granted, as well as by recent surveys which show a decline in the share of households planning to undertake home improvements over the next year. In the medium term, housing investment growth is expected to stabilise at low levels, reflecting increasingly binding capacity constraints in the construction sector in some countries. Adverse demographic trends in some countries are also expected to dampen housing investment in the medium term.

Business investment is expected to remain subdued in the short term, before gradually gathering pace over the projection horizon. Business investment growth is expected to remain muted in the short term, largely on account of adverse cyclical effects associated with weak external demand, a decline in capacity utilisation towards its historical average and elevated uncertainty. In the medium term, business investment growth is expected to gather pace but to be less dynamic than in previous years, reflecting the relatively modest developments in global trade as well as lower new plant capacity needs. In the longer term, however, as uncertainty is assumed to dissipate, a number of favourable fundamental factors are expected to support business investment. First, with aggregate demand remaining strong for a number of years, firms will strengthen their investment so that their productive capital stock expands. Second, financing conditions are expected to remain very supportive over the projection horizon. Third, profit margins are expected to improve, which should support investment growth. Fourth, support to business investment should come from a decline in the leverage ratio of non-financial corporations over recent years driven by a recovery in stock prices, the continued accumulation of assets and moderate debt financing growth, although consolidated gross indebtedness still stands above pre-crisis levels and is expected to increase moderately over the projection horizon. Finally, the gross interest payments of non-financial corporations have declined to record low levels in the past few years and are expected to increase only gradually in the coming years, supporting business investment.

Export growth is projected to be subdued in the near term and to gradually recover over the rest of the projection horizon. Following low rates of growth in the second and the third quarters of 2019, exports are projected to remain weak in the final months of 2019, consistent with the persisting slowdown in global trade. In the medium term, euro area exports are projected to recover and to grow broadly in line with foreign demand (see Box 2). Following a strong outturn in the second quarter of 2019 (related to a spike in investment growth in Ireland) and moderate growth in the third quarter, imports are expected to grow broadly in line with total demand (domestic demand plus exports) over the projection horizon. Overall, the contribution of net trade to real GDP growth is projected to be broadly neutral over the entire projection horizon.

Employment growth is projected to be subdued, partially reflecting temporary factors in the short term, while labour supply constraints are expected to emerge later in the horizon. Headcount employment grew by 0.1% in the third quarter of 2019, indicating a slowing of momentum compared with the quarterly growth rates seen in the past four years. Employment growth is projected to remain rather subdued over the medium term, owing to labour supply constraints. In addition, towards the end of the projection horizon, labour demand is also projected to moderate in line with the slowdown in activity.

Labour force growth is expected to moderate over the projection horizon. The labour force is expected to continue to expand, reflecting the projected net immigration of workers (including the expected integration of refugees) and ongoing increases in the participation rate. Nevertheless, these factors are projected to fade over the projection horizon and the adverse impact of the ageing of the population on labour force growth is expected to increase, as older cohorts leave the workforce in higher numbers than younger cohorts enter it.

The euro area unemployment rate is expected to decline steadily to 7.1% in 2022. The unemployment rate declined to 7.5% in October 2019, which is the lowest level observed since 2008. Unemployment rates are expected to continue to exhibit substantial differences across euro area countries.

Labour productivity growth is projected to recover over the projection horizon. Following its strong momentum in 2017, per worker and per hour labour productivity growth declined in 2018, reflecting the unexpected weakening of activity. Productivity growth will also be muted in 2019, owing to weak output growth but still fairly robust employment growth. Over the remainder of the horizon, productivity growth is expected to pick up, as activity regains momentum, while labour input growth slows down. Over the medium term, year-on-year labour productivity growth should converge towards its pre-crisis average of 1.0%.^[4]

Compared with the September 2019 projections, real GDP growth has been revised down in 2020, while it is unrevised for 2021. Growth in 2020 has been revised down as the impact of the sizeable downward revisions to foreign demand is only partially offset by the impact of more supportive fiscal and monetary policies, and an effective depreciation of the euro. In 2021 the impact of a more limited further downward revision to foreign demand is balanced by more supportive policies.

2 Prices and costs

HICP inflation is expected to decline to 1.1% in 2020 and then rise to 1.4% in 2021 and 1.6% in 2022 (see Chart 2). Headline inflation rates are likely to be moderate but somewhat volatile until the second quarter of 2020, mainly reflecting base effects in HICP energy inflation. Until the beginning of 2021, HICP energy inflation will remain negative and turn positive only in the second quarter of 2021 as the oil price futures curve stabilises and some tax increases also take effect. HICP food inflation is envisaged to hover around 1.8%. After a moderate rise by end-2019, HICP inflation excluding energy and food will move sideways in the course of 2020 and increase to 1.4% in 2021 and 1.6% in 2022. The upward path of HICP inflation excluding energy and food is expected to be supported by strengthening economic activity, by relatively robust wage growth amid tight labour markets, and by recovering profit margins as activity regains pace, aided, among other things, by the ECB’s September 2019 monetary policy measures. Rising non-energy commodity prices are also expected to provide some support to HICP inflation excluding energy and food.

After easing in the second half of 2019, growth in compensation per employee is projected to gradually gain momentum as labour markets remain tight. The main driver of wage growth is the envisaged increase in labour market tightness in some parts of the euro area. Beyond the cyclical momentum, the pick-up in headline inflation over the last two years can be expected to contribute to robust wage growth in euro area countries where the wage formation process includes backward-looking elements. In addition, some countries have introduced increases in minimum wages that might pass through to the wage distribution.

Growth in unit labour costs is projected to decrease until the beginning of 2021 and move sideways thereafter. Following a spike in 2019 in the context of the cyclical slowdown in productivity, unit labour cost growth is expected to moderate in the course of 2020 and stay at 1.4% thereafter. The slowdown in unit labour cost growth in 2020 reflects a pick-up in productivity growth against the background of flat wage growth, while the subsequent flat profile denotes a continued rise in productivity growth combined with a pick-up in wage growth.

After contracting in 2019, profit margins are expected to continue declining in 2020 before recovering slightly over the remainder of the projection horizon. Profit margins have been squeezed since mid-2018 and are expected to remain compressed in the course of 2020 owing to the weakening of economic activity, in particular in the manufacturing sector. In this environment, they are buffering the productivity-related acceleration in unit labour costs. In addition, past increases in oil prices have weighed on the terms of trade, adversely affecting profit margin developments. These factors should become less important as oil prices stabilise and economic activity regains pace, with past increases in wages gradually being passed on to prices.

Following a slowdown in the course of 2019, external price pressures are expected to rise moderately until 2021 and to be stable thereafter. The annual growth rate of the import deflator is estimated to have decreased in 2019 and is expected to rise gradually in 2020 and 2021. This profile is largely determined by movements in oil prices, which have pushed down import prices in 2019 and, as suggested by the oil futures curve, will continue to dampen them somewhat over the projection horizon, but to a notably lesser extent. Rising non-oil commodity prices and underlying global price pressures should provide support for import price inflation.

Compared with the September 2019 exercise, the projection for HICP inflation has been revised up for 2020 and down for 2021. These revisions are partly explained by the energy component, which has been revised upwards in 2020 but downwards in 2021, owing to higher oil prices in the short term and a slightly more downward-sloping oil price futures curve. Food price inflation has also been revised down for 2020 and 2021, partly reflecting lower inflation for international food commodity prices. The projection for HICP inflation excluding food and energy has been revised slightly up in 2020 and slightly down in 2021, reflecting the interplay between, on the one hand, upward pressures from a weaker exchange rate and the indirect effects of higher oil prices, and, on the other, weaker global prices and a lower path for wages and profit margins.

3 Fiscal outlook

The euro area fiscal stance^[7] is assessed to be expansionary over 2019-21 and broadly neutral in 2022. The projected loosening of the fiscal stance over 2019-21 mostly stems from cuts in direct taxes and higher government transfers, and to some extent from higher government investment and consumption. In 2022 the fiscal stance is projected to be broadly neutral, with some limited further direct tax cuts and additional expenditure.

The euro area budget balance is projected to decline steadily over 2019-21 and to stabilise in 2022, while the debt ratio remains on a downward path. The decline in the budget balance over 2019-21 stems from the expansionary fiscal stance. This is partly compensated by lower interest expenditure, while the cyclical component remains unchanged over the projection horizon. The declining government debt ratio over the projection horizon is supported by the favourable interest rate-growth differential and by the primary surplus, although the latter is diminishing over time.

The euro area fiscal outlook for 2020-21 has deteriorated somewhat compared with the September 2019 projections. Following a limited upward revision in 2019, the higher budget deficit in 2020 and 2021 reflects the additional fiscal loosening, while the cyclical component and the interest payment projections remain broadly unchanged. The debt ratio is projected to be on a slightly higher path than in the September 2019 projections, on account of upward revisions in the historical data, lower projected primary surpluses and less favourable interest rate-growth differentials over 2020-21.