Euro area macro monitor: Headed for a challenging winter

Europe worsening energy crisis dominated market focus during August. European natural gas and electricity prices surged, as a confluence of factors (French nuclear power outages, low Rhine water levels, constraints on Norwegian hydroelectric stations, North Stream 1 shut-down) intensified supply fears heading into the autumn. Should prices stay at current elevated levels, consumers will face another marked increase in their energy bills this winter (rule of thumb: 100 EUR/Mwh increase in gas prices leads to 1.5-2pp upside risk for HICP), worsening the real wage and consumption squeeze. According to Bruegel, European governments have already allocated some EUR 280bn to cushion their economies from the energy crisis and more is likely to come. The EU is working on a plan to curtail the strong rise in prices, with discussions about a gas/electricity price cap, windfall taxes on energy companies and mandatory electricity demand cuts gathering pace.

Although euro area growth stayed surprisingly resilient in H1 22, recession risks have further intensified for the second half of the year. For a third month in row Europe’s beleaguered manufacturers reported a steep drop in production in the August PMI survey. Weaker demand – notably from Asia – and efforts to reduce high inventory levels point to further downside risks to manufacturing activity ahead. Services activity remains more robust, but continued to ease notably during August, amid clear signs that high inflation has led consumers to cut back on non-essential services spending. The flipside of the weaker demand environment remains further evidence of easing supply bottlenecks and price pressures, with selling price expectations softening across sectors. Also, the post-pandemic employment recovery continued, although firms have overall become more reluctant to hire new staff in light of weakening order books. With the threat of energy rationing and outright production stops still looming large later this year if gas flows through North Stream 1 remain suspended during winter, the nearterm outlook for the euro area economy remains challenging and we think a recession in H2 22 will be difficult to avoid.

Rising recession risks amid stubbornly high inflation are a headache for Europe´s politicians and central bankers alike. For governments, the weakening economy risks drying up tax revenues just at a time when the bill for support measures is increasing by the day and investments in defence, energy security and the green transition have never been more pressing. For the ECB, the economic downturn is sharpening its policy dilemma ahead. Both euro area HICP and core inflation rose to new record highs in August and with the latest rise in energy commodity prices yet to feed through, we expect headline inflation to reach double digit rates in Q4 22. The prospect for more fiscal easing amid higher energy prices has lead markets to anticipate more frontloaded central bank tightening and we now also look for a 75bp ECB hike in September given that inflation expectation have continued to adjust higher (see here). However, we see an increased risk that aggressive rate hikes will not help much in slowing inflation pressures that remain largely driven by external forces. Until Europe’s energy crisis is resolved, returning inflation back to target will remain a difficult feat to achieve. In the worst case, rising borrowing costs will only further delay the implementation of investments that are needed to solve Europe’s energy troubles.

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