Overview

Real GDP growth remained unexpectedly sluggish in the fourth quarter of 2018, and recent indicators point to substantially weaker than previously expected activity also in the first half of 2019. While some temporary factors are likely to have contributed to the slowdown in activity in late 2018, the broad-based worsening of economic sentiment indicators across countries and sectors in recent months suggests that more persistent adverse factors have also been at play and that the underlying cyclical momentum is somewhat weaker than previously assessed. In the shorter term, a combination of global uncertainties (such as threats of an escalation of protectionist measures and the possibility of a disorderly Brexit) as well as adverse domestic factors in some euro area countries are likely to continue to weigh on euro area activity. Thereafter, the baseline assumes that these domestic and global headwinds gradually fade out and that the fundamental factors supporting the euro area expansion remain broadly in place. These factors include, notably, the very accommodative stance of monetary policy, rising wages, a recovery in foreign demand and some fiscal loosening. As these favourable factors are expected to gradually prevail, real GDP growth is projected to increase from 1.1% in 2019 to 1.6% in 2020 and 1.5% in 2021. Compared with the December 2018 projections, real GDP growth for 2019 has been revised down by 0.6 percentage point. HICP inflation is expected to continue to decrease in the course of 2019 and to rise over the remainder of the projection horizon, reaching 1.6% in 2021. The decrease in HICP inflation in 2019 is accounted for by a sharp decline in HICP energy inflation, reflecting the recent drop in oil prices. HICP inflation excluding energy and food is projected to pick up gradually over the projection horizon, reflecting the continued but more moderate strengthening in economic activity and the tightening of labour markets. Compared with the December 2018 projections, HICP inflation has been revised down over the entire projection horizon, mainly reflecting recent weaker data outturns, the weaker outlook for economic growth and a downward revision to the oil price assumptions.^[1]

1 Real economy

Growth weakened notably in the second half of 2018 and exhibited increased divergence among the largest euro area countries (see Chart 1). The slowdown in real GDP growth, from quarterly rates of 0.4% in the first half of 2018 to 0.2% in the second half, is partly related to specific factors that affected activity. Among the largest euro area countries, this was particularly the case in Germany and Italy, which recorded substantial declines in GDP growth rates (from quarterly rates of 0.4% in the first half of 2018 to a standstill in the second half of the year in Germany, and from 0.2% to negative rates for the same periods in Italy). In Germany, the sharp slowdown in the second half of 2018 was partly related to disruptions in the car industry, which have proved to be more persistent than previously expected, but it also reflected broader weakness across sectors. In Italy, uncertainty, financial market volatility and deterioration in business confidence had an increasingly adverse impact on economic activity. Quarterly GDP growth in France and Spain in the second half of 2018 slightly exceeded the pace seen in the first half of the year.

With few exceptions, recent sentiment indicators have broadly worsened, reflecting domestic and global uncertainties, as well as an earlier than expected weakening of the underlying cyclical momentum. The Economic Sentiment Indicator (ESI) compiled by the European Commission has continued to decline in recent months, with its decline being broad-based across euro area countries and across sectors. While remaining above historical averages, the industrial, services and consumer confidence indices included in the ESI have fallen to levels last seen in late 2016. The Purchasing Managers’ Indices also continued to decline in recent months, as the assessment of new export orders and inventory stocks worsened. The broad-based downward surprises in economic releases may reflect a stronger than previously expected impact of global uncertainties – in particular related to global trade disputes and Brexit – as well as the impact of the aforementioned uncertainties in Italy and possible adverse impacts of the protests in France. They may also suggest that the underlying cyclical momentum has weakened earlier than previously expected, acknowledging the increasingly mature cyclical position of the euro area economy. These factors are reflected in downward revisions to real GDP growth for the coming quarters.

Over the medium term, the baseline assumes a gradual dissipation of global and domestic headwinds, allowing fundamental factors supporting the euro area expansion to regain traction (see Table 1). In particular, the baseline assumes no disorderly exit of the United Kingdom from the European Union and that the current level of uncertainty regarding global trade and domestic policies in some euro area countries gradually normalises. The fading away of these negative headwinds will give way to a number of favourable fundamental factors. The ECB’s monetary policy stance is expected to remain very accommodative and to continue to be transmitted to the economy. Lending to the private sector should remain resilient, spurred by low interest rates and favourable bank lending conditions for both households and non-financial corporations. Growth in private consumption and residential investment should also benefit from rising wage growth and net worth, as well as from declining unemployment. At the same time, business investment will continue to expand against a background of rising profits, high capacity utilisation and likely labour-saving investment in the context of increasing labour shortages. Euro area exports are expected to benefit from the projected recovery in euro area foreign demand and by some competitiveness gains. Finally, the fiscal stance is expected to move from broadly neutral in 2018 to loosening over the full horizon (see Section 3).

Nevertheless, the fading out of some tailwinds will restrain the recovery in economic growth over the latter half of the projection horizon. The technical assumptions imply that financing conditions will become gradually less favourable, although they will continue to support growth. In addition, following several years of robust growth, employment is expected to grow at a somewhat lower rate over the medium run, mostly reflecting increasingly binding labour supply shortages in some countries.

Real disposable income is expected to maintain its solid momentum in 2019 and 2020, before weakening in 2021. This reflects offsetting developments in nominal disposable income growth and consumer price inflation in 2019 and 2020, while both weakening nominal income growth and slightly higher inflation dampen real income growth in 2021. The contribution of gross wages and salaries to nominal disposable income growth is projected to decline somewhat in 2019 (due to the impact of weaker employment growth) and to remain broadly unchanged thereafter (as an expected increase in nominal wage growth compensates for a further slowdown in employment growth). Non-labour income declined in the second half of 2018 and is projected to recover gradually over the projection horizon, broadly in line with profits. The contribution of net fiscal transfers is expected to turn positive in 2019, for the first time since 2010, reflecting a mix of cuts to direct taxation and rising transfers to households; it is expected to turn broadly neutral in 2020 and 2021.

Private consumption is projected to recover in the near term, but uncertainties in some countries are likely to weigh on its momentum. Private consumption has decelerated in the course of 2018. Looking forward, still relatively favourable consumer confidence, further expected improvements in labour market conditions and rising real wages per employee suggest stronger consumption growth over the next few quarters, further compounded by a positive effect of fiscal loosening in certain countries. At the same time, a persistent adverse impact of domestic uncertainties in some euro area countries is assumed to weigh on private consumption in the coming quarters.

Private consumption growth should be supported in the medium term by favourable financing conditions and rising net worth. Bank lending rates are projected to increase moderately over the projection horizon. However the impact of rising bank lending rates on gross interest payments is expected to be limited due to the long maturity of household debt and the relatively low share of variable rate debt on the households’ balance sheet. Thus, despite the increase in lending rates, gross interest payments are expected to remain at low levels and therefore to continue to support private consumption. In addition, net worth is projected to increase by around 2.5% in real terms each year over the period 2019-21, spurred by the continued robust valuation gains on real estate holdings, which explain more than half of the projected increase. Rising real net worth should support consumption, even though household gross indebtedness remains at levels prevailing before the start of the global financial crisis.

The expansion of residential investment is expected to continue, albeit at a more moderate pace. Confidence in the construction sector and rising granted building permits suggest a continued expansion of housing investment in the next few quarters. Nonetheless, the pace of this expansion is expected to slow. This weakening is also suggested by surveys showing a recent decline in the share of households planning to undertake home improvements over the next year. Such moderation may emerge partly as financing conditions are set to become slightly tighter, but also as a result of increasingly binding capacity constraints in the construction sector and adverse demographic trends in some countries.

Business investment is expected to continue recovering over the projection horizon, albeit at a rather subdued pace. Business investment is estimated to have lost some momentum in the second half of 2018. Looking ahead, business investment is expected to remain rather subdued in 2019, as persistent concerns about global trade policies, a no-deal Brexit and a hard landing in China appear to have increasingly adversely affected business confidence across countries. In general, however, a number of favourable fundamentals are expected to continue to support business investment in the euro area: capacity utilisation in manufacturing remains above its long-term average and a large share of manufacturing firms report lack of equipment as a factor limiting production; financing conditions are expected to remain supportive, albeit gradually tightening over the projection horizon; profits are expected to increase, which adds further to the sizeable liquid asset overhang firms have built up in recent years; and companies may increase investment as a means of compensating for labour-related supply-side constraints.

Extra-euro area exports are projected to grow slightly faster than foreign demand in the near term and in line thereafter. Following a decline in the first quarter of 2018, extra-euro area exports are estimated to have recovered gradually in the second and third quarters and to have outpaced foreign demand in the fourth quarter. The resulting market share gains in the fourth quarter partly reflect country specific factors. As these unwind, and as foreign demand remains rather sluggish in 2019, extra-euro area export growth is expected to remain subdued in the short term, while still growing somewhat faster than foreign demand during 2019, implying slight gains in market share. The relative strength of extra-euro area exports vis-à-vis foreign demand in the short term reflects improving price competitiveness across euro area countries, compounded by a further normalisation of car exports. Over the medium term, extra-euro area exports are expected to grow in line with foreign demand (see Box 2). Extra-euro area imports are estimated to have slowed to below the pace of exports in the fourth quarter of 2018, implying a positive contribution from net trade to real GDP growth. Looking ahead, extra-euro area imports are expected to grow broadly in line with total demand (domestic demand plus exports). As imports are projected to rise somewhat faster than exports, the contribution of net trade to economic growth is projected to turn slightly negative in 2019 and to be broadly neutral over the remainder of the projection horizon.

Employment growth is projected to decline given weakening activity and increasingly binding labour shortages in some countries. Forward-looking surveys suggest modest employment growth in the near term. Employment growth is expected to be dampened in the near term, mainly by the sharp slowdown in activity. Over the medium term employment growth is likely to remain subdued, as labour supply is expected to limit further employment growth in some countries and labour demand is projected to moderate in line with the slowdown in activity.

The expansion of the labour force is expected to moderate over the projection horizon. The labour force is expected to continue to expand, reflecting the projected net positive immigration of workers, 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 unemployment rate is expected to decline to 7.5% in 2021. The unemployment rate stood at 7.9% in the fourth quarter of 2018, which is the lowest level observed since the third quarter of 2008. Looking ahead, the number of unemployed persons is projected to decline by around 0.9 million to 12.9 million by the end of the projection horizon, still somewhat above the level of its pre-crisis trough. While the unemployment rate is expected to drop in almost all euro area countries over the projection horizon, individual country levels are expected to still exhibit substantial differences.

Labour productivity is projected to recover over the projection horizon. Following its strong momentum in 2017, labour productivity per worker declined slightly in quarter-on-quarter terms during the course of 2018, reflecting the unexpected weakening of activity and some labour hoarding in response to labour shortages. A moderate acceleration in productivity growth in quarter-on-quarter terms is expected later in 2019 as activity regains momentum. Beyond that, labour productivity is expected to increase at a pace close to its pre-crisis average rate of 1.0%^[4], supported by an increase in the number of hours worked per person and some gains in total factor productivity.

Compared with the December 2018 projections, real GDP growth has been revised down substantially for 2019 and slightly for 2020. The notable downward revision in real GDP growth for 2019 is driven by the weaker data outturn in the fourth quarter of 2018 and a less favourable assessment of the short-term outlook, reflecting a more lasting adverse impact of specific factors in some euro area countries and heightened global policy uncertainties. The medium-term projection for real GDP growth is broadly unchanged, given the assumption that a gradual dissipation of the global and domestic headwinds will allow the expansion to regain traction.

2 Prices and costs

HICP inflation is expected to continue to decrease until the fourth quarter of 2019 and to pick up over the remainder of the projection horizon, reaching 1.6% in 2021 (see Chart 2). The decline in headline inflation in 2019 is mainly accounted for by a significant decrease in HICP energy inflation given the recent strong drop in oil prices and downward base effects related to their previous increase in 2018. In 2020 and 2021, HICP energy prices are expected to rise at subdued rates consistent with the relatively flat oil price futures curve. HICP food inflation is envisaged to hover around rates of 1.9% over the projection horizon. HICP inflation excluding energy and food will be on a gradual upward path, reaching 1.6% in 2021. The pick-up in HICP inflation excluding energy and food is expected to be supported by the more gradual but continued economic recovery. Moreover, tightening labour markets will support wage growth, leading to higher domestic cost pressures. Rising non-energy commodity prices and rising underlying global prices will also bolster HICP inflation excluding energy and food.

Wage growth is expected to increase somewhat further over the projection horizon as labour markets continue to tighten and measures that have dampened wage growth in some countries over the past few years expire. Growth in compensation per employee is projected to rise from 2.2% in 2018 to 2.6% in 2021. At the same time, unit labour cost growth is expected to decline somewhat over the projection horizon, as productivity is envisaged to strengthen. The main driver behind the pick-up in wage growth is the envisaged further improvement in euro area labour market conditions over the projection horizon, with increasing labour market tightness in some parts of the euro area. Beyond the cyclical momentum, the significant recent pick-up in headline inflation can be expected to contribute to a pick-up in wage growth in euro area countries where wage formation processes include backward-looking elements. In addition, the wage-dampening effects of crisis-related factors, such as the need for wage moderation to regain price competitiveness in some countries and pent-up wage restraint in view of binding downward rigidities in nominal wages during the crisis, should gradually abate as the economic expansion continues. Some countries have also introduced increases in minimum wages, which might pass through to the wage distribution.

Profit margins are expected to develop more favourably over the projection horizon than in 2018. Profit margins have been squeezed over the last few quarters on account of a surge in unit labour costs, reflecting the weakening in economic activity that has led to a drop in productivity growth. In addition, deteriorations in the terms of trade, related to the past increases in oil prices, weighed on profit margin developments. Both factors should lose importance over the next few quarters as the paces of economic activity and productivity pick up, while the terms of trade are expected to improve given the recent fall in oil prices.

External price pressures are expected to recede in 2019 and to rise moderately over the remainder of the projection horizon. The annual growth rate of the import deflator is envisaged to decrease in 2019, compared with 2018, and to rise gradually thereafter. This profile is strongly determined by the movements in oil prices, which pushed up import prices in 2018 and are expected to dampen their developments in 2019. At the same time, non-oil commodity prices and underlying global price pressures are assumed to rise and contribute to the gradual increase in import prices.

Compared with the December 2018 projections, the projection for HICP inflation has been revised down for the whole projection horizon. The downward revision in HICP inflation mainly reflects the assumption of significantly lower oil prices (particularly in 2019 and 2020) and a lower path for HICP inflation excluding energy and food. In turn, the downward revision in HICP inflation excluding energy and food reflects the impact of lower oil prices via indirect effects, weaker recent data outturns, a more moderate outlook for economic activity and some limited reassessment of the strength of the pass-through of wages to prices.

3 Fiscal outlook

The euro area fiscal stance is assessed to have been broadly neutral in 2018 and is projected to loosen from 2019 onwards. The fiscal policy stance is measured as the change in the cyclically adjusted primary balance net of government support to the financial sector. In 2019, the main contribution to the looser fiscal stance stems from cuts to direct taxes and social security contributions, as well as higher government expenditure in some countries. For 2020, further loosening is projected. The main contributions to this stem from further cuts to direct taxes and social security contributions, still rather strong expenditure growth and higher transfers. For 2021, the baseline incorporates some loosening that is mostly related to expenditure growth in some countries.

The euro area budget balance is projected to deteriorate in 2019 and to remain broadly unchanged for the rest of the projection horizon, while the debt ratio remains on a downward path. The widening in the government deficit is due to a deterioration in the cyclically adjusted primary balance. This is partly offset by a slight decline in interest expenditures, resulting from the replacement of high-cost old debt with new debt issued at lower interest rates. The declining path of the government debt-to-GDP ratio is supported by positive primary balances and a favourable interest-growth rate differential.

The euro area deficit outlook has deteriorated significantly compared with the December 2018 projections, in particular for 2020 and 2021. The higher budget deficit is due to a less favourable primary balance and a lower cyclical component, reflecting the weaker macroeconomic outlook. The debt-to-GDP ratio is projected to be higher, mainly reflecting an increasing interest-growth rate differential in 2019, owing to the downward revision of GDP growth, and lower primary balances.