Overview

Although real GDP growth was stronger than expected in the first quarter of 2019, recent indicators point to weaker growth in the second quarter and a moderate increase during the remainder of 2019. Economic sentiment indicators have continued to worsen across euro area countries over recent months, notably in sectors exposed to global trade. This reflects the ongoing weakness in global trade in an environment of continued global uncertainties (such as threats of an escalation of protectionism and the possibility of a disorderly Brexit). These factors weigh on export order books and on production expectations in the manufacturing sector, and are likely to continue to hold back euro area activity in the near term. At the same time, sentiment in the domestically-oriented services and construction sectors has been more resilient in recent months and the labour market situation has continued to improve. Overall, the fundamental domestic factors that should support the euro area expansion, namely the very accommodative stance of monetary policy, rising wages and some fiscal easing, remain broadly in place. In addition, foreign demand is expected to gradually recover during the course of 2019 and to provide a stronger impetus over the remainder of the projection horizon. Altogether, real GDP growth is projected to decline from 1.8% in 2018 to 1.2% in 2019 before increasing to 1.4% in 2020 and 2021. Compared with the March 2019 projections, real GDP growth in 2019 has been revised up slightly, as the upward impact of a stronger than expected first quarter more than offsets downward revisions to growth in the following quarters, mainly due to more persistent weakness in global trade. This implies a weaker carry-over into 2020. In addition, the medium-term projections have been revised down marginally.

HICP inflation is expected to moderate this year but to recover thereafter, reaching 1.6% in 2021. Energy inflation will continue to decline in the short term, on the back of downward base effects and slightly declining oil price assumptions, and stabilise thereafter. HICP inflation excluding energy and food will pick up gradually, supported by the envisaged economic expansion. At the same time, past increases in labour costs will feed into prices and profit margins will recover. Compared with the March 2019 projections, HICP inflation has been revised marginally upwards in 2019 due to higher oil prices and marginally downwards in 2020 due to a more steeply downward sloping path of the oil price assumptions. HICP inflation excluding energy and food is revised down slightly in the near term reflecting weaker data outturns^[1].

1 Real economy

Real GDP in the euro area rebounded in the first quarter of 2019 partly reflecting some temporary positive factors (see Chart 1). The increase in real GDP growth from 0.2% in the fourth quarter of 2018 to 0.4% in the first quarter of 2019 was in part related to specific factors which temporarily boosted growth. Some countries benefited from a spike in foreign demand related to exceptionally strong import demand from the United Kingdom, in anticipation of the original Brexit date. In addition, in Germany, private consumption rebounded strongly as private car registrations surged following disruptions in car production in the second half of 2018. Private consumption was also supported by fiscal measures which became effective in the first quarter and are expected to have their biggest impact in the same quarter. Construction also benefited from mild weather conditions in some countries. In Italy, the stronger growth reflected some rebound in manufacturing activity, after a strong fall in late 2018 due to policy uncertainty.

Indicators point to a weakening of growth in the short term, after relatively strong growth in the first quarter. The Economic Sentiment Indicator compiled by the European Commission continued to decline overall in recent months, with the fall being broad-based across euro area countries and approaching its longer-term average level. This decline mostly reflected a further worsening of sentiment in the manufacturing sector, driven by a more negative assessment of current order books and less optimistic production expectations. This seems to reflect the ongoing weakness of global trade as well as the impact of uncertainty – in particular related to global trade disputes and Brexit. By contrast, sentiment in the more domestically-oriented services and construction sectors remained broadly unchanged in recent months and consumer confidence also remained fairly resilient. Recent developments in the Purchasing Managers’ Indices confirm this divergence across sectors, with manufacturing data remaining far below the zero-growth threshold of 50, while the indices related to the services and construction sectors stood well above 50. Overall, the latest indicators suggest a weakening of growth in the second quarter, mostly in Germany and Italy, partly reflecting the fading of the temporary boosts in the first quarter.

Over the medium term, the baseline assumes a gradual dissipation of global headwinds, allowing fundamental factors supporting the euro area expansion to regain traction (see Table 1). The baseline assumes an orderly exit of the United Kingdom from the EU and that the current level of uncertainty regarding the future of global trade will gradually normalise, in particular that there will be no further protectionist measures beyond those already announced. As these headwinds fade, they will give way to a number of favourable fundamental factors. The ECB’s monetary policy stance is assumed to remain very accommodative and to continue to be transmitted to the economy. Lending to the non-financial private sector should strengthen moderately towards the end of the projection horizon, spurred by low interest rates and favourable bank lending conditions for both households and non-financial corporations. Lower deleveraging needs across sectors will also contribute to the dynamism of private expenditure. Growth in private consumption and residential investment should also benefit from rising wage growth and net worth as well as from declining unemployment. Euro area exports are expected to benefit from the projected recovery in foreign demand. Finally, the fiscal stance is expected to be mildly expansionary over the full horizon (see Section 3).

Nevertheless, the fading out of some tailwinds would lead to slower growth towards the end of the projection horizon. The technical assumptions imply that nominal interest rates will remain low but rise moderately over the projection horizon. Business investment is expected to weaken considerably over the projection horizon, reflecting a protracted period of low business confidence and the expiration of some tax incentives. Employment is also expected to slow down over the medium run, reflecting increasingly binding labour supply shortages in some countries as well as higher wage costs.

Real disposable income growth is expected to gain momentum in 2019 before weakening in 2020 and 2021. The strengthening in 2019 reflects an increase in nominal disposable income growth and a decline in consumer price inflation. Both weakening nominal income growth and gradually rising inflation are expected to dampen real income growth in 2020 and 2021. The contribution of gross wages and salaries to nominal disposable income growth is projected to decline somewhat in 2019 and 2020 (due to the impact of weaker employment growth) and to remain broadly unchanged in 2021. Other personal income is projected to increase moderately over the projection horizon, broadly in line with profits (as measured by the gross operating surplus). The contribution of net fiscal transfers is expected to turn positive in 2019, for the first time since 2010, reflecting a mix of cuts in direct taxation and rising transfers to households; it is expected to turn broadly neutral in 2020 and in 2021 in the context of lower transfers to households and gradually increasing revenues from direct taxation.

Private consumption is projected to be solid over the projection horizon. It is estimated to have accelerated in the first quarter of 2019 supported by robust real disposable income growth. Looking forward, still relatively favourable consumer confidence, expected improvements in labour market conditions and rising real wages per employee suggest strong consumption growth over the next few quarters, compounded by the positive effect of fiscal loosening in certain countries. Thereafter, the expected gradual slowdown in employment growth and more neutral fiscal transfers are assumed to weigh on private consumption.

Private consumption growth should be supported by favourable financing conditions and rising net worth. Nominal bank lending rates are projected to increase moderately over the projection horizon but will remain at low levels. 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 household debt. Thus gross interest payments are expected to remain at low levels and therefore continue to support private consumption. At the same time, gross interest revenues are expected to increase modestly, mainly owing to the continued accumulation of interest-bearing assets. In addition, net worth is projected to increase further, spurred by the continued robust valuation gains on real estate holdings. Together with the progress achieved in deleveraging, rising net worth should also support consumption.

The expansion of residential investment is expected to continue, albeit at a more moderate pace. Resilient confidence in the construction sector and rising numbers of building permits suggest a continued expansion of housing investment in the next few quarters. Nonetheless, the momentum is expected to ease. This weakening is suggested by recent surveys showing a decline in the share of households planning to undertake home improvements over the next year. The moderation may result from increasingly binding capacity constraints in the construction sector and adverse demographic trends in some countries.

Business investment is expected to increase over the projection horizon, albeit at a rather subdued pace. Business investment is estimated to have slowed in the first quarter of 2019 and is expected to remain rather subdued during the course of the year, reflecting the impact of the relative weakness of global trade and persistent concerns about global trade policies, a “no-deal” Brexit and a hard landing in China. In general, however, a number of favourable fundamentals are expected to continue supporting business investment in the euro area. First, capacity utilisation remains above its long-term average and a higher than usual share of manufacturing firms report lack of equipment as a factor limiting production. Second, financing conditions are expected to remain supportive over the projection horizon. Third, profits are expected to increase, which adds further to the sizeable liquid asset overhang firms have built up in recent years. Finally, companies may increase investment as a means of compensating for labour-related supply-side constraints.

Extra-euro area exports are projected to grow at a subdued rate in the course of 2019 before recovering over the remainder of the horizon, broadly in line with foreign demand. Following weak rates of growth and market share losses in the first three quarters of 2018, extra-euro area export growth surprised on the upside in the last quarter of 2018 and outpaced foreign demand. As the strength in exports in the fourth quarter of last year to some extent reflected idiosyncratic factors, and as short term indicators remain subdued, extra-euro area exports are projected to weaken and fall below the pace of foreign demand in the first half of 2019, amid an adverse international environment with persisting global uncertainty. Thereafter, over the medium term, extra-euro area exports are projected to recover and grow broadly in line with foreign demand. While some gains in price competitiveness would support stronger gains in export market shares, these are offset by the effects of trade uncertainty as the composition of euro area exports is tilted towards investment-related products that are particularly susceptible to the adverse effects of trade policy-related uncertainty. Meanwhile, extra-euro area import growth is also expected to weaken in the near term, reflecting both developments in exports themselves and at the same time weak investment and activity dynamics in some euro area countries. Looking further ahead, extra-euro area imports are expected to grow broadly in line with total demand (domestic demand plus exports). Overall, the contribution of net trade to real GDP growth is expected to turn negative during the remainder of 2019 before turning neutral from 2020 onwards.

Employment growth is projected to be subdued in the short term, partially due to temporary factors, but also later on in the horizon as labour supply constraints kick in. Employment growth is projected to decrease in 2019 before increasing modestly again in 2020. The decline in the growth rate of employment expected during the course of 2019 is mainly a delayed response to the weakness in activity in some countries. In 2020, employment growth is expected to pick up somewhat, supported by stronger activity. In 2021, employment growth is projected to decrease again as labour supply is expected to limit further employment growth, while labour demand is also 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 immigration of workers, the expected integration of refugees, and ongoing increases in the participation rate. Nevertheless, these factors fade over the projection horizon and, therefore, the adverse impact of the ageing of the population on the 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 7.3% in 2021. The unemployment rate fell to 7.8% in the first quarter of 2019, which is the lowest level observed since the third quarter of 2008. Looking ahead, the unemployment rate is projected to remain broadly unchanged at its current level during 2019, and decrease afterwards. The number of unemployed persons is projected to decline by around 0.8 million to 12.9 million by the end of the projection horizon, although still remaining somewhat above its pre-crisis trough level (12.2 million). While the corresponding fall in the unemployment rate is expected to be broadly shared across countries, the unemployment rates are still expected to differ substantially between countries.

Labour productivity is projected to recover over the projection horizon. Following its strong momentum in 2017, labour productivity growth per worker declined in 2018, reflecting the unexpected weakening in activity. A moderate rise in productivity growth in quarter-on-quarter terms is expected later in 2019 as activity regains momentum. Over the medium term, labour productivity growth should remain slightly below its pre-crisis average rate (of 1.0%^[4]).

Compared with the March 2019 projections, real GDP growth is revised up for 2019 and is revised down for 2020 and 2021. In 2019 the upward surprise in growth in the first quarter more than offsets downward revisions for the rest of the year. The latter are due to: (a) the unwinding of the temporary factors which boosted growth in the first quarter, (b) weakened sentiment and downward revisions to foreign demand that largely reflect more prolonged global policy uncertainties (e.g. Brexit and trade disputes), and (c) persisting policy uncertainty in Italy. These downward revisions to the short-term outlook imply a weaker carry-over in 2020. The medium-term outlook has been revised down only slightly.

2 Prices and costs

HICP inflation is expected to average 1.3% in 2019 and then rise to 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 on the back of downward base effects and slightly declining crude oil prices in euro. In 2020 and 2021, HICP energy prices are expected to rise at subdued rates, partly reflecting the slightly downward sloping oil price futures curve. After a downturn in the near term reflecting an easing of the pace of increase in food commodity prices, HICP food inflation is envisaged to hover around rates of 2%. HICP inflation excluding energy and food will be on a gradual upward path as from the end of this year, 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 ongoing economic recovery. Moreover, tightening labour markets will continue to support wage growth, while unit profits are expected to recover, as economic activity regains pace and as past increases in labour costs are passed through to prices. As a result, domestic cost pressures would rise. Rising non-energy commodity prices are also expected to support HICP inflation excluding energy and food.

Growth in compensation per employee is projected to rise from 2.2% in 2018 to 2.5% in 2021 as labour markets continue to tighten. At the same time, following a spike in 2018 in the context of the cyclical slowdown in productivity and one-off factors affecting compensation per employee, unit labour cost growth is expected to moderate somewhat over the projection horizon as productivity growth strengthens, but to stand at higher levels than those seen in recent years. The main driver supporting 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 also be expected to contribute to a pick-up in nominal wage growth in those euro area countries where wage formation processes include backward-looking elements. 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 past few quarters by a surge in unit labour costs and past increases in oil prices that weighed on the terms of trade. These downward factors should fade as economic activity regains pace and as the terms of trade are expected to improve (see Box 3).

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 somewhat thereafter. This profile is strongly determined by movements in oil prices, which pushed up import prices in 2018 and will dampen them in 2019. At the same time, rising non-oil commodity prices and underlying global price pressures should bring some, albeit more moderate, support to import price inflation.

Compared with the March 2019 projections, HICP inflation is revised up for 2019 and down for 2020. These revisions are largely explained by the energy component which is revised notably upwards for 2019, due to stronger growth in oil prices, and downwards for 2020, due to a more steeply downward sloping profile for oil price futures. In addition, HICP inflation excluding energy and food is revised marginally downwards for the near term, mainly reflecting weaker data outturns.

3 Fiscal outlook

The euro area aggregate fiscal stance is assessed to be mildly expansionary over the entire projection horizon. The fiscal policy stance is measured as the change in the cyclically adjusted primary balance net of government support to the financial sector. After having been neutral in 2018, the fiscal stance is projected to become mildly expansionary in 2019, mostly on account of cuts to direct taxes as well as public expenditure increases in some countries. In 2020, the main contributions to the expected additional easing of the fiscal stance stem from further cuts to direct taxes and social security contributions, and higher transfers. In 2021, a further slight easing is mostly related to expenditure growth and direct tax cuts in some countries.

The euro area budget balance is projected to deteriorate in 2019 and remain broadly unchanged in the following years, 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, because of the expected expansionary fiscal stance. 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 an increasingly favourable interest-growth rate differential and enduring positive primary balances, which are however declining over time.

The euro area deficit outlook has improved marginally compared to the March 2019 projections. The slightly lower budget deficits reflect a somewhat less expansionary fiscal stance compared to the March 2019 projections, without however changing the overall picture of a mildly expansionary fiscal stance. The projection for the debt ratio remains broadly unchanged as there were only marginal revisions to the deficit.