Overview

The euro area economy is recovering swiftly despite continued uncertainty related to the coronavirus (COVID-19) pandemic and supply bottlenecks.^[1] It rebounded more strongly than expected in the second quarter of 2021 and should continue to grow rapidly during the second half of the year, with real GDP exceeding its pre-crisis level by the end of 2021. Growth is subsequently expected to remain strong but to gradually normalise. This outlook is based on several assumptions: a rapid relaxation of containment measures during the second half of 2021, a gradual dissipation of supply bottlenecks as of early 2022, substantial ongoing policy support (including favourable financing conditions) and a continued global recovery. Domestic demand should remain the key driver of the recovery, also benefiting from the expected rebound in real disposable income and a reduction in uncertainty. In addition, private consumption and residential investment are likely to be supported by the large stock of accumulated savings. Real GDP is expected to grow by 5% this year, and to moderate to 4.6% and 2.1% in 2022 and 2023 respectively. Compared with the June 2021 Eurosystem staff projections, the projection for quarterly growth during the second half of 2021 has been downgraded slightly on the back of more persistent than expected supply bottlenecks, the more infectious Delta variant of the coronavirus, and the stronger data outturns for the first half of the year reducing the scope for stronger growth thereafter. This notwithstanding, for 2021 as a whole, the projection for real GDP growth has been revised up by 0.4 percentage points. The projections for 2022 and 2023 are broadly unchanged.

The inflation outlook remains characterised by a hump in 2021 followed by more moderate rates in 2022 and 2023. Inflation is expected to average 2.2% in 2021, driven by temporary upward factors. These include: a rebound in energy inflation amid strong base effects; strong increases in input costs related to supply disruptions; one-off increases in services prices as COVID-19-related restrictions ease; and the reversal of the German VAT rate cut. As these factors fade from the beginning of 2022 and temporary imbalances between supply and demand ease, HICP inflation is expected to decline to rates of 1.7% and 1.5% in 2022 and 2023, respectively. Looking through these mostly temporary factors, HICP inflation excluding energy and food is expected to strengthen gradually as the recovery progresses, economic slack declines, and recent commodity price increases, including oil, gradually pass through to consumer prices. Food prices are also projected to accelerate. These upward effects on headline inflation are broadly counterbalanced over the projection horizon by a slower rise in energy prices, which is shaped by the technical assumptions for oil prices. Compared with the June 2021 projections, both headline and underlying inflation have been revised upwards across the whole projection horizon. The reasons for these revisions are: recent data surprises; some more persistent upward pressures from supply disruptions; the improved demand outlook; upward effects from higher oil and non-oil commodity prices; as well as the recent depreciation of the euro exchange rate.

1 Real economy

Real GDP rose by 2.2% in the second quarter of 2021^[2], 0.8 percentage points above the figure expected in the June 2021 projections. The rebound was driven primarily by domestic demand, and notably private consumption, on account of a pick-up in real disposable income and a substantial decline in the savings rate. While the stringency of containment measures was only slightly lower than in the first quarter and broadly in line with what had been assumed in the June projections, the upward surprise in activity seems to have reflected a lower sensitivity of economic activity to COVID-19 restrictions. The level of real GDP in the second quarter was still 2½% below its level in the fourth quarter of 2019.

Real GDP growth is expected to increase again vigorously in the third quarter, amid a further loosening of containment measures and strong economic sentiment indicators (Chart 1). Containment measures are assumed to be eased further in the third and fourth quarters of the year. However, these measures are expected to be somewhat stricter than assumed in the June 2021 projections, given the emergence of the Delta variant of COVID-19 and the renewed increase in new cases in July and August. Despite some easing, sentiment indicators remain at high levels, suggesting that the remaining containment measures will not result in significant disturbances to the economy. Therefore, real GDP growth is expected to remain strong in the second half of 2021 despite being revised down slightly compared with the June projections. This reflects containment measures being more stringent and supply bottlenecks more persistent than previously assumed, together with the assessment that the positive data surprises in the first half of the year reduce the scope for an additional strong rebound in the second half of the year.

Real GDP growth is projected to remain strong in 2022 before slowing down in 2023 to a more normal rate. The projected GDP path is based on a number of assumptions. These include a full relaxation of containment measures by early 2022, a further decline in uncertainty, strong confidence in the wake of the gradual resolution of the COVID-19 pandemic, and the ongoing global recovery (Box 2). Moreover, the current supply disruptions are assumed to gradually dissipate as of early 2022. In addition, the Next Generation EU (NGEU) is expected to boost investment in some countries. More generally, fiscal, supervisory and monetary policies are assumed to remain very supportive, thereby avoiding strong adverse real-financial feedback loops. Overall, real GDP is projected to exceed its pre-crisis level in the fourth quarter of 2021 (Chart 2), one quarter earlier than in the June 2021 staff projections and, by the end of 2022, to reach a level only somewhat below that expected before the pandemic.

As the key driver of the recovery, private consumption is expected to grow strongly over the projection horizon, exceeding its pre-crisis level by the first quarter of 2022. Private consumption recovered much more strongly than previously expected in the second quarter of 2021, but still stood around 6% below its pre-pandemic level. The upward surprise is likely to reflect both a stronger decline in the savings rate and stronger real income growth. Income remained mostly driven by labour income, which typically entails a relatively higher marginal propensity to consume. Private consumption is expected to continue growing strongly in the second half of the year. This is linked to containment measures being eased and also the large stock of accumulated savings which allows for the release of some pent-up demand. In the medium term, private consumption growth is projected to continue to outstrip the lower path of real income growth as the expected dissipation of uncertainty will allow for a further unwinding of excess savings.

Higher wage income is expected to support real disposable income throughout the projection horizon. As the economy continues to reopen and employment growth strengthens, wage income is expected to provide a strong contribution to real disposable income. In contrast net fiscal transfers, following their strong positive contribution in 2020, will weigh on income growth as of 2021. This reflects the expected expiry of COVID-19 support measures. Moreover, real disposable income is projected to be dampened by the projected increase in consumer price inflation.

The household saving ratio is expected to drop below its pre-crisis level in 2022, as the services sector reopens and the motives for precautionary savings lose importance. The saving rate is expected to fall substantially over the next couple of quarters as the proportion of forced savings dwindles linked to the assumed relaxation of containment measures. In addition, precautionary savings are expected to dissipate as uncertainty recedes and labour markets improve. The saving ratio should drop below its pre-crisis level in 2022 and then continue to decline slightly. It is foreseen to marginally undershoot the level expected in the pre-pandemic baseline, resulting in some unwinding of previously accumulated excess household savings. This would support a vigorous rebound in consumption. The role that accumulated savings is expected to play in the recovery of consumption is, however, somewhat reduced due to the concentration of savings in wealthier and older households with a lower propensity to consume.^[3]

The recovery in housing investment is expected to lose steam during the projection horizon. Housing investment is estimated to have increased modestly in the second quarter of 2021, having already reached its pre-pandemic level in the first quarter. In the short term, positive Tobin’s Q effects, a recovery in disposable income, improved consumer confidence and the high level of accumulated savings should all support housing investment during the second half of 2021, despite some headwinds due to a further tightening of supply constraints. Housing investment momentum should gradually normalise over the remainder of the projection horizon.

Business investment is expected to remain resilient and to recover substantially over the projection horizon. Business investment continued to climb back to its pre-crisis level during the first half of 2021, benefiting from the recovery in demand, favourable financing conditions and positive Tobin’s Q effects. The rebound is expected to accelerate in the second half of 2021 as global and domestic demand recover and profit growth improves, also supported by favourable financing conditions and the positive impact of the NGEU programme. Business investment is also expected to receive a boost throughout the projection horizon from investment related to digitalisation, as well as the low carbon transition (including in the car industry, due to environmental regulations and the transition to electric vehicle production). Altogether, business investment is projected to return to its pre-pandemic level by the end of 2021.

Following export market share losses in 2021 related to temporary supply bottlenecks, exports are expected to expand at a robust pace, sustained by strong foreign demand and gains in competitiveness. The rapid increase in demand since the second half of 2020 is expected to continue to cause a mismatch between global supply capacity and demand conditions in 2021. This mismatch, COVID-19-related lockdowns and extreme events led to a combination of global logistic problems and a scarcity of some key intermediate inputs, which has weighed on euro area goods exports. Given that there continue to be shortages of some intermediate inputs, very elevated transport costs and long supplier delivery times, the bottlenecks are assumed to persist throughout 2021 and to gradually dissipate as of early 2022. Services trade, and in particular tourism, has recovered strongly during the summer amid successful vaccination campaigns that have allowed economies to reopen, although overall activity in the sector remains well below pre-crisis levels. Together with dissipating bottlenecks, this will allow euro area exports to pick up momentum in the medium term, given strong foreign demand and gains in export competitiveness following the recent depreciation of the euro exchange rate. Net exports are expected to provide a mildly positive contribution to annual real GDP growth in all three years of the projection horizon.

The unemployment rate declined in the second quarter of 2021 and is expected to remain broadly flat for the rest of the year, before falling to its pre-crisis level by early 2023. A stronger than expected expansion in employment growth in the second quarter of 2021, related to the stronger recovery in activity, led to a decline in unemployment. Temporary labour shortages reflecting increasing job reallocation and some mismatches are expected to affect the labour market in the short run for specific countries and sectors. A high share of workers in job retention schemes are assumed to return to regular employment, benefiting from the strong post-pandemic recovery. Accordingly, starting in 2022 the unemployment rate is expected to gradually decline and in early 2023 it is expected to drop below its pre-crisis level.

Labour productivity growth per person employed is expected to rebound sharply in 2021 before normalising gradually over the projection horizon. Having dropped sharply in 2020, it is estimated to have increased by 1.5% in the second quarter of 2021 (compared with the previous quarter), benefiting from a decline in the number of persons in job retention schemes. After peaking in the third quarter of 2021 it is projected to gradually moderate thereafter. The growth profile of productivity per hour worked has been much more resilient during the pandemic as total hours worked have more closely followed GDP developments.

Compared with the June 2021 projections, real GDP growth has been revised up in 2021 and is broadly unchanged in 2022 and 2023. Positive statistical carry-over effects from upward revisions to data in 2020 and a stronger outcome in the first half of 2021 more than compensate for a slightly weaker rebound in the second half of 2021 in the wake of tighter lockdown measures and more persistent supply-side bottlenecks than previously assumed. This has led to an upward revision to the projection for the year as a whole by 0.4 percentage points. For the remainder of the projection horizon, downward effects from the above headwinds and higher oil prices compensate for the moderately positive impact of lower lending rates, the weaker effective exchange rate of the euro and stronger foreign demand.

2 Fiscal outlook

Only limited further stimulus measures have been added to the baseline since the June 2021 projections. The estimate for the extraordinary fiscal stimulus in response to the pandemic in 2020 has been revised slightly upwards to 4.2% of euro area GDP. With 2022 budgets still in preparation, fiscal news since the June 2021 projections has been limited, but continues to point to additional COVID-19 crisis and recovery stimulus amounting to 0.2% of GDP in 2021. This reflects updated estimates of the fiscal cost of measures, expanded programmes and the adoption of new measures in many countries. Most of the additional measures are temporary, will be reversed in 2022 and relate mainly to subsidies and transfers to firms.

Overall, the discretionary stimulus related to the crisis and recovery is estimated at 4.6% of GDP in 2021, 1.5% in 2022 and 1.2% in 2023. In terms of the composition of the overall stimulus, the largest share in 2021 is still accounted for by subsidies and transfers, including those under job retention schemes, with the latter projected to be almost fully reversed in 2022. Measures classified under government consumption mostly include higher health expenditure, including wages, related to the vaccination campaigns. On the revenue side, the measures relate to cuts in direct and indirect taxes. Additional government investment was limited in 2020, but has a higher share in the stimulus packages as of 2021, mainly on the back of the ongoing NGEU financing. In addition to the COVID-19 crisis and recovery measures, in some countries, governments adopted further stimulus measures.^[5]

The euro area fiscal stance adjusted for NGEU grants is projected to be expansionary in 2021, tighten notably in 2022, and remain broadly neutral in 2023. After the strong expansion in 2020, the fiscal stance – adjusted for the impact of NGEU grants on the revenue side – remains expansionary in 2021. The fiscal stimulus in 2021, as measured by the fiscal stance, is larger than implied by the COVID-19 crisis and recovery measures, mostly on account of measures not directly related to the crisis, including stronger structural expenditure growth, and methodological differences. Given the temporary nature of the emergency measures adopted in 2021 and the expected fading of the pandemic, the fiscal stance is projected to tighten notably in 2022 and to remain broadly neutral in 2023. Compared with the June 2021 projections, the fiscal stance has loosened slightly in 2021 and tightened over the rest of the projection horizon, especially in 2022.

The euro area budget deficit is projected to decline slightly in 2021 and more strongly as of 2022, with the fiscal outlook improving relative to the June 2021 projections. The decline in the budget deficit in 2021 reflects the improved cyclical component and lower interest payments, which more than offset the additional stimulus measures not covered by NGEU grants. The sizeable budget balance improvement in 2022 is mainly due to the unwinding of the COVID-19 crisis stimulus measures and a much more favourable cyclical component. In 2023, with a broadly neutral fiscal stance and better cyclical conditions, the aggregate budget balance is projected to increase further to just below -2% of GDP. Interest payments are projected to continue declining over the projection horizon and reach 1.0% of GDP in 2023. After the sharp increase in 2020, euro area aggregate government debt is expected to peak at around 99% of GDP in 2021. The decline thereafter is mainly due to favourable interest-growth differentials, but also to deficit-debt adjustments, which more than offset the continuing, albeit decreasing, primary deficits. The fiscal outlook has improved compared with the June 2021 projections. The euro area budget deficit and debt paths have been revised downwards over the entire projection horizon on account of the improved cyclical component and lower interest payments. The budget deficit and debt in 2023 remain significantly above the pre-crisis level of 2019, mainly on account of a higher expenditure ratio.

3 Prices and costs

HICP inflation is projected to continue to rise until the end of this year, to decline in the first half of 2022 and to gradually strengthen thereafter (Chart 3). Headline inflation is projected to average 2.2% in 2021, peaking at 3.1% in the fourth quarter of 2021 before declining to an average of 1.7% in 2022 and 1.5% in 2023. The spike in headline inflation in 2021 reflects upward effects from largely temporary factors, such as the rebound in the energy inflation rate amid strong base effects and the reversal of the German VAT rate cut. Increases in input costs related to supply disruptions and one-off re-opening effects on services prices, as COVID-19-related restrictions eased in the summer, have added to the upward pressure on inflation. Changes in HICP weights imply some volatility in the inflation profile in 2021 but, on average over the year, are expected to have only a small downward impact on HICP inflation. These temporary factors are expected to fade from the beginning of 2022. Also a further downward base effect from the surge in inflation in July 2021 dampens annual inflation in the third quarter of 2022. Thereafter, HICP inflation is expected to gradually increase over the remainder of the projection horizon, supported by the envisaged economic recovery. This is reflected in a strengthening of HICP inflation excluding energy and food over the projection horizon. Looking through the temporary surge in inflation in 2021, over the medium term a combination of increasing upward price pressures from the recovery in demand, while remaining somewhat muted, and indirect effects from past increases in commodity prices, including oil, should outweigh a reduction in upward price pressures from supply effects related to the pandemic. Increases in domestic cost pressures are envisaged to be the main driver of stronger underlying consumer price developments, while developments in external price pressures are expected to moderate over the latter half of the projection horizon. HICP food inflation is also expected to rise gradually. The moderately increasing upward price pressures on headline inflation from these two HICP components are somewhat offset in 2022 and 2023 by the envisaged declines in HICP energy inflation related to the downward sloping profile of the oil price futures curve.

Unit labour costs are expected to decline in both 2021 and 2022, driven by fluctuations related to the job retention schemes, before increasing by 1.4% in 2023. Following the strong increases in 2020 due to the sharp loss in labour productivity, unit labour costs are projected to be depressed by the rebound in labour productivity in 2021 and 2022, but to gradually increase by 2023. Both labour productivity and growth in compensation per employee have been subject to large swings in the presence of job retention schemes safeguarding employment. This pushed down the annual growth rate of compensation per employee in 2020 and has caused a subsequent rebound in the first half of 2021. As labour markets gradually recover over the projection horizon and the impact of the schemes fades, developments in compensation per employee are expected to normalise, with annual growth standing at 2.5% in 2023, somewhat above the rates seen prior to the pandemic. This mainly reflects the improvement in the labour market over the projection horizon. The projected strong rise in euro area headline inflation in the second half of 2021 is not expected to lead to significant second round effects on wage growth in the medium term.

Import price dynamics are expected to be strongly influenced by oil and non-oil commodity price movements and to reflect moderate external price pressures over the latter part of the projection horizon. The annual growth rate of the import deflator is expected to move from -2.5% in 2020 to 5.4% in 2021, largely reflecting increases in oil and non-oil commodity prices but also increases in other input costs related to supply shortages and the depreciation of the euro, before moderating to 0.8% in 2023. In addition to some assumed declines in oil prices, global price dynamics more generally are expected to remain moderate over the projection horizon and contribute to the moderate outlook for external price pressures.

Compared with the June 2021 projections, the projection for HICP inflation has been revised upward by 0.3 percentage points for 2021, by 0.2 percentage points for 2022 and by 0.1 percentage points for 2023. The upward revisions relate to HICP excluding food and energy across the projection horizon and to the energy component, especially in 2021 and 2022, while the food component is broadly unchanged. These revisions reflect a number of elements: recent positive data surprises; some upward pressures from more persistent supply disruptions; the improved demand outlook; the euro exchange rate depreciation; and upward revisions to the technical assumptions for oil prices (Box 1).