Eurosystem staff macroeconomic projections for the euro area, December 2023

The euro area economy weakened in the second half of 2023, dragged down by tighter financing conditions, subdued confidence and competitiveness losses. It is now expected to recover at a slightly slower pace than foreseen in the September 2023 ECB staff macroeconomic projections. Short-term indicators suggest weak economic activity in the fourth quarter of 2023. However, growth is expected to strengthen from early 2024, as real disposable income rises – supported by declining inflation, robust wage growth and resilient employment – and export growth catches up with improvements in foreign demand. The impact of the ECB’s monetary policy tightening and adverse credit supply conditions continues to feed through to the economy, affecting the near-term growth outlook. These dampening effects are expected to fade later in the projection horizon, supporting growth. Overall, annual average real GDP growth is expected to slow down from 3.4% in 2022 to 0.6% in 2023, before recovering to 0.8% in 2024 and stabilising at 1.5% in 2025 and 2026. Compared with the September 2023 projections, the outlook for GDP growth has been slightly revised down for 2023-2024, on the back of the recent data releases and weak survey data, whereas it is unrevised for 2025.^[1]

Inflation has continued to decline owing to falling energy inflation, the impact of monetary policy tightening and the ongoing easing of pipeline pressures and supply bottlenecks. Having dropped to 2.4% in November 2023, HICP inflation is expected to temporarily pick up in the short term owing to a rebound in energy inflation. The underlying disinflationary process is, however, expected to continue, despite strong increases in labour costs, which are increasingly the dominant driver of HICP inflation excluding energy and food. Despite some cooling, the labour market is projected to remain tight which, together with compensation effects from past high inflation, should keep nominal wage growth high. However, wage growth is expected to ease over the projection horizon as the upward impacts from inflation compensation gradually fade. Profits expanded notably in 2022, but are set to weaken over the projection horizon and provide a buffer to the pass-through of labour costs. Overall, with medium-term inflation expectations assessed to remain anchored at the ECB’s 2% inflation target, headline HICP inflation is expected to decrease from 5.4% in 2023 to an average of 2.7% in 2024, 2.1% in 2025 and 1.9% in 2026. Compared with the September 2023 projections, HICP inflation has been revised down for 2023 and 2024, mainly owing to lower than expected recent data outturns and lower assumptions for energy commodity prices, whereas it is unrevised for 2025.

The economic outlook continues to be surrounded by high uncertainty as reflected in the uncertainty bands surrounding the growth and inflation projections (Charts 1, 4 and 7). This report contains a scenario assessing the implications for the euro area economy of a potential escalation of the conflict in the Middle East (Box 3) and a number of sensitivity analyses related to alternative paths for energy and food commodity prices (Box 4).

Economic activity in the euro area marginally declined in the third quarter of 2023, reflecting a negative contribution to growth from destocking which was counterbalanced by a positive contribution from domestic demand (Chart 1). Euro area growth in the third quarter of 2023 was -0.1%, which is slightly below the zero growth expected in the September 2023 projections.^[2] Manufacturing and construction value added continued to decline in the third quarter, while services value added increased. As regards demand components, private consumption increased in the third quarter, in particular for services, likely supported by contact-intensive services during the summer season, and for durable goods. In contrast, competitiveness losses owing to both exchange rate developments and energy price developments have led to a drop in exports.

Real GDP growth is expected to be weak in the fourth quarter of 2023, amid tight financing conditions, and to recover gradually from the first quarter of 2024, supported by increases in real income and foreign demand. The boost to activity from the post-pandemic reopening of the economy and the unwinding of supply bottlenecks is fading, while the drag from tight financing conditions and elevated consumer uncertainty remains significant. Survey indicators suggest very weak or contracting domestic economic activity in the fourth quarter of 2023, with some tentative signs of a bottoming-out. Moreover, declining inflation and rising wages, in the context of a still tight labour market, should support households’ purchasing power around the turn of the year. In addition, export growth, albeit still muted, is expected to recoup some of the export market share losses seen in recent quarters. Overall, while economic activity is expected to remain subdued in the fourth quarter of 2023, it should gradually strengthen thereafter, driven by further increases in real disposable income and foreign demand, and thus by rising private consumption and exports, amid a likely recovery in confidence in the absence of any new adverse shocks.

Tight financing conditions are expected to continue to have a negative impact on growth, but this impact should gradually fade over the projection horizon. The impact of the monetary policy measures taken since December 2021 continues to feed through to the real economy, affecting the growth outlook, particularly for 2023 and 2024.^[3] In addition, credit supply conditions, as reported in the ECB’s latest euro area bank lending survey, have tightened significantly since the start of the year and loan growth has decreased sharply. The negative credit supply effects are assumed to affect mostly business and housing investment, and, to a lesser extent, private consumption. Although there is considerable uncertainty surrounding the precise timing and magnitude of the impact of monetary policy and credit supply conditions on the real economy, on the basis of market expectations for the future path of interest rates (Box 1), the impact on economic growth is expected to start fading after 2024. Therefore, part of the projected increase in GDP growth over the medium term relates to the fading of these dampening effects.

Compared with the September 2023 projections, real GDP growth has been revised down by 0.1 percentage points for 2023 and by 0.2 percentage points for 2024, and it is unrevised for 2025. The revisions reflect the weaker data outturns for the third quarter of 2023 and deteriorating survey indicators. The recent more negative outturns and forward-looking indicators for exports imply downward revisions to net trade in 2023-2025, which are partly counterbalanced by small upward revisions to domestic demand.

Turning to the components of real GDP, real private consumption is expected to gradually recover and underpin economic growth, as uncertainty and inflation decline and real incomes and confidence improve. Private consumption stagnated in the first half of the year, amid a contraction in spending on goods, while spending on consumer services remained resilient. Reflecting the decline in inflation and still lingering post-pandemic reopening effects, coupled with a slight recovery in confidence in November, consumer spending is estimated to have strengthened in the second half of the year. Beyond the short term, as inflation and uncertainty recede further and real incomes improve, in the absence of any additional adverse shocks, consumption should further improve and underpin economic growth, notwithstanding the waning of reopening effects. Household consumption growth is expected to remain robust in 2026, supported by increases in both labour and non-labour income and the fading of earlier precautionary motives. Private consumption growth has been revised up by 0.2 percentage points for 2023, compared with the September 2023 projections, owing to upward data revisions for the first half of the year, but it has been revised down by 0.2 percentage points for 2024, on account of higher savings in the short term, while it is unrevised for 2025.

The household saving ratio is expected to remain elevated relative to its pre-pandemic level throughout the projection horizon. The saving ratio increased in the first half of 2023 and is expected to remain high for some time, reflecting strong non-labour income growth in the first half of the year (in part owing to the high propensity to save this type of income), still elevated uncertainty and strong saving incentives stemming from increasing interest rates. However, as uncertainty recedes, the household saving ratio should edge down from 2025, albeit remaining well above its pre-pandemic level, as higher interest rates counterbalance households’ desire to normalise their saving behaviour after the pandemic. The stock of excess savings is not expected to provide support to consumption growth, given that it is concentrated among wealthy households and mostly accumulated in illiquid assets, and as high inflation rates have had a dampening effect on the real value of this stock. The saving ratio has been revised up compared with the September 2023 projections, largely reflecting revisions to historical data, expected more cautious household behaviour and stronger incentives to save owing to high interest rates and tighter credit access.

Box 3
Scenario analysis of a potential further escalation of the conflict in the Middle East

This scenario analysis explores tail risks to the December 2023 baseline projections stemming from a potential further escalation of the conflict in the Middle East. The December 2023 baseline projection assumes that the current conflict will be contained geographically and therefore is not expected to have significant economic effects on the euro area economy beyond those already observed. The reaction of the global financial markets following the outbreak of the conflict has been muted, with a modest initial increase in oil prices and economic uncertainty, in line with the limited trade and financial linkages of the euro area with the affected areas. The scenario in this box assumes a major and prolonged escalation of the conflict and a partial closure of the Strait of Hormuz, which would entail stronger repercussions for the global economy and the euro area relative to the December 2023 baseline projection. This would imply disruptions in economic activity, particularly for countries directly involved in the conflict, as well as higher energy commodity prices, and a rise in broader economic uncertainty and financial market disruptions (Chart A). Such a scenario is considered a tail risk scenario and, given the high uncertainty surrounding the evolution of the conflict, the estimates should be treated with great caution.

Chart A

Scenario of a potential escalation of the conflict in the Middle East

a) Synthetic energy price index	b) US stock market volatility index (VIX)	c) Euro area foreign demand growth
(USD/MWh)	(index)	(percentage point deviation from baseline)

In a hypothetical escalation of the conflict, oil and gas prices could increase substantially, particularly in case of a partial blockage of the Strait of Hormuz. The scenario assumes that about one third of the oil and gas in transit via the Strait of Hormuz is disrupted, contributing to a tightening in the global energy markets. As a result, in the second quarter of 2024 oil prices would rise to almost 130 USD per barrel and gas prices would surge to €83 per MWh (57% and 74% respectively above the levels assumed in the baseline projections). Overall, a synthetic energy price index (which combines oil and gas prices) is assumed to be 64% above the baseline in the second quarter of 2024 and to remain 36% above the baseline in 2026 (Chart A, panel a). Such a scenario is an extreme one, as it would push energy prices above the 75th percentile of the option-implied distribution for energy futures (see also Box 4). The Strait of Hormuz has never been truly blocked, while the assumed oil and gas supply shock is more persistent than historical supply shocks, as energy markets tend to rebalance more quickly.

The escalation scenario would likely also make the economic outlook more uncertain, causing a drop in private consumption, investment and trade and translating into a significant repricing of financial market instruments. The escalation scenario assumes that the VIX volatility index, a proxy for global uncertainty, would increase by around 14 points in the beginning of 2024 (Chart A, panel b), a magnitude similar to the developments seen following the onset of the Ukraine war and at the time of past geopolitical events in the Middle East. Thereafter, it is assumed to gradually return to pre-conflict levels, in line with historical regularities. High financial market volatility would be associated with a sharp deterioration in business, consumer and financial market confidence.

The resulting impact on global economic activity and euro area foreign demand would be considerable. Even assuming a sharp drop in domestic economic activity in Israel, Palestine, Lebanon, Syria and Iran, the direct impact on global GDP and euro area foreign demand would be limited owing to the small trade weights of the region. However, higher oil and gas prices as assumed in the scenario would raise global price pressures and dampen global GDP, thereby further reducing demand for euro area exports, though with some delay. An increase in global uncertainty would also dampen global economic activity. Overall, euro area foreign demand growth would decline by 1.2 percentage points in 2024 relative to the December 2023 baseline (Chart A, panel c).

Euro area economic growth would weaken owing to higher energy prices, uncertainty effects and international spillovers, while consumer price inflation would rise mainly as a result of higher energy prices (Chart B). As with the global economy, the higher oil and gas prices and heightened uncertainty would also directly impede euro area economic activity, as households and firms would curtail real consumption and investment in response to the shock. Furthermore, international spillovers would have a negative impact on foreign demand for euro area exports, further reducing aggregate demand. Overall, euro area real GDP growth is estimated to be 0.7 percentage points lower in 2024 and 0.3 percentage points lower in 2025 than in the December 2023 baseline projection, and is estimated to rebound in 2026 as uncertainty effects are assumed to gradually unwind at that horizon. Euro area HICP inflation would increase by 0.9 percentage points in 2024 and 0.4 percentage points in 2025, mainly on account of higher global energy prices.

Chart B

Impact of the scenario on euro area real GDP growth and HICP inflation

(percentage point deviation from baseline annual growth)

Real GDP growth	HICP inflation

The fiscal stance is projected to tighten over the projection horizon, in particular in 2024 (Table 3). The level of fiscal support in the euro area remains largely accommodative, reflecting past measures – especially those taken in the context of the coronavirus (COVID-19) pandemic in 2020 and the energy support measures taken from 2022. However, the partial withdrawal of this support results in a tightening of the fiscal stance (which is defined as the change in the cyclically adjusted primary balance^[7]) over the projection horizon – especially in 2024 when a large share of the energy and inflation compensatory support expires. In 2025 and 2026 the fiscal stance slightly tightens on account of a further scaling-down of the remaining support measures and increases in indirect taxes. Compared with the September 2023 projections, some additional tightening is projected at the euro area level in 2023 and 2025, but marginally less tightening is now expected in 2024. An upward revision to the fiscal costs of existing energy measures explains about half of the revision to the fiscal stance for 2024. In particular, lower energy taxes paid by electricity companies in France and new measures adopted in Spain outweigh an earlier than previously expected end of the electricity and gas price ceilings in Germany (this early termination results from the recent judgment by the German Federal Constitutional Court on the use of emergency credits). In addition to changes in energy price measures, the revisions to the total discretionary measures stem from somewhat higher transfers and government consumption. These two factors partly reflect wage and pension growth as they are explicitly or implicitly indexed – with a lag – to prices.

The euro area fiscal outlook is set to improve over the projection horizon. The budget deficit is projected to decline in 2024 to 2.8% of GDP and remain below the 3% reference value for the rest of the projection horizon. In 2026 the budget deficit is projected to be 1.0 percentage point below the 2022 figure. This is mainly due to a decrease in the cyclically adjusted primary deficit in 2023-26 outweighing an increase in interest payments, which is, however, expected to be moderate compared with the increase in market interest rates, as the pass-through is gradual on account of the relatively high residual sovereign debt maturity in the euro area. Compared with the September projections, the euro area budget balance projection for 2024 remains unchanged, as the upward revisions for a few countries are counterbalanced by larger projected deficits for most other countries. The euro area debt-to-GDP ratio is projected to continue to decline to stand at 88.1% in 2026, driven by negative interest rate-growth differentials that more than compensate for primary deficits and expected positive deficit-debt adjustments. The debt-to-GDP ratio has been revised down compared with the September 2023 projections, on account of a level shift owing to an upward revision to GDP in 2021 for several countries.

HICP inflation is projected to decrease from an average of 5.4% in 2023 to 2.7% in 2024 and 2.1% in 2025, and then to stand at 1.9% in 2026 (Chart 4). Following the strong decline in HICP inflation to stand at 2.4% in November, in the very short term a temporary rebound is expected, related predominantly to upward base effects in the energy component and the reversal of some fiscal support measures (Chart 5). As a result, energy inflation should increase in 2024, partly offsetting further declines in food inflation and HICP inflation excluding energy and food (HICPX). This implies that headline inflation will fall only gradually during the course of 2024. From the end of 2024 all the main inflation components are expected to continue to ease, supporting headline HICP inflation in reaching the ECB’s target in the second half of 2025 (Chart 6).

Energy inflation is projected to temporarily rise strongly, before declining again in the second half of 2024 and moving to around zero in 2025 and 2026. The increase in the annual energy inflation rate in the near term reflects predominantly an upward base effect for December 2023 (Chart 5) and the reversal of energy inflation compensatory fiscal measures in 2024 (with a particularly strong impact on gas and electricity prices). Changes in these measures from December 2023 are estimated to lift headline HICP inflation in 2024 by around 0.4 percentage points. The upward impacts from base effects and the expiry of government measures are likely to more than offset recent declines in energy commodity prices (oil, gas and electricity prices), as well as in carbon emission prices. Once these impacts fade, the slight downward trend in energy commodity price futures is seen to be the main driver of a slight decline in HICP energy inflation towards the end of the projection horizon.

Food inflation is projected to decline sharply in the course of 2024, owing to easing pipeline price pressures, and to decrease more gradually thereafter. Food inflation is envisaged to continue its recent significant decline, falling from a still elevated level of 6.9% in November 2023 to stand at 2.6% in the last quarter of 2024. This reflects a significant easing in pipeline pressures owing to decreases in food and energy commodity prices. Thereafter, food inflation is expected to gradually slow to 2.3% in 2026, which is still somewhat above the long-term pre-COVID-19 average rate of 2.1%, as continued high labour cost pressures are envisaged to prevent a faster unwinding.

HICPX inflation is expected to gradually decline over the projection horizon (Chart 7). It is envisaged to fall from 3.6% in November 2023 to 2.7% in the fourth quarter of 2024 and then to decline further to average rates of 2.3% and 2.1% in 2025 and 2026. Over the near term, receding pipeline price pressures are expected to have a strong downward impact, whereas elevated labour cost pressures are expected to support HICPX inflation. The profile for HICPX inflation over the whole projection horizon reflects fading impacts from earlier pipeline pressures and supply bottlenecks, the normalisation of demand after post-COVID-19 reopening effects, and the ECB’s monetary policy tightening. A faster decline in HICPX inflation over the horizon is hindered by declining but still elevated upward pressures from labour cost developments which are seen to be only partially buffered by unit profits.

Compared with the September 2023 projections, the outlook for HICP inflation has been revised down by 0.2 percentage points for 2023 and by 0.5 percentage points for 2024, but it is unrevised for 2025. The downward revision for 2024 is mainly due to recent data surprises in the energy and HICPX components, together with lower futures for energy commodity prices. Over the course of 2024 higher domestic cost pressures (reflected in an upward revision to unit labour cost growth) and the assumed depreciation of the euro are expected to gradually gain traction and eventually dominate, leading to a slight upward revision to HICPX inflation for 2025. However, headline inflation is unrevised for 2025, as the upward revision to HICPX inflation is seen to be offset by downward revisions to energy inflation, owing to the slightly steeper downward-sloping oil and gas price futures curves.

While nominal wage growth is expected to remain strong, supported by still tight labour markets, it is projected to gradually decline over time, as pressure linked to inflation compensation and increases in minimum wages fades. Growth in compensation per employee is projected to decline from 5.3% in 2023 to 3.3% in 2026. Compared with the September projections, the growth rate has been revised up for 2024 but is unrevised for 2025. The upward revision for 2024 reflects a tighter labour market and expected stronger increases in negotiated wages in the near term. Stronger wage growth also implies that losses in purchasing power incurred since the surge in inflation are expected to be recovered by the end of 2024, which is slightly earlier than expected in the September projections. Growth in unit labour costs is expected to have peaked and is projected to decline notably, benefitting in part from the projected rise in productivity growth (Chart 8), which is nonetheless expected to remain below the level implied by the historical trend.

Domestic price pressures, as measured by the growth of the GDP deflator, are projected to decrease gradually from their current historical highs as first profit growth and then unit labour cost growth declines (Chart 9). The annual growth rate of the GDP deflator peaked at 6.1% in the first half of 2023 and is projected to recede quickly to 2.6% by the end of 2024, before declining more gradually thereafter to an average of 1.9% in 2026. Unit profit growth also peaked in early 2023 and is projected to turn negative in 2024. Such a profile implies that from the second half of 2023 profits will in part buffer the relatively strong labour cost growth.^[8] As growth in unit labour costs moderates, unit profit growth will strengthen from 2025, supported by an improving growth outlook and recovering productivity growth.

Following a surge in 2022, the annual growth rate of import prices declined into negative territory in 2023, but is expected to rebound as base effects from commodity prices fade before normalising later in the horizon. Growth in the import deflator is expected to have dropped sharply from 17.4% in 2022 to -2.9% in 2023. It is then expected to turn positive and stand at 1.0% in 2024 and 2.3% in 2025, before moderating to 2.0% in 2026 broadly in line with the projected path for export competitors’ prices (Box 2).