European economic outlook: on interest rates, central bankers are hiking to the summit

Strong core inflation and wage growth likely to drive interest rates even higher. We differ most from consensus in our 2024 growth outlook.

• Theme 1: still-high core inflation and wage dynamics are expected to cause central banks to raise interest rates higher than previously expected.
• Theme 2: the lagged impact of monetary policy tightening is set to slow growth into 2024. This is also where we differ most from consensus forecasts.
• Theme 3: while the ECB and Fed appear to be nearing the end of their hiking cycles, inflation and labour market data are forcing the BoE to do more. 

Still elevated core inflation and wage growth since last quarter suggest interest rates are headed higher for longer. We now expect two more rate hikes from the ECB, and a terminal refinancing policy rate of 4.5%, and add 25bps to our Swiss National Bank forecast. We also increase our Bank of England (BoE) policy rate forecast by 75bps, but today's larger than expected 50bps hike, the May CPI report and latest labour market data all add further upside risks to our 5.25% terminal rate. The full weight of monetary tightening is still to come, and we lower our 2024 euro area and UK GDP growth forecasts notably lower than consensus. However, after the UK's better-than-expected Q1 GDP performance we raise our full-year UK 2023 GDP growth forecast by 0.4ppts to 0.1%. We also flag upside risks to Swiss near-term GDP growth.

Table 1: Key Europe economic forecasts

The rapid descent of producer price inflation (PPI) we highlighted last quarter is continuing to play out in the euro area with lower energy prices and the easing of supply chain pressures. PPI inflation was just 1% y-o-y in the euro area in April, and forward-looking selling price expectations have fallen to 1Q-2021 levels. In contrast, we do not believe European core inflation has necessarily peaked and expect core CPI inflation to be higher than headline CPI by the end of Q3 (see Figure 1). Wage growth, already elevated, is expected to accelerate in the coming months, driven by factors such as the multi-year wage deal structure in many European labour markets. This means wage inflation will likely ease more slowly in the euro area than in the US, adding comparatively greater risks in the euro area of a de-anchoring of medium-term inflation expectations. We expect this to push up core services inflation.

Figure 1: Headline and core inflation forecasts, and inflation paths with 0% m-o-m inflation

We expect tighter monetary and lending conditions to weigh increasingly on economic activity in the second half of this year and 2024, even as real household incomes start recovering on disinflation. The full effects of the rapid monetary policy tightening have not yet been felt: for example, it is estimated that only 25% of the BOE's rate hikes have so far passed through to UK residential mortgage markets.¹ Coupled with expected fiscal drag, we have revised down our 2024 forecasts considerably below consensus (see Figure 2). To counter the high risk of overtightening policy as they approach terminal interest rates, we expect that central banks' interest rate policy emphasis to shift from "higher" to "longer" in Q3 meetings. Labour market loosening may be an early indicator of a more severe downturn.

Figure 2: 2024 Annual GDP forecasts

In May, UK core inflation rose to 7.1% y-o-y and services inflation reached multi-decade highs (see Figure 3), yet another upside surprise. Beats across the sub-categories means broad-based price pressures are likely to accompany the UK into Q3, adding upside risk to our annal average 2023 CPI inflation forecast. High discretionary services inflation, including in recreation and hospitality, indicate that demand is too strong for inflation to fall back to target in the short-term. Further, upward revisions to employment gains and average weekly earnings growth at 7.6% 3m/y-o-y in the private sector reveal that the labour market is tighter than the BoE forecast in May. The BoE acted forcefully by increasing the incremental size of its hike to 50bp, and with more aggressive tightening in 2H-2023 to be expected if inflation pressures persist, we flag upside risk to our BoE rate forecast. Finally, higher policy rate expectations have forced UK government bond yields higher in recent weeks, adding upside risk to our 2023 year-end 10-year yield forecasts.

Figure 3: UK inflation sub-categories, y-o-y