The Purchasing Managers' Index for May indicated that momentum in the European economy is improving. With inflation at manageable levels, the question arises as to what extent the ECB will allow investments to structurally strengthen the economy. This was reported by ING.
The European economy has had its fair share of challenges over the past few years. First, the pandemic, from which the European economy recovered relatively quickly, followed by an energy crisis, inflation at its highest in decades, and the highest interest rates in the history of the ECB. Despite all this, the economy – except perhaps for the first few months of the pandemic - has not experienced a real recession. However, significant economic growth has also been absent from the end of 2022 to the end of 2023. It was a long period of stagnation, especially considering the strong growth shown by the United States during the same period.
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A Hopeful Start
But this year has started on a hopeful note. In the first quarter of 2024, the eurozone economy grew by 0.3% compared to the previous quarter, the strongest growth since Q3 2023. And the outlook seems to be getting stronger. The Purchasing Managers' Index for May – released this morning – rose from 51.7 to 52.3, corresponding with accelerating growth. Thus, the economy seems to be moving past the period of stagnation and is growing again.
Factors Behind the Improved Economic Outlook
The improved economic outlook didn't come out of nowhere. Inflation has significantly decreased over the past year, and wage growth has picked up. Today, it was revealed that wage growth in the eurozone in the first quarter was 4.7%. This is slightly stronger than in Q4 and significantly higher than inflation. This is now compensating for previous losses in purchasing power, translating into increased household consumption. At the same time, long-term interest rates have dropped in recent months compared to last autumn. This makes it more attractive for companies to make investments. The expectation is that wage growth will continue to outpace inflation for the rest of the year, and that a lower ECB interest rate could provide a moderate boost to investments. This helps to keep economic growth positive in the coming quarters.
Outlook for Inflation and ECB Interest Rates
For this to happen, inflation needs to remain low and the ECB interest rate needs to come down. This is in line with expectations. Concerns about inflation are mainly focused on strong wage growth, and the expectation is that this will flatten out over the course of the year. Inflation is currently at 2.4%, but the ECB expects it to settle at exactly 2% in 2025 and even fall slightly below 2% in 2026. This is an inflation outlook that seems comfortable enough for the ECB to lower interest rates to give the economy more breathing room. Our expectation is therefore that the ECB will lower interest rates by 0.25% in June, but the question remains to what extent the ECB will continue to lower rates thereafter.
The Importance of Stimulating Investment
This presents a more attractive economic outlook. Inflation has dropped to manageable levels without an increase in unemployment, and the economy is starting to pick up. The likelihood of both a recession and a resurgence of inflation appears to be diminishing. At the same time, this is not the moment for European policymakers to rest on their laurels. Despite the absence of a recession, the eurozone has missed out on a lot of prosperity compared to the pre-corona trend. Stimulating investments after this economically disappointing period is important to keep the European economy dynamic and strong. Waiting too long to lower interest rates could also harm the economy in the long run. Thus, monetary policy remains exciting, even now that inflation has again dropped to relatively safe levels.
Source: ING
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