Banco de España

06/20/2024 | Press release | Distributed by Public on 06/20/2024 02:15

ECB Economic Bulletin. Issue 4/2024

Economic, financial and monetary developments

Overview

At its meeting on 6 June 2024, the Governing Council decided to lower the three key ECB interest rates by 25 basis points. Based on an updated assessment of the inflation outlook, the dynamics of underlying inflation and the strength of monetary policy transmission, it was appropriate to moderate the degree of monetary policy restriction after nine months of holding rates steady. Since the Governing Council meeting in September 2023, inflation has fallen by more than 2.5 percentage points and the inflation outlook has improved markedly. Underlying inflation has also eased, reinforcing the signs that price pressures have weakened, and inflation expectations have declined at all horizons. Monetary policy has kept financing conditions restrictive. By dampening demand and keeping inflation expectations well anchored, this has made a major contribution to bringing inflation back down.

At the same time, despite the progress over recent quarters, domestic price pressures remain strong as wage growth is elevated, and inflation is likely to stay above target well into next year. The latest Eurosystem staff projections for both headline and core inflation have been revised up for 2024 and 2025 compared with the March projections. Staff now see headline inflation averaging 2.5% in 2024, 2.2% in 2025 and 1.9% in 2026. For inflation excluding energy and food, staff project an average of 2.8% in 2024, 2.2% in 2025 and 2.0% in 2026. Economic growth is expected to pick up to 0.9% in 2024, 1.4% in 2025 and 1.6% in 2026.

The Governing Council is determined to ensure that inflation returns to its 2% medium-term target in a timely manner. It will keep policy rates sufficiently restrictive for as long as necessary to achieve this aim. The Governing Council will continue to follow a data-dependent and meeting-by-meeting approach to determining the appropriate level and duration of restriction. In particular, its interest rate decisions will be based on its assessment of the inflation outlook in light of the incoming economic and financial data, the dynamics of underlying inflation and the strength of monetary policy transmission. The Governing Council is not pre-committing to a particular rate path.

The Governing Council also confirmed that it will reduce the Eurosystem's holdings of securities under the pandemic emergency purchase programme (PEPP) by €7.5 billion per month on average over the second half of the year. The modalities for reducing the PEPP holdings will be broadly in line with those followed under the asset purchase programme (APP).

Economic activity

After five quarters of stagnation, the euro area economy grew by 0.3% over the first quarter of 2024. The services sector is expanding, and manufacturing is showing signs of stabilisation at low levels.

Employment rose by 0.3% in the first quarter of this year, with around 500,000 new jobs created, and surveys point to continued job growth in the near term. The unemployment rate edged down to 6.4% in April, its lowest level since the start of the euro. Companies are still posting many job vacancies, though slightly fewer than before.

The euro area economy recovered at the start of 2024 by more than expected in the March 2024 ECB staff projections, with a boost from net trade and rising household spending. Incoming information suggests continued growth in the short run, at a higher pace than previously foreseen. Real disposable income should continue to increase amid robust wage growth, gradually increasing confidence and improving terms of trade, giving rise to a consumption-driven recovery in the course of 2024. The boost from net trade at the start of the year partly reflects volatility following a temporary decline at the end of 2023. However, foreign demand is expected to continue to expand, supporting euro area export growth. Over the medium term, the negative impact of the past monetary policy tightening is seen to gradually fade, with activity supported by an assumed easing of financing conditions in line with market expectations for the future path of interest rates. Growth will also benefit from a resilient labour market, with the unemployment rate declining to historically low levels later on in the projection horizon. As some of the cyclical factors that have lowered productivity growth in the recent past unwind, productivity is expected to pick up over the projection horizon. Overall, annual average real GDP growth is expected to be 0.9% in 2024, and to strengthen to 1.4% in 2025 and 1.6% in 2026. Compared with the March 2024 projections, the outlook for GDP growth has been revised up for 2024 owing to the positive surprise at the start of the year and improved incoming information. The GDP growth outlook has been revised down marginally for 2025 and remains unchanged for 2026.

National fiscal and structural policies should be aimed at making the economy more productive and competitive, which would help to raise potential growth and reduce price pressures in the medium term. An effective, speedy and full implementation of the Next Generation EU programme, progress towards a capital markets union and the completion of the banking union, and a strengthening of the Single Market would help foster innovation and increase investment in the green and digital transitions. Implementing the EU's revised economic governance framework fully and without delay will help governments bring down budget deficits and debt ratios on a sustained basis.

Inflation

Annual inflation rose to 2.6% in May, from 2.4% in April, according to Eurostat's flash estimate. Food price inflation declined to 2.6%. Energy price inflation increased to 0.3%, after recording negative annual rates for a year. Goods price inflation continued to decrease in May, to 0.8%. By contrast, services price inflation rose markedly, to 4.1% from 3.7% in April.

Most measures of underlying inflation declined further in April, the last month for which data were available, confirming the picture of gradually diminishing price pressures. However, domestic inflation remains high. Wages are still rising at an elevated pace, making up for the past inflation surge. Owing to the staggered nature of the wage adjustment process and the important role of one-off payments, labour costs will likely fluctuate over the near term, as seen in the pick-up in negotiated wages in the first quarter. At the same time, forward-looking indicators signal that wage growth will moderate over the course of the year. Profits are absorbing part of the pronounced rise in unit labour costs, which reduces its inflationary effects. Measures of longer-term inflation expectations have remained broadly stable, with most standing at around 2%.

Headline inflation is projected to moderate further to levels close to target in the course of 2025. This reflects an easing of cost pressures, including from the labour side, and the lagged impact of past monetary policy tightening gradually feeding through to consumer prices. Headline inflation as measured by the Harmonised Index of Consumer Prices (HICP) is expected to show some volatility over the remainder of 2024 owing to base effects and higher energy commodity prices. Over the medium term, energy inflation should settle at low positive rates, given market expectations for the future paths of oil and gas prices and planned climate change-related fiscal measures. Recent quarters have seen food price inflation decline strongly, as pipeline pressures have eased with lower energy and food commodity prices. Looking ahead, food price inflation is expected to fluctuate around its current levels before moderating further from the end of 2025. HICP inflation excluding energy and food (HICPX) should remain above headline inflation for most of the projection horizon but is expected to continue its disinflationary path, although at a slow pace and mainly in 2025 and 2026. A central element in the June projections is the expected gradual easing of nominal wage growth from initially still elevated levels as upward impacts from inflation compensation pressures in a tight labour market fade. The expected recovery in productivity growth should support the moderation in labour cost pressures. Moreover, profit growth is set to weaken and partially buffer the pass-through of labour costs to prices, especially in 2024. Overall, annual average headline HICP inflation is expected to decline from 5.4% in 2023 to 2.5% in 2024, 2.2% in 2025 and 1.9% in 2026. Compared with the March 2024 projections, HICP inflation has been revised up by 0.2 percentage points in 2024 and 2025. This is mainly due to higher energy commodity prices and slightly higher than expected incoming data for HICPX inflation. In addition, labour cost pressures are expected to be somewhat stronger on account of higher wage growth coupled with a slightly more cautious outlook for productivity growth. The outlook for both headline inflation and HICPX inflation for 2026 is unrevised.

Risk assessment

The risks to economic growth are balanced in the near term but remain tilted to the downside over the medium term. A weaker world economy or an escalation in trade tensions between major economies would weigh on euro area growth. Russia's unjustified war against Ukraine and the tragic conflict in the Middle East are major sources of geopolitical risk. This may result in firms and households becoming less confident about the future and global trade being disrupted. Growth could also be lower if the effects of monetary policy turn out stronger than expected. Growth could be higher if inflation comes down more quickly than expected and rising confidence and real incomes mean that spending increases by more than anticipated, or if the world economy grows more strongly than expected.

Inflation could turn out higher than anticipated if wages or profits increase by more than expected. Upside risks to inflation also stem from the heightened geopolitical tensions, which could push energy prices and freight costs higher in the near term and disrupt global trade. Moreover, extreme weather events, and the unfolding climate crisis more broadly, could drive up food prices. By contrast, inflation may surprise on the downside if monetary policy dampens demand more than expected, or if the economic environment in the rest of the world worsens unexpectedly.

Financial and monetary conditions

Market interest rates have risen since the Governing Council's meeting on 11 April 2024. Financing costs have plateaued at restrictive levels as the past policy rate increases have worked their way through the financial system. The average interest rates on new loans to firms and on new mortgages were unchanged in April, at 5.2% and 3.8% respectively.

Credit dynamics remain weak. Bank lending to firms grew at an annual rate of 0.3% in April, down slightly from the previous month. Loans to households continued to grow at 0.2% on an annual basis. The annual growth in broad money - as measured by M3 - rose to 1.3% in April, from 0.9% in March.

In line with its monetary policy strategy, the Governing Council thoroughly assessed the links between monetary policy and financial stability. Euro area banks remain resilient. The improving economic outlook has fostered financial stability, but heightened geopolitical risks cloud the horizon. An unexpected tightening of global financing conditions could prompt a repricing of financial and non-financial assets, with negative effects on the wider economy. Macroprudential policy remains the first line of defence against the build-up of financial vulnerabilities. The measures that are currently in place or will soon take effect are helping to keep the financial system resilient.

Monetary policy decisions

The interest rate on the main refinancing operations and the interest rates on the marginal lending facility and the deposit facility were decreased to 4.25%, 4.50% and 3.75% respectively, with effect from 12 June 2024.

The APP portfolio is declining at a measured and predictable pace, as the Eurosystem no longer reinvests the principal payments from maturing securities.

The Governing Council will continue to reinvest, in full, the principal payments from maturing securities purchased under the PEPP until the end of June 2024. Over the second half of the year, it will reduce the PEPP portfolio by €7.5 billion per month on average. The Governing Council intends to discontinue reinvestments under the PEPP at the end of 2024.

The Governing Council will continue applying flexibility in reinvesting redemptions coming due in the PEPP portfolio, with a view to countering risks to the monetary policy transmission mechanism related to the pandemic.

As banks are repaying the amounts borrowed under the targeted longer-term refinancing operations, the Governing Council will regularly assess how targeted lending operations and their ongoing repayment are contributing to its monetary policy stance.

Conclusion

The Governing Council decided at its meeting on 6 June 2024 to lower the three key ECB interest rates by 25 basis points. The Governing Council is determined to ensure that inflation returns to its 2% medium-term target in a timely manner. It will keep policy rates sufficiently restrictive for as long as necessary to achieve this aim. The Governing Council will continue to follow a data-dependent and meeting-by-meeting approach to determining the appropriate level and duration of restriction. In particular, the interest rate decisions will be based on the Governing Council's assessment of the inflation outlook in light of the incoming economic and financial data, the dynamics of underlying inflation and the strength of monetary policy transmission. The Governing Council is not pre-committing to a particular rate path.

In any case, the Governing Council stands ready to adjust all of its instruments within its mandate to ensure that inflation returns to its medium-term target and to preserve the smooth functioning of monetary policy transmission.

1 External environment

Global economic activity is showing signs of strengthening, although headwinds to growth remain. Incoming data on global activity (excluding the euro area) confirm a very gradual improvement since the beginning of the year, with hard data aligning increasingly with positive signals from soft data. The outlook for global growth, asreflected in the June 2024 Eurosystem staff macroeconomic projections for the euro area, is broadly unchanged compared with the March 2024 ECB staff macroeconomic projections for the euro area, with a slight decrease in global growth projected for this year. Global trade is projected to recover this year and grow more in line with global activity thereafter, albeit remaining below its historical trend level over the projection horizon and broadly unchanged compared with the March 2024 ECB staff macroeconomic projections. Inflation at the global level is projected to gradually decline over the projection horizon.

Incoming data confirm an upward momentum in global activity as signals from survey and hard data align more closely. The global (excluding the euro area) composite output Purchasing Managers' Index (PMI) increased in May 2024 as output improved in the manufacturing and services sectors (Chart 1).[1] This aligns with evidence from the ECB's global activity tracker, which points to improved momentum underpinned by positive readings in both soft and hard data. This tracker has indicated a gradual improvement in global activity since the start of this year, with recent hard data becoming increasingly aligned with positive signals from soft data. Nonetheless, headwinds to global growth remain, including the diminished stock of excess savings in advanced economies and subdued domestic demand in China against the backdrop of a troubled residential real estate sector. Moreover, labour markets in key advanced economies are gradually cooling and nominal wage growth is moderating, providing less support to growth in disposable incomes. As a result, global consumer spending, which underpinned the recovery in economic activity following the COVID-19 pandemic, remains subdued. Growth in global real GDP is estimated to have slowed slightly to 0.8% in the first quarter of 2024, down from 0.9% in the fourth quarter of 2023.

Chart 1

Global PMI output

The projected outlook for global growth remains broadly unchanged compared with the March 2024 ECB staff macroeconomic projections. A modest decrease in growth this year reflects the impact of the aforementioned headwinds, continued restrictive monetary policies and elevated uncertainty amid geopolitical tensions. Overall, global real GDP growth is projected to stand at 3.3% this year compared with 3.5% in 2023. Global real GDP growth is projected to stand at 3.3% in 2025 and 3.2% in 2026, slightly below the average global growth rate for the past decade.

Global trade is expected to gradually recover as post-pandemic demand patterns normalise. In the first quarter of 2024, world trade growth accelerated as post-pandemic compositional effects started to dissipate. The buoyant demand for services observed at the global level throughout last year is now shifting towards stronger goods demand. Looking ahead, global import growth is expected to rise further, in line with signals from the ECB's nowcasting tool which embeds hard and soft data on global trade (Chart 2). In particular, the global PMI new export orders indicate that growth momentum will pick up gradually. Moreover, sectoral survey data point to a more dynamic recovery in trade-intensive sectors such as tourism and technology equipment. Finally, the impact of the Red Sea disruptions on global trade remains contained and in line with the March 2024 projections, although a potential escalation in these disruptions continues to pose a downside risk to global trade in the near term.

Chart 2

World imports

Beyond the near term, global trade is projected to continue recovering gradually over the projection horizon and to grow more in line with global activity. Overall, global import growth is projected to increase to 2.6% this year, up from 1.0% in 2023, before gradually rising to 3.3% annually over 2025-26, broadly in line with the previous round of projections. Recovering imports in emerging markets and major advanced economies, particularly the United States, are expected to contribute to trade recovery this year. However, global trade levels are expected to remain below the 2012-19 trend level, owing to subdued real GDP growth and to ongoing structural changes in trade relations caused by rising geopolitical tensions. The recovery in euro area foreign demand this year is expected to be less dynamic, standing at 2.1%. This largely reflects weaker imports by some of the euro area's key trading partners, such as the United Kingdom and central and eastern European countries, in the second half of 2023 and in the first quarter of 2024. Over the projection horizon, euro area foreign demand is expected to increase by 3.4% in 2025 and 3.3% in 2026, aligning more closely with the growth dynamics of global imports.

Inflation across the member countries of the Organisation for Economic Co-operation and Development is projected to decline gradually over the projection horizon. Headline consumer price index (CPI) inflation across the member countries of the Organisation for Economic Co-operation and Development (OECD) stood at 3.4% in April 2024, slightly below readings observed since the beginning of this year.[2] Core inflation (excluding food and energy) declined in April, to 3.8% from 4.0% in March. The slowing pace of disinflation in the OECD countries appears to be mainly due to persistent services inflation in an environment where tight labour markets across major economies are only very gradually adjusting. The higher momentum in headline CPI inflation, measured as a three-month-on-three-month annualised percentage change, indicates that inflation across OECD countries could increase over the near term (Chart 3). This is corroborated by the latest signals from survey data. Manufacturing input price PMIs indicate that goods inflation could rebound from its currently very low levels over the near term, while services input price PMIs suggest that services inflation, which accounts for almost two-thirds of the core CPI measure, could continue moderating gradually towards its historical average. With regard to external price pressures, growth in euro area competitors' export prices, in national currency and in annual terms, is expected to turn positive this year and remain close to its estimated long-term average over the rest of the projection horizon. This outlook has been revised downwards slightly compared with the March 2024 ECB staff macroeconomic projections owing to weaker than previously expected export price inflation outturns, which outweigh the impact of higher commodity price assumptions in the current projection round.

Chart 3

OECD headline consumer price inflation momentum

As for commodity prices, European gas and food prices have increased since the last Governing Council meeting, while oil prices have declined. Although European gas prices have increased, these remain low compared with the levels observed after Russia's invasion of Ukraine. Higher gas prices reflect supply disruptions relating to liquefied natural gas exports from the United States and Qatar, extended pipeline maintenance in Norway and to Russian attacks on Ukrainian gas storage facilities. Crude oil prices declined, as the tensions in the Middle East continued to have only short-lived effects on oil prices, with the global oil supply remaining largely unaffected. Moreover, lower-than-expected global oil demand counteracted the impact of the reduced oil supply and the supply risks on prices. The International Energy Agency forecasts a modest global oil supply deficit in 2024 and 2025, but the buffers needed to absorb further shocks seem to be larger than they were before Russia's invasion of Ukraine. Risks to oil prices remain tilted to the upside, particularly if tensions in the Middle East were to escalate. Food commodity prices increased significantly, largely reflecting developments in cocoa prices amid severe supply disruptions in West Africa. Cocoa prices have recently declined from the peaks observed in late April 2024 but remain volatile. Grains prices increased due to adverse supply developments.

In the United States, continued robust economic activity and persistent inflation led the Federal Open Market Committee to delay its first rate cut. Real GDP growth slowed in the first quarter of 2024 to 0.3%, down from 0.5% in the fourth quarter of last year. However, domestic demand remained solid, as the negative net trade contribution reflected a large increase in imports. Real disposable income growth slowed and the savings rate fell further in the first quarter. Available estimates based on high-frequency data suggest that real GDP growth may increase slightly in the second quarter of 2024 but remain below the pace of growth recorded in the second half of 2023. Although remaining very tight, the US labour market continues to show some signs of cooling. While non-farm employment increased in April, it was markedly below the average observed in the first quarter of 2024 and the unemployment rate increased slightly. Both the vacancy-to-unemployed ratio and wage growth remain high but they are declining, albeit only slowly. Consumer price inflation declined slightly in April, with its headline and core inflation measures standing at 3.4% and 3.6% respectively.[3] Looking ahead, inflation is expected to slowly decline further but remain above the Federal Reserve's target of 2% for an extended period. Against this macroeconomic backdrop, the Federal Open Market Committee has recently emphasised in its communications that interest rates will remain "high for longer".

Domestic demand remains subdued in China, although growth in the first quarter of 2024 turned out stronger than expected. Quarterly real GDP growth increased to 1.6% in the first quarter, up from 1.2% in the previous quarter. This reflects rising public investment from fiscal stimulus carried over from a budget revision in late 2023, while private sources of domestic demand, notably consumption, remained weak and slowed down in April 2024. By contrast, high growth resumed in industrial production and investment continues to improve steadily, driven by stimulus in infrastructure projects. The property market appears to be showing some tentative signs of stabilisation. While the overall housing market is still rather stagnant, housing sales and investment showed a recent uptick, accompanied by a slowing decline in construction starts. On the policy front, authorities' statements in April 2024 signalled an increase in government support to the housing market through the direct acquisition of unfinished housing projects from developers, sparking some optimism among market participants. Annual headline CPI inflation increased to 0.3% in April from 0.1% in the previous month, while core CPI also rose slightly to 0.7% from 0.6% over the same period. The continued weakness in producer price developments, together with sluggish domestic demand, suggests that inflationary pressures in the Chinese economy remain subdued.

Economic growth in the United Kingdom rebounded once again in the first quarter of 2024 and the labour market is showing signs of easing. Following the technical recession in the second half of 2023, real GDP grew by 0.6% quarter on quarter in the first quarter of 2024, well above the official and market expectations. The net trade contribution was positive owing to a large contraction in imports which more than compensated for the decline in exports. While incoming data indicate a solid start to the second quarter, economic activity is expected to grow at a more moderate pace for the rest of the year. Furthermore, private consumption remains relatively subdued in line with suppressed real wages, high interest rates, and restrictive monetary and fiscal policies. Headline inflation has decreased further, but services price pressures persist. Headline CPI inflation continued to decline in April 2024, dropping to 2.3% from 3.2% in March. However, services inflation surprised to the upside, standing at 5.9% in April, only marginally easing from 6.0% in the previous month and reflecting elevated wage growth, as well as persisting labour shortages. Labour market tightness remains above its pre-pandemic average. Nominal wage growth - a key factor behind stubborn services inflation - continued to decline in the first quarter of this year but remains at very high levels. The Bank of England projects that wage pressures will continue to diminish in the coming months.

2 Economic activity

Euro area real GDP rose by 0.3%, quarter on quarter, in the first quarter of 2024. This pick-up in growth, which follows five quarters of broadly stagnant activity, reflected a positive contribution from net trade and domestic demand and a negative contribution from changes in inventories. Survey results point to continued growth in the second quarter. While production in industry is still affected by weak demand, especially in energy-intensive sectors, the services sector shows clearer signs of a broad-based improvement. On the supply side, the recovery in the first quarter was entirely driven by employment, while productivity stagnated. The euro area economy is expected to continue to recover over the course of this year on the back of rising real incomes, resulting from lower inflation, increased wages and improved terms of trade, in addition to the gradually fading impact of the monetary policy tightening. Furthermore, exports should continue to grow in line with global demand in the coming quarters, although external competitiveness challenges remain a downward risk.

This outlook is broadly reflected in the June 2024 Eurosystem staff macroeconomic projections for the euro area, which foresee annual real GDP growth of 0.9% in 2024, picking up to 1.4% and 1.6% in 2025 and 2026 respectively.[4]

Euro area output picked up at the beginning of 2024, following more than a year of stagnation. According to Eurostat's flash estimate, real GDP increased by 0.3%, quarter on quarter, in the first quarter of 2024: its largest quarterly rise since the third quarter of 2022 (Chart 4).[5] Short-term indicators and available country data point to positive contributions from domestic demand and net trade, alongside a negative contribution from changes in inventories.[6] The improvement in aggregate demand appears to have been mostly driven by services. This is confirmed by the available value-added country data, as well as by monthly production data.

Chart 4

Euro area real GDP and its components

Survey data point to a continued services-led expansion in the second quarter of 2024. The composite output Purchasing Managers' Index (PMI) stood at 51.9 on average in April and May, up from 49.2 in the first quarter of 2024. The index, which is now indicating positive growth, is thus continuing its upward movement that started in October 2023. Across sectors, the PMI for manufacturing output remained in contractionary territory in May, having increased steadily from the summer of 2023 (Chart 5, panel a). The new orders index, which should be more forward looking, has shown a similar, albeit somewhat stronger, improvement. Overall, these indicators suggest that the fall in activity in the manufacturing sector is bottoming out. The recovery of activity in the services sector has been more pronounced, suggesting that the second-quarter outcome will also be characterised by a services-led expansion (Chart 5, panel b). The assessment for the second quarter is corroborated by the evidence provided in Box 2, which shows that demand and supply sentiment have largely normalised since 2022, based on corporate earnings calls. At the same time, risk sentiment has receded somewhat, while remaining elevated by historical standards.

Chart 5

PMI indicators across sectors of the economy

Employment growth was in line with economic activity in the first quarter of 2024.Employment rose by 0.3% in the first quarter of the year (Chart 6, panel a) driven mainly by the continued growth of the labour force. The implicit labour force, inferred from the unemployment rate and the number of unemployed, also increased by 0.3%. Productivity per employee remained unchanged in the first quarter of the year, given the similar growth in GDP and employment. In terms of the intensive margin, preliminary data suggest an increase in hours worked in the first quarter of 2024. The unemployment rate declined marginally to 6.4% in April, from 6.5% in March, reaching its lowest level since the euro was introduced. Labour demand remains at high levels, although the job vacancy rate fell slightly in the first quarter of 2024, to 2.8%, 0.1 percentage points lower than in the previous quarter.

Chart 6

Euro area employment, PMI assessment of employment and unemployment rate, and sectoral employment PMIs

Short-term labour market indicators continue to point to employment growth in the second quarter of 2024. The monthly composite PMI employment indicator rose from 52.0 in April to 52.1 in May, suggesting an increase in employment. This indicator had declined substantially from its peak of April 2023, but has edged up again in the last few months, driven by the services sector (Chart 6, panel b). The PMI services indicator increased from 53.5 in April to 53.6 in May. By contrast, the PMI manufacturing indicator remained in contractionary territory.

Private consumption is estimated to have increased in the first quarter of 2024 and should strengthen further in the short term. The aggregation of country data available at the time of the June Governing Council meeting points to a small rise in the first quarter of the year, with the consumption of goods likely to have remained subdued and that of services dynamic.[7] The subdued spending on goods is reflected in the ongoing weakness of retail sales volumes, which in the first quarter of 2024 stood at just 0.1% above the level seen in the fourth quarter of 2023. With regard to spending on services, services production in January and February was, on average, 1.6% above the level seen in the fourth quarter of 2023. While incoming survey data suggest that spending on goods might remain weak in the near term, there are some signs of a gradual recovery. The European Commission's consumer confidence indicator continued to increase in May. At the same time, the Commission's indicators for business expectations for retail trade and motor vehicle sales improved, while still remaining below their long-term averages. Business expectations for contact-intensive services remained in growth territory and rose strongly in May (Chart 7). Overall, the ongoing divergence between the consumption of goods and services is supported by the ECB's latest Consumer Expectations Survey, which indicates resilient expected demand for holiday bookings and only a gradual improvement in the propensity to spend on major items.

Chart 7

Private consumption and business expectations for retail trade, contact-intensive services and motor vehicles

Business investment is estimated to have picked up at the start of 2024, after contracting sharply at the end of 2023, with the recovery expected to continue further ahead. According to the aggregation of available national accounts data, non-construction investment (excluding Irish intangibles) is expected to have returned to growth in the first quarter of 2024, only partially reversing the deep contraction seen at the end of last year. The pick-up in the first quarter was broadly in line with survey data, which showed an improvement after bottoming out at the start of the fourth quarter of 2023. However, the improvement in the PMI for the capital goods sector came to a standstill in the first quarter of this year. PMI data point to further muted growth for business investment in the near term, as confidence was weak in April and May, with renewed falls in output and new orders still deep in negative territory (Chart 8, panel a). European Commission surveys also suggest a further increase in the number of capital goods producers citing low demand as a limit to production in the sector. The March/April biannual investment survey carried out by the Directorate General for Economic and Financial Affairs of the European Commission suggests a slowdown in the annual rate of business investment in 2024, which fell to a level consistent with stabilisation in annual terms, albeit with intentions typically more positive in those countries benefitting most from newly-disbursed Next Generation EU funds.[8] Preliminary data from earnings calls point to improving profit and investment sentiment for the second half of 2024, indicating a recovery of investment further ahead. On a similar note, the Sentix six-month ahead euro area investor confidence indicator moved into growth territory in April for the first time since February 2022 and strengthened further in May, which also implies greater investment appetite in the second half of the year.

Chart 8

Real investment dynamics and survey data

Housing investment likely increased in the first quarter of 2024 despite the weak underlying momentum, which should persist in the short term. According to the aggregation of available national accounts data, housing investment in the euro area rose markedly in the first quarter of 2024 compared with the previous quarter. This outcome was largely driven by exceptionally mild weather in Germany and the strong, albeit diminishing, effects of past fiscal incentives in Italy. It was also broadly in line with output for building and specialised construction in the euro area, which rose by 0.8% in the first quarter of 2024 compared with the previous quarter. However, recent survey-based indicators point to a decline in housing investment in the second quarter, with the PMI output for housing activity and the European Commission's indicator for activity in building and specialised construction both remaining in contractionary territory in the first months of the second quarter (Chart 8, panel b). Overall, the downward trend in housing investment reflects the significant rise in mortgage interest rates and the moderation in house price growth resulting from the past monetary policy tightening, which had a negative impact on the affordability and profitability of housing. The persistently elevated level of interest rates is likely to cause housing affordability and profitability to remain low and continue to weigh on the momentum of housing investment.

Growth in euro area exports started to normalise in the first quarter of 2024, after lagging growth in global imports for almost a year. Extra-euro area goods export volumes recovered slightly in the first quarter, expanding by 0.1% as subdued global demand continued to hold back exports. Exports of goods are likely to have underperformed exports of services, still reflecting some drag on competitiveness stemming from the European gas crisis. High energy prices seem to have played an important role in the weak performance of euro area exports in recent years, as the changes in export market shares across sectors since 2019 appear to be negatively correlated with sectoral energy intensity. The correlation is stronger for China, where losses of euro area export market share have been substantial. Looking ahead, exports should continue to perform in line with foreign demand. However, survey-based indicators point to continued weakness in exports in the near term. New export orders for both manufactured goods and services improved in May 2024 but remain below the expansion threshold (Chart 5). Despite the stronger domestic spending in the euro area, the recovery in imports was small and goods volumes continued to decline, falling by 1.7% in the first quarter of 2024. In the first quarter of the year net exports made a positive contribution to GDP, reflecting a better performance from exports than imports. The combined effect of falling import prices and a pick-up in export prices is likely to lead to a renewed improvement in terms of trade.

The euro area economy is expected to recover over the course of 2024, largely on the back of private consumption.This will be facilitated by rising real incomes, resulting from lower inflation, increased wages and improved terms of trade. While the boost from net trade at the start of 2024 largely reflects volatility following the temporary decline at the end of 2023, foreign demand is expected to continue to expand and support growth in euro area exports. Over the medium term the recovery is also expected to be supported by the gradually fading negative impact of the past monetary policy tightening and an assumed easing of financial conditions, in line with market expectations for the future path of interest rates. Additionally, growth will be supported by a resilient labour market, with unemployment declining further later along the projection horizon to reach historically low levels.

The June 2024 Eurosystem staff macroeconomic projections for the euro area foresee annual real GDP growth of 0.9% in 2024, 1.4% in 2025 and 1.6% in 2026. Compared with the March 2024 projections, the outlook for GDP growth has been revised up for 2024, owing to the positive surprise at the start of the year and improved incoming information. The GDP growth outlook has been revised down marginally for 2025 and remains unchanged for 2026.

3 Prices and costs

Euro area headline inflation edged up to 2.6% in May 2024, after standing at 2.4% in March and April. Most measures of underlying inflation declined further in April. Domestic price pressures decreased in the first quarter of the year, reflecting weakening profits. Measures of longer-term inflation expectations remained broadly stable, with most standing at around 2%. The June 2024 Eurosystem staff macroeconomic projections for the euro area foresee that headline inflation will decline gradually from 2.5% in 2024, to 2.2% in 2025 and 1.9% in 2026.

Euro area headline inflation increased to 2.6% in May (according to Eurostat's flash estimate) from 2.4% in April (Chart 9).[9] This uptick resulted from higher inflation rates for energy and services inflation, while food inflation and non-energy industrial goods (NEIG) inflation eased. The annual rate of change of energy inflation increased to 0.3% in May, after recording negative rates in the previous twelve months. This rise reflects an upward base effect, owing to a significant decline in May 2023. Food inflation continued to ease, falling from 2.8% in April to 2.6% in May. This decrease reflected a lower annual rate of change in processed food prices, while the annual rate for unprocessed food prices increased. HICP inflation excluding energy and food (HICPX) rose to 2.9% in May, up from 2.7% in April, owing to an increase in services inflation (4.1% in May, after 3.7% in April). The declining growth rates for processed food and NEIG reflect the continued easing of pipeline price pressures, while more persistent services inflation is related to the stronger role of labour costs in some of its items, among other factors.

Chart 9

Headline inflation and its main components

Most indicators of underlying inflation have continued to decline, reflecting the fading effects of previous large shocks, as well as weaker demand amid tight monetary policy (Chart 10). The indicator values ranged from 1.9% to 4.4% in April, with the Persistent and Common Component of Inflation (PCCI) at the bottom of the range and the domestic inflation indicator (excluding HICP items with a large import content) at the top. HICPXX inflation (which refers to HICPX inflation excluding travel-related items, clothing and footwear) decreased from 2.8% in March to 2.7% in April. The Supercore indicator, which comprises HICP items that are sensitive to the business cycle, declined from 3.4% in March to 3.1% in April, while the model-based PCCI measure ticked downwards to 1.9% from 2.0% over the same period. The indicator for domestic inflation has been the highest and most persistent measure, standing at 4.4% in March and April 2024, reflecting the strong weight of services items such as insurance or health in its calculation. The prices of these items typically adjust less frequently and saw a delayed reaction to the earlier cost surges.

Chart 10

Indicators of underlying inflation

Most indicators of pipeline pressures continued to ease as the cumulative effects of past shocks dissipated further (Chart 11). At the early stages of the pricing chain, producer price inflation for energy, which has been negative since March 2023, edged up to -14.7% in April from -20.3% in March. The annual growth rate of producer prices for domestic sales of intermediate goods also remained negative (-3.9% in April, up from -4.8% in March). The same holds for import price inflation for intermediate goods (-3.5% in April, after -5.4% in March). Meanwhile, at the later stages of the pricing chain, domestic producer price inflation for durable consumer goods stabilised to 1.0% in March and April, after 1.1% in February. The corresponding annual growth rate of import prices stood at 0.2% in April and March, following zero growth in February. Further easing of accumulated pipeline pressures was also observed for producer price inflation for non-durable goods, which declined further in April to 0.9%. The annual growth rate of import prices for non-durable goods showed zero growth in April, after -1.3% in March. Non-durable consumer goods include food products, which initially recorded a faster decline in their annual rates of producer price change than non-food goods. More recently, however, food product prices have converged towards non-food goods in terms of the speed of unwinding.

Chart 11

Indicators of pipeline pressures

The latest data available at the time of the review suggest that domestic cost pressures, as measured by growth in the GDP deflator, have started to ease. The annual growth rate of the GDP deflator decreased to 5.1% in the fourth quarter of 2023, down from 6.0% in the previous quarter, owing to a smaller contribution from unit profits and labour costs (Chart 12). The reduced impact from unit labour costs stemmed from slightly less negative growth in labour productivity and a decline in wage growth, measured in terms of compensation per employee, which fell from 5.3% in the third quarter to 4.9% in the last quarter of 2023.[10] Similarly, wage growth measured in terms of compensation per hour decreased to 4.7% in the fourth quarter from 5.1% in the third quarter. These downward pressures from unit profits and labour costs were partly offset by a larger contribution from unit net taxes, owing to an increase in unit taxes and a more negative growth rate for unit subsidies. Meanwhile, negotiated wage growth increased to 4.7% in the first quarter of the year, after having decreased slightly to 4.5% in the fourth quarter of 2023. This increase reflected both the gradual adjustment of wages to past inflation shocks and tight labour markets. Nevertheless, data on the latest wage agreements point to an ongoing gradual easing of wage pressures, though these are likely to remain at relatively high levels for the remainder of 2024.[11] Annual growth in compensation per employee for 2024 is projected to stand at 4.8% on average. However, it is then expected to continue to moderate over the projection horizon, albeit remaining above historical levels owing to still tight labour markets, inflation compensation and increases in minimum wages.

Chart 12

Breakdown of the GDP deflator

Survey-based indicators of longer-term inflation expectations and market-based measures of inflation compensation remained broadly unchanged, with most standing at around 2% (Chart 13). In both the ECB Survey of Professional Forecasters for the second quarter of 2024 and the June 2024 ECB Survey of Monetary Analysts, average longer-term inflation expectations (for 2028) stood at 2.0%. Market-based measures of inflation compensation (based on the HICP excluding tobacco) at the longer end of the yield curve remained broadly unchanged, with the five-year forward inflation-linked swap rate five years ahead standing at around 2.3%, markedly lower than the multi-year peak reached in early August 2023. It should, however, be noted that these market-based measures of inflation compensation are not a direct gauge of the genuine inflation expectations of market participants, as these measures include inflation risk premia. Model-based estimates of genuine inflation expectations, excluding inflation risk premia, indicate that market participants expect inflation to be around 2% in the longer term. Market-based measures of near-term euro area inflation outcomes suggest that investors expect inflation to decline further in 2024, standing on average at 2.1% in the second half of the year. The one-year forward inflation-linked swap rate one year ahead was broadly unchanged over the review period, standing at 2.2%. On the consumer side, inflation expectations have moderated slightly overall. The ECB's Consumer Expectations Survey for April 2024 reported that median expectations for headline inflation over the next year stand at 2.9%, compared with 3.0% in March, while inflation expectations for three years ahead decreased to 2.4% from 2.5% in March.

Chart 13

Market-based measures of inflation compensation and consumer inflation expectations

The June 2024 Eurosystem staff macroeconomic projections expect headline inflation to moderate further, from 2.5% in 2024 to 2.2% in 2025 and 1.9% in 2026 (Chart 14).[12] This moderation reflects the continued fading of pipeline pressures as well as the impact of monetary policy tightening. This is supported by weaker growth of labour costs and the fading effects of the energy crisis. Compared with the March 2024 projections, the projections for headline inflation have been revised upwards for 2024 and 2025, by 0.2 percentage points for both years, mainly owing to base effects arising from energy inflation and the withdrawal of the energy-related fiscal measures. HICPX inflation is projected to ease further in the coming years and to average 2.8% in 2024, 2.2% in 2025 and 2.0% in 2026. Compared with the March 2024 projections, HICPX inflation has been revised upwards for 2024 and 2025, by 0.2 and 0.1 percentage points respectively.

Chart 14

Euro area HICP and HICPX inflation

4 Financial market developments

During the review period from 7 March to 5 June 2024 the focus in euro area financial markets remained on the pace of disinflation and its implications for the timing and extent of possible monetary policy rate cuts. Short-term risk-free rates shifted upwards for all but the most near-term maturities as market participants internalised macroeconomic surprises on both sides of the Atlantic, which resulted in a moderation intheir expectations of monetary policy easing. The short end of the euro short-term rate (€STR) forward curve was little changed, almost fully pricing in an initial interest rate cut of 25 basis points at the June Governing Council meeting. By contrast, market pricing of rate cuts in the remainder of the year declined to 65 basis points of cumulative cuts. The forward curve signals that the easing cycle is priced to level off at between 2% and 2.5% by the end of 2026. Longer-term risk-free rates also moved slightly higher, with sovereign bond yields moving broadly in line with risk-free rates. There was also little change in sovereign spreads over the overnight index swap (OIS) rate as strong bond issuances continued to be well absorbed by investors. Euro area stock prices rose further, supported by improved earnings expectations and strong risk appetite, despite still-elevated geopolitical tensions. Finally, in foreign exchange markets the euro appreciated slightly in trade-weighted terms but was broadly stable against the US dollar.

The OIS forward curve has shifted upwards since the March Governing Council meeting in the context of a moderation in market participants' expectations of rate cuts for 2024 (Chart 15). The benchmark euro short-term rate (€STR) remained stable at 3.9% over the review period, reflecting the unchanged deposit facility rate, which the Governing Council has kept at 4% since the monetary policy meeting in September 2023. Excess liquidity decreased by around €302 billion from 7 March to 4 June to stand at €3,198 billion. This mainly reflected repayments in March of the third series of targeted longer-term refinancing operations (TLTRO III) and, to a lesser degree, the decline in the asset purchase programme (APP) portfolio, as the Eurosystem no longer reinvests the principal payments from maturing securities in this portfolio. The short end of the €STR-based OIS forward curve was almost fully pricing in an initial rate cut of 25 basis points at the June meeting. By contrast, forward rates associated with subsequent Governing Council meetings have increased since the March meeting. This movement indicates that market participants expect subsequent policy rate cuts over the remainder of the year to be fewer and later than previously expected. Overall, the forward curve moved from pricing in, in March, around 100 basis points of cumulative cuts in the course of 2024, to pricing in around 65 basis points of cumulative cuts.

Chart 15

€STR forward rates

Euro area long-term risk-free rates edged up, albeit by less than their US counterparts (Chart 16). Long-term risk-free rates rose substantially in the first half of the review period, mainly driven by the reassessment of the US interest rate outlook, before declining moderately. The ten-year euro OIS rate increased by 30 basis points up to the end of April and ended the review period at around 2.6%, 16 basis points above the level at the time of the March meeting. In the United States, long-term risk-free rates generally fluctuated more significantly and rose more noticeably during the review period, particularly on days of releases of consumer price index (CPI) data. The ten-year US Treasury yield increased by 19 basis points to 4.3%, leaving the differential between long-term risk-free rates in the euro area and the United States approximately unchanged. The UK sovereign bond yield rose by 19 basis points to 4.2%.

Chart 16

Ten-year sovereign bond yields and the ten-year OIS rate based on the €STR

Euro area sovereign bond yields moved broadly in line with risk-free rates, leaving sovereign spreads little changed (Chart 17). At the end of the review period, the ten-year GDP-weighted euro area sovereign bond yield stood about 24 basis points higher at around 3.04%, leading to only a slight increase of 5 basis points in its spread over the OIS rate based on the €STR. Sovereign spreads across countries, including those for lower-rated euro area countries, moved little over the review period. The review period was marked by resilience in the sovereign bond market, where exceptionally strong issuances were well absorbed by the buoyant demand of investors seeking to lock in yields in anticipation of an impending cycle of policy rate cuts.

Chart 17

Ten-year euro area sovereign bond spreads vis-à-vis the ten-year OIS rate based on the €STR

Spreads of high-yield corporate bonds showed some modest decreases amid strong overall risk appetite. Over the review period, spreads on high-yield corporate bonds declined by 14 basis points, with the spreads of financial corporations decreasing by 23 basis points, while spreads of non-financial corporations (NFCs) declined by 12 basis points. Spreads on investment-grade corporate bonds fluctuated moderately, standing 8 basis points lower at the end of the review period. Spreads on the better-rated part of the high-yield segment (B-BB) continue to stand well below their historical median, despite a rise in expected default frequencies in this market segment in recent months. The resilience of the euro area corporate sector has helped to contain bond funding costs.

Euro area equity prices increased somewhat further despite elevated macroeconomic uncertainty and higher discount rates (Chart 18). Broad stock market indices in both the euro area and the United States increased further over the review period, even though geopolitical tensions remained elevated. The euro area and US indices increased by around 2.5% and 3.8% respectively. Euro area equity prices were supported by lower equity risk premia and higher short and long-term earnings expectations, which more than offset the impact of higher discount rates. NFC equity prices in the euro area and the United States increased over the review period by 0.9% and 3.6% respectively. Euro area bank equity prices, which increased by 12.4%, continued to outperform their US counterparts, which recorded a 4.5% increase.

Chart 18

Euro area and US equity price indices

In foreign exchange markets, the euro appreciated slightly in trade-weighted terms but was broadly stable against the US dollar (Chart 19). During the review period, the nominal effective exchange rate of the euro - as measured against the currencies of 41 of the euro area's most important trading partners - appreciated by 0.5%. The slight appreciation of the euro was mostly driven by gains against the currencies of several advanced economies. It appreciated by 5.2% against the Japanese yen, 1.3% against the Swiss franc, 1.2% against the Swedish krona and 1.1% against the Canadian dollar. These developments mainly reflected heterogeneous monetary policy developments. For example, the Swiss National Bank cut interest rates by 25 basis points to 1.5% in March, the Sveriges Riksbank cut its key interest rate from 4.00% to 3.75% at its May meeting, and the Bank of Canada cut its interest rate by 25 basis points to 4.75% on 5 June. The euro depreciated by 0.4% against the pound sterling as market participants pushed back their expectations regarding the timing of potential policy rate cuts by the Bank of England. The euro remained relatively stable against the US dollar (-0.2%), despite some intra-period fluctuations.

Chart 19

Changes in the exchange rate of the euro vis-à-vis selected currencies

5 Financing conditions and credit developments

In April 2024 composite euro area bank funding costs and bank lending rates remained stable at high levels. The cost to non-financial corporations (NFCs) of market-based debt and equity financing increased over the period from 7 March to 5 June 2024. In April bank lending to firms and households stabilised at low levels, reflecting high lending rates, weak economic growth, and tight credit standards. The annual growth rate of broad money (M3) continued its gradual recovery, driven by sizeable net foreign inflows.

Euro area bank funding costs remained high by historical standards. As the funding composition continued to shift to more expensive sources, bank funding costs remained elevated. In April 2024 the composite funding cost of debt financing for euro area banks was unchanged from March, standing at 2.07% (Chart 20, panel a). Bank bond yields increased slightly in April and aggregate deposit rates, which account for the largest share of bank funding costs, saw no change (Chart 20, panel b). This development masks considerable cross-country heterogeneity and variation across instruments and sectors. Rates on overnight deposits remained stable in April, while rates on time deposits up to 2 years fell, resulting in a slight narrowing of the large spread between the two. Rates on deposits redeemable at a period of notice of up to three months edged up, however.

Chart 20

Composite bank funding costs in selected euro area countries

In April 2024 lending rates for firms and for housing loans remained stable at high levels. In April lending rates for firms saw no change, standing at 5.18%, and were only slightly below the peak of 5.27% reached in October 2023 (Chart 21), amid heterogeneity across euro area countries and maturities. On the back of the inverted yield curve, rates on loans with longer interest rate fixation periods continued to be lower than those with short fixation periods. The spread between interest rates on small and large loans to euro area firms narrowed further in April to 0.23 percentage points, which is the lowest level since the pandemic, reflecting lower rates on small loans and unchanged rates on large loans. After four consecutive declines, lending rates on new loans to households for house purchase saw no change, standing at 3.80% in April and below the high of 4.02% seen in November 2023 (Chart 21). This stabilisation was broad-based across maturity segments. In April bank rates on new loans to households for consumption increased slightly from their March level and amid volatility, while there was a small decrease for loans to sole proprietors.

Chart 21

Composite bank lending rates for NFCs and households in selected countries

Over the period from 7 March to 5 June 2024, the cost of market-based debt and equity financing to NFCs increased. Based on the available monthly data, the overall cost of financing for NFCs - i.e. the composite cost of bank borrowing, market-based debt and equity - stood at 6.2% in April, 20 basis points higher than the level in March but still lower than the multi-year high reached in October 2023 (Chart 22).[13] All components contributed to the increase in the overall cost index, other than the cost of short-term loans, which remained broadly unchanged. The daily data on the cost of market-based debt and equity financing show an increase in both indicators over the period from 7 March to 5 June 2024. The cost of market-based debt edged up, given that the rise in the risk-free interest rate - as approximated by the ten-year overnight index swap rate - was not offset by the compression of spreads on bonds issued by NFCs in both the investment grade and high yield segments. Likewise, the cost of equity financing increased over the same period, reflecting the higher risk-free rate that outweighed the marginally lower equity risk premium (Section 4).

Chart 22

Nominal cost of external financing for euro area NFCs, broken down by component

In April 2024 the annual growth rate of bank lending to firms and households remained virtually at zero, reflecting high lending rates, weak economic growth and tight credit standards. Annual growth in loans to NFCs saw a slight decline to 0.3% in April, down from 0.4% in March (Chart 23, panel a). The annual growth rate of loans to households remained unchanged at 0.2% in April (Chart 23, panel b). While consumer loans remained resilient, housing loans showed slightly positive growth and loans to sole proprietors continued to have negative growth rates. The ECB's Consumer Expectations Survey in April 2024 showed that a still large, but declining, net percentage of survey respondents had the impression that credit access had become harder over the previous 12 months and expected it to become even more difficult over the next 12 months. The ongoing weakness in loan growth reflects the stagnant lending dynamics observed since the beginning of 2023, on the back of weak aggregate demand, tight credit standards and the impact of restrictive monetary policy on lending rates.

Chart 23

MFI loans in selected euro area countries

Net external financing of euro area firms was subdued in the first quarter of 2024 and in April. Net external financing flows continued to be small compared with historical averages (Chart 24). This development is explained by the low levels of debt securities issuance by firms and of borrowing from banks, given that economic activity remained weak and policy rates are restrictive. The strong decline in the volume of short-term loans was consistent with lower working capital needs and with the increase in the stock of finished products seen in mid-2023, while loan flows for longer-term maturities also remained weak, amid muted demand for investment. At the same time, the issuance of listed shares picked up slightly in March and April, but remained low overall.

Chart 24

Net external financing flows for euro area NFCs

Firms and households recorded a further increase in time deposits, amid signs of a slowing of the ongoing reallocation to time deposits in April 2024.The annual growth rate of overnight deposits contracted at a slowing pace of -7.0% in April, after having fallen to -7.5% in March (Chart 25). The ongoing preference among firms and households for holding time deposits and marketable instruments is still explained by the remuneration being higher than on overnight deposits.[14] While deposit flows are still significantly more tilted towards time deposits than in the past, this reallocation is losing steam, with the spread between the returns on both instruments stabilising. Firms' deposit allocation is moving closer to a level that is more in line with historical patterns, and household overnight deposits saw the first positive monthly inflow since September 2022. High short-term interest rates continued to support strong growth of money market funds.

Chart 25

M3, M1 and overnight deposits

The annual growth rate of broad money (M3) continued its gradual recovery in April 2024, driven by another sizeable net foreign inflow. Money growth has been gradually increasing over recent months, even though loans to households and firms remained weak. In April M3 growth in the euro area increased to 1.3%, up from 0.9% in March (Chart 20). Annual growth of narrow money (M1) - which comprises the most liquid assets of M3 - stayed in negative territory, but increased further, rising to -6.0% in April compared with -6.6% in March. In April money creation was driven by a large foreign inflow, amid the ongoing current account surplus from weak imports, and was supported by a large net issuance of euro area governments bonds. These inflows were partially offset by the continuing contraction of the Eurosystem balance sheet, while the contribution of lending to firms and households continued to be muted.

6 Fiscal developments

According to the June 2024 Eurosystem staff macroeconomic projections, the euro area general government budget deficit, which stood at 3.6% of GDP in 2023, should decline to 3.1% of GDP in 2024 and then fall gradually to 2.8 in 2025 and 2.6% in 2026. The euro area fiscal stance is projected to tighten significantly in 2024 and somewhat further in the subsequent two years. The tightening in 2024 mostly reflects expectations that governments will largely phase out their energy and inflation-related support measures. This factor will also marginally contribute to the tightening of the fiscal stance in 2025, while somewhat slower expenditure growth and additional consolidation measures on the revenue side in some countries add to the projected slight additional tightening over 2025-2026. The euro area debt-to-GDP ratio is projected to broadly stabilise at an elevated level of around 89% as a result of continued primary deficits and positive deficit-debt adjustments compensated by shrinking but still negative interest rate-growth differentials. It will now be important for governments to implement the EU's revised economic governance framework fully and without delay to bring down budget deficits and debt ratios on a sustained basis. At the same time, an effective and rapid implementation of the Next Generation EU (NGEU) programme is crucial in fostering innovation and increasing investment in the green and digital transitions.

According to the June 2024 Eurosystem staff macroeconomic projections, the euro area general government budget balance will improve moderately over the projection horizon (Chart 26).[15] Looking back, the euro area budget deficit declined very marginally from 3.7% in 2022 to 3.6% of GDP in 2023. Looking forward, the deficit should decline more significantly to 3.1% of GDP in 2024 and then further to 2.8% of GDP in 2025 and to 2.6% of GDP in 2026. The projected path mainly reflects a gradually shrinking but still negative cyclically adjusted primary balance over the forecast horizon, with the largest reduction occurring in 2024. This impact will, however, be partly compensated by gradually increasing interest expenditures over the whole period, reflecting a slow pass-through of past interest rate increases given long sovereign debt residual maturities. The significant fall in the cyclically adjusted primary deficit in 2024 is largely driven by the significant scaling back of government fiscal support measures as the energy shock and high overall consumer price inflation fades.

Chart 26

Budget balance and its components

Compared with the March 2024 ECB staff macroeconomic projections, the budget deficit in 2023 turned out to be 0.4 percentage points higher. This surprise was, at the euro area level, driven mainly by higher-than-anticipated primary expenditure growth. Moreover, it is estimated that the more adverse outcome will also spill over into 2024, with a downward revision of the budget balance of 0.2 percentage points on account of a lower primary balance. While revisions to the budget balance and its components are negligible for 2025, an upward revision of 0.2 percentage points is foreseen for 2026 owing to an improving primary balance.

The euro area fiscal stance is projected to tighten significantly in 2024 and somewhat more in the subsequent two years.[16] The annual change in the cyclically adjusted primary balance, adjusted for grants extended to countries under the NGEU programme, points to a significant tightening of fiscal policies in the euro area in 2024 (of 0.7 percentage points of GDP). This mostly reflects expectations that governments will largely phase out energy and inflation-related support measures. This effect will also marginally contribute to the tightening of the stance in 2025 in conjunction with an increase in tax and social security contributions as well as slower growth in fiscal transfers. This tightening is projected to be only partly offset by weak government investment growth. A further tightening of the fiscal stance in 2026 is mostly on account of declining subsidies and other fiscal transfers. The total tightening of the fiscal stance over the 2024 - 2026 horizon amounts to 1.3 percentage points of GDP.

The euro area debt-to-GDP ratio is projected to remain elevated and stable at around 88.5% over the whole projection horizon (Chart 27). During the pandemic, the debt ratio increased significantly to around 97% in 2020 but has gradually fallen since. However, this improving trend seems to have ceased. Instead, the debt ratio is expected to remain rather stable over the forecast horizon, with a marginal increase in 2025 driven by primary deficits and expected positive deficit-debt adjustments, which are compensated by shrinking but still negative interest rate-growth differentials.

Chart 27

Drivers of change in euro area government debt

Implementing the EU's revised economic governance framework fully and without delay will be crucial to help governments bring down budget deficits and debt ratios on a sustained basis. Such a consolidation of public finances, designed in a growth-friendly manner, will be necessary over the coming years against the background of a period when fiscal policies had to counter repeated economic shocks. At the same time, an effective and speedy implementation of the NGEU programme is crucial in fostering innovation, boosting potential growth, and increasing investment in the green and digital transitions. This is because, as was highlighted by the Commission in its mid-term evaluation of the Recovery and Resilience Facility (RRF), there have to date been delays in disbursements and investments under the programme, leading to a significantly lower positive growth impact than anticipated at the outset.

Boxes

1 The post-pandemic recovery - why is the euro area growing more slowly than the United States?

Prepared by Malin Andersson, Cristina Checherita-Westphal, António Dias Da Silva and Michel Soudan

Real GDP growth has been notably weaker in the euro area than in the United States since the start of the pandemic.[17] Between the fourth quarter of 2019 and the fourth quarter of 2023, the euro area economy grew by around 3% in cumulative terms, while real GDP in the United States rose by more than 8% (Chart A), resulting in a cumulative growth differential of around 5 percentage points.[18] This gap is primarily attributable to weaker private consumption in the euro area than in the United States, where direct income support and a relatively larger reduction in excess savings provided a particularly strong boost. The euro area suffered a substantial terms-of-trade shock after the invasion of Ukraine sparked an energy crisis. While there is mixed evidence of the relative size of monetary policy impacts across these two regions, fiscal policy support may have been stronger in the United States relative to the intensity of the various shocks, albeit different reporting conventions make comparisons harder to draw. This box examines these and other contributing factors; it does not assess the diverging underlying structural growth trends prior to the pandemic.[19]

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2 Insights from earnings calls - what can we learn from corporate risk perceptions and sentiment?

Prepared by Malin Andersson, Juliette Guillotin and Pedro Neves

This box evaluates perceived risks and sentiment using evidence from corporate earnings calls.[20] Using textual analysis of earnings calls conducted by large euro area firms, this box derives timely measures of corporate perceptions of specific risks, as well as indices of demand and supply sentiment. Such analysis is particularly informative when assessing how firms perceive the repercussions of severe global shocks.

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3 Higher profit margins have helped firms hoard labour

Prepared by Vasco Botelho

The ECB's labour hoarding indicator measures the share of firms that have not reduced their workforce despite a worsening of their firm-specific outlook. This indicator is constructed for the first time using the ECB and European Commission Survey on the Access to Finance of Enterprises (SAFE) in the euro area. The labour hoarding indicator can be decomposed into two margins: an "activity margin", which captures the share of firms that have faced a deterioration in their specific outlook, and an "employment margin", indicating the share of firms that have not reduced their workforce despite reporting a deterioration in their outlook. The activity margin depicts to what extent adverse shocks affect the outlook of firms in the euro area, while the employment margin reflects firms' ability to hold on to their workforce while facing an adverse shock.[21]

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4 Drivers of employment growth in the euro area after the pandemic - a model-based perspective

Prepared by Agostino Consolo and Claudia Foroni

The adjustment in real wages has been key in supporting post-pandemic employment growth in the euro area. This box looks at developments in employment growth after the end of the pandemic, focusing on the period since early 2022. The strong growth of employment compared with economic activity has been remarkable in an economic environment characterised by very high energy prices. The adjustment mechanism was different from that seen following the 1970s energy crisis, when real wages increased substantially and outpaced productivity growth. By contrast, since early 2022, real wages have fallen more than productivity, providing firms with leeway in their margins and thus helping to sustain job creation amid a scarcity of skilled labour. The following empirical analysis sheds light on the key drivers behind recent employment growth.

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5 Will the euro area car sector recover?

Prepared by Roberto A. De Santis, Virginia Di Nino, Nina Furbach, Ulla Neumann and Pedro Neves

The automotive industry contributes a significant share to the value added of the euro area economy. The share of the car industry in the manufacturing sector's real value added amounts to 10% and the share in real GDP is slightly below 2%. The car industry accounts for 1% of total euro area employment and 4% of extra-euro area exports. When inter-sectoral linkages are taken into account, the value added almost doubles, highlighting the sector's extensive reach within the economy.[22] The resilience of the industry can be seen from its historical performance compared with aggregate GDP. Apart from during the global financial crisis and the most recent period, the sector had been expanding by more than aggregate GDP, reaching a peak in early 2018. Moreover, the sector has maintained a relatively stable share of total euro area employment since 2012 (Chart A).

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6 Profit indicators for inflation analysis considering the role of total costs

Prepared by Elke Hahn and Théodore Renault

Standard indicators of profits in the economy which are derived from national accounts use GDP rather than economic output as a benchmark. While "output" is often used as a synonym for GDP, national accounts make a distinction between the two. Output, unlike GDP, includes intermediate consumption, i.e. the consumption of goods and services used in the generation of GDP or the related concept of "value added".[23] "Output" is a well-defined concept, but the quarterly national accounts do not contain timely data on output for the euro area.[24] The standard national accounts profit indicators based on GDP hence allow profit developments - measured in terms of gross operating surplus and mixed income - to be assessed in relation to labour costs but not in relation to total costs. These indicators are therefore useful for assessing how profits are currently buffering rising labour costs, but do not show precisely how this has been hampered or facilitated by developments in costs for intermediate inputs such as energy. Such insights would be provided by profit indicators based on output.

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7 Liquidity conditions and monetary policy operations from 31 January to 16 April 2024

Prepared by Juliane Kinsele and Vagia Iskaki

This box describes liquidity conditions and the Eurosystem monetary policy operations during the first and second reserve maintenance periods of 2024. Together, these two maintenance periods ran from 31 January to 16 April 2024 (the "review period").

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8 Credit risk and bank lending conditions

Prepared by Francesca Barbiero and Maria Dimou

Credit risk has been gradually increasing in recent quarters, but has not reached the levels of deterioration implied by headline measures of bank credit risk based on historical regularities, given a weak economic outlook for the euro area, higher interest rates and rising numbers of bankruptcies. Both non-performing loan ratios and broader measures of credit risk, such as early arrears and underperforming (Stage 2) loans, have been steadily increasing in recent quarters, with some heterogeneity across countries resulting from, for instance, different exposures to more interest rate sensitive sectors like commercial real estate. However, the increase has remained contained overall.[25] In addition, probabilities of default on banks' balance sheet exposures have barely moved up since the start of the recent monetary policy tightening cycle, despite an increased interest rate burden and a worsened economic outlook.[26] In general, reported default frequencies are below the levels that might be expected based on historical regularities, given the current macroeconomic outlook.[27]

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Articles

1 Sectoral dynamics and the business cycle in the euro area

Prepared by Niccolò Battistini and Johannes Gareis

Sectoral dynamics are key to understanding the business cycle in two ways. First, sectors are an important source of aggregate fluctuations. For example, an individual sector may experience unexpected changes, or shocks, in its production processes, including severe disruptions to its supply chains. Recent examples of this include the semiconductor shortage that hit the automotive sector or the difficulties the transport sector had in sourcing labour.[28] Second, sectors play a prominent role in the propagation of shocks to overall economic activity. Indeed, different sectors interact through a network of input-output linkages, which in turn connect the primary inputs of production, such as labour and capital, to the final uses of goods and services, such as consumption and investment. Taken together, these interconnections shape the sectoral structure of the economy and affect how different sectors respond to shocks and propagate them to the business cycle.[29]

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2 Longer-term challenges for fiscal policy in the euro area

Prepared by Edmund Moshammer

In the future, various longer-term challenges are likely to exert pressure on public finances in the euro area. On top of the existing fiscal burdens - as reflected in the high debt ratios in a number of euro area countries, which were exacerbated by the pandemic and the subsequent energy crisis - there are several important longer-term challenges for fiscal dynamics. This article starts by reviewing some of the most important challenges and discussing their fiscal relevance, with a focus on demographic ageing (Section 2), the end of the "peace dividend" (Section 3), digitalisation (Section 4) and climate change (Section 5). Acknowledging the uncertainties surrounding any quantification of these challenges, Section 6 then presents some tentative - purely indicative - estimates of the additional fiscal effort that could be required to ensure the long-term sustainability of public finances in the presence of such developments. The implications of digitalisation are excluded from that exercise, given the particular uncertainty that surrounds their quantification. Section 7 then provides some concluding remarks.

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https://www.ecb.europa.eu/pub/pdf/ecbu/ecb.eb_annex202404~c592526f18.en.pdf

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