Frederik Ducrozet & Axel Roserens, Pictet Wealth Management

As if the economic situation facing the euro area were not challenging enough, gas and electricity prices have skyrocketed to new highs in recent days. With no end in sight to the Russian war in Ukraine, there is no point in trying to forecast energy costs on a daily basis. But one thing is clear: a recession in Europe looks all but inevitable, and the only question is how long and how severe it will be.

Although hard data so far have been more resilient than expected, forward-leading indicators for the euro area are deteriorating at an alarming pace. We have therefore marked down our euro area real GDP forecasts to incorporate a deeper (but brief) recession than previously foreseen, potentially around the turn of the year. Overall, we now expect annual GDP growth in the euro area to fall from 2.9% in 2022 to 0% in 2023. We have yet to see the peak in euro area inflation. Headline inflation is likely to top 10% by Q4 2022, increasing the risk that core inflation will also stay higher for longer, hovering around 4% going into next year.

National governments will likely implement new support measures to mitigate the impact of the energy shock on real incomes. But while public spending will surely continue to rise as the shock hits real incomes, there are several reasons to believe that a gigantic, pandemic-like policy response is unlikely this time—or that we will see a centralised European response involving debt mutualisation for that matter. Most importantly, high inflation could well reduce governments’ appetite for bolder fiscal support.

The European Central Bank (ECB) has no choice but to commit to faster monetary tightening as long as inflation keeps rising. The latest policy signals from Jackson Hole suggest that the ECB is placing more weight on actual inflation than on its own staff projections, making a 75bp hike more likely in September. However, policy normalisation will be bumpy, and a ‘stop-and-go’ approach looks increasingly possible. This means the ECB could pause when recession hits by the turn of the year but could resume hiking rates once the economy recovers in 2023. We still forecast a terminal deposit rate of 1.50% in 2023.