Spring 2023 Economic Forecast: An improved outlook amid persistent challenges

Remarks by EU Commissioner Gentiloni at the press conference on the Spring 2023 Economic Forecast

Brussels, 15 May 2023
Let me begin with the five key messages emerging from this forecast:

First, the EU economy has avoided a recession. It expanded in the first quarter and is set to continue growing moderately.

Second, the key factors underpinning this forecast go in opposite directions: on the one hand, declining energy prices and a resilient labour market and, on the other hand, tightening financial conditions.

Third, headline inflation is declining rapidly, but core inflation (headline inflation excluding more volatile energy and unprocessed food components) remains high.

Fourth, government deficit and debt ratios continue declining.

Fifth, the balance of risks has tilted back to the negative side.

Finally, let me welcome the inclusion in this forecast for the first time of sections on the new candidate countries, namely Ukraine, Moldova and Bosnia and Herzegovina.

A first key positive change underpinning this forecast is the further fall in energy commodity prices.

Wholesale prices of gas and electricity in the EU have come down significantly from the peaks of last year, and continued declining even after the winter forecast. Thanks to effective diversification of supply and a sizeable fall in consumption – also supported by mild winter temperatures – the major concern for the European economy, that is a disruptive shortage of gas supply, did not materialise.

Gas prices reached 35 euros per Megawatt Hour at the end of last week, the lowest level since summer 2021. Futures prices for 2023 and 2024 have declined as well. As the EU approaches the gas-refilling season, gas storages are at comfortable levels and risks of shortages have considerably abated.

Electricity prices have declined in parallel with gas, while oil prices are expected to be decrease over the forecast horizon.

With imported energy prices rapidly falling, the trade balance for goods is set to improve and, with it, the current account surplus is set to rebound from 0.5% in 2022 to 2.3% in 2024.

In 2021 and 2022, the surge in imported energy prices resulted in a transfer of purchasing power from the EU to the rest of the world. The rapid fall of energy prices is driving a reversal of this effect, to the benefit of the domestic sectors of the economy – households, corporates and governments.

The EU economy continues to be underpinned by the strongest labour market in decades. Unemployment rates keep hitting record lows. And the participation and employment rates stayed at record high.

Despite the expected slowdown in economic activity, the labour market is set to remain strong. Continued labour market tightness, labour hoarding due to skills shortages, as well as the strong performance of the service sector are expected to keep the unemployment rate broadly stable at around the current record lows in both 2023 and 2024.

Nominal wage growth picked up in 2022, and more substantial wage increases are expected this year on the back of significant increases in minimum wages in several Member States and, more generally, pressure from workers to recoup lost purchasing power.

Still, wage growth is set to fall short of inflation again this year, while a significant recovery of real wages is expected to take place in 2024. Corporate profit margins have been on the rise since 2021, providing a potential buffer for the absorption of wage increases. The strong growth in labour costs is set to lead to a reduction in these profit margins in 2024.

Last but not least, another important tailwind for the outlook is the continued deployment of the Resilience and Recovery Facility, including REPowerEU.

Over the forecast horizon, absorption of RRF grants is set to increase from 0.3% of GDP in 2022 to around 0.4% of GDP in both 2023 and 2024. This is the average.

Over the 2021-24 period, expenditure financed by RRF grants is expected to be above 3.5% of GDP in Spain and Greece, more than 3% in Croatia and Portugal, around 2.5% in Slovakia and Italy, around 2% in Latvia, Bulgaria and Romania, close or above 1.5% in Lithuania, Poland, Hungary, Cyprus and Czechia, and more than 1% in Slovenia, Malta, Estonia, and France.

To be clear, these projections are based on the planned timeline for milestones and targets set out in the plans.

Now to turn to less positive factors. The tightening of financing conditions is set to weigh on economic activity over the forecast horizon.

The progressive firming of core inflation has set EU monetary authorities on a path of forceful tightening. Compared with our previous forecasts, market expectations point to higher rates, though markets still expect the ECB to be nearing the end of its tightening cycle. At the cut-off date of the forecast, the euro area short-term rate was expected to peak at 3.8% during the third quarter of this year, before abating in the course of 2024.

The tighter monetary conditions are feeding through the credit channel with rising borrowing costs and decelerating credit flows to both firms and households. Banks’ heightened risk perception (in particular in the aftermath of the crises experienced in the US and Switzerland) is likely also contributing to tighter lending standards. What this means is that credit is not only more expensive, but also more difficult to access. At the same time, higher interest rates are leading to a decline in loan demand.

It is important to note that the cooling of the EU credit market is a sign of an effective transmission of monetary policy normalisation, rather than a sign of weakness in the EU banking sector. Thanks to reforms implemented since the global financial crisis, EU banks have solid capital positions, robust asset quality and sufficient liquidity buffers.

In the first quarter of this year, GDP grew by 0.3% in the EU, which is slightly above the projection in our Winter Forecast. Information available at this stage for only a few countries, points to subdued consumption growth and robust investment growth, despite tighter financing conditions. Net exports contributed to growth thanks to the improvement in the terms of trade and a strong tourism performance.

For the second quarter, survey indicators suggest continued expansion, with services clearly outperforming the manufacturing sector. In particular, the energy-intensive manufacturing sectors are still reeling from the energy shock of last year. Consumer confidence has continued its recovery from last autumn’s historic low.

Overall, growth this year is set to reach 1% in the EU, and 1.1% in the euro area. So no recession, but subdued growth.

Following the weakness in the past two quarters, private consumption is set to increase moderately this year, as inflation keeps eroding households’ purchasing power.

Housing investment, which is of course particularly sensitive to interest rates, is expected to contract. By contrast, business investment is projected to still increase, though at a slower pace than last year, helped by corporates’ overall healthy balance sheet position and the roll-out of the RRF.

Net exports are expected to contribute positively to GDP, but only moderately. Weaker demand from key trading partners and a stronger euro weigh on exports. Furthermore, the rebound in economic activity expected in China is set to benefit primarily the domestic sectors, services in particular, with limited positive spillovers to the EU.

In 2024, growth is expected to gain strength. Moderating inflation, continued employment expansion and strong wage growth are projected to boost households’ real disposable incomes, leading to a rebound in private consumption. Investment is expected to be supported by the RRF, despite the delayed impact of monetary policy tightening. Stronger import growth in line with strengthening domestic demand lowers the contribution of external demand to growth. Overall annual GDP growth is projected for 2024 at 1.7% in the EU, 1.6% in the euro area.

Almost all EU economies are expected to continue growing in 2023, then experience a pickup in activity in 2024.

A few words now on the largest EU economies.

In Germany, the economy is progressively recovering after the energy price shock of last year. A rebound in industrial production and construction took place in the first quarter, but domestic demand remains sluggish. GDP is forecast to grow by a subdued 0.2% in 2023, led by net exports, before accelerating to 1.4% growth next year, led by investment and especially consumption.

In France, growth is projected at 0.7%. Investment is set to slow down on the back of tighter financial conditions, while consumption is expected to remain sluggish this year. The economy is expected to gain momentum in 2024, reaching 1.4% growth thanks mainly to higher consumption.

In Italy, real GDP growth is forecast at 1.2% in 2023. Economic activity remains supported by investments, while net exports contribute positively to growth. GDP is expected to expand at a similar rate next year, by 1.1%, thanks to a recovery in consumption, while the contribution from investments and external demand slows down.

In Spain, economic activity, which is still recovering from the pandemic slump, is expected to decelerate this year as in other EU countries. But the rate of expansion of 1.9% in 2023 remains well above the EU average, thanks to the implementation of the Recovery and Resilience Plan and a very strong labour market. The country’s economy is set to expand further, by 2%, in 2024, driven by consumption and investment.

In Poland, growth is expected to slow markedly this year as elevated inflation, tightened financing conditions and low consumer and business confidence take their toll on domestic demand. Economic activity should recover next year as inflationary pressures gradually subside and financing conditions improve. Overall, real GDP growth is forecast to slow to 0.7% in 2023, before rebounding to 2.7% in 2024.

Lastly, I mentioned earlier that this forecast for the first time covers also the new candidate countries. For Ukraine, this section gives an idea of the immense shock to the economy caused by the war, but also of the tremendous resilience it has shown. After a drop of around 29% last year, the economy is projected to grow by 0.6% this year and 4.0% in 2024. Of course these projections are subject to all the caveats you would expect in the current wartime situation.

Inflation continues to fall, thanks to rapidly declining energy prices. The euro area headline inflation fell to an average of 8% in the first quarter of 2023, down from 10% in the final quarter of last year.

However, core inflation remains persistently high, rising in March to an all-time high of 7.5% in the euro area.  According to the recent flash estimate for April (released after the cut-off date of the forecast) it declined to 7.3%, corroborating our projection that the peak in core inflation is behind us.

Looking ahead, headline inflation is set to continue slowing.

Core inflation is expected to slow more gradually, as pressures from past cost shocks wane and financing conditions tighten. However, it should remain elevated throughout the forecast horizon, reflecting the strong wage outlook.

So inflation in the euro area is still projected to decline from 8.4% in 2022 to 5.8% in 2023 and 2.8% in 2024.

Intra-EU differences in inflation rates are expected to remain very high in 2023, but to narrow considerably in 2024.

As core goods and services take over as the main inflation drivers, the wide range of inflation projections predominantly reflects differences in the outlook for core inflation. These can be attributed to different domestic conditions, and in particular wage growth.

Inflation in central and eastern Europe is still markedly higher compared to the rest of the EU.  For the most part this reflects domestic drivers, including higher wage growth and exchange rate movements.

Strong nominal GDP growth and the reduced cost of pandemic-related emergency measures supported the further reduction of the EU government deficit in 2022, to 3.4% of GDP (3.6% in the euro area) despite sizeable energy support measures.

In 2023 and especially in 2024, the gradual phasing out of energy support measures is expected to drive further deficit reductions on aggregate in the EU, to 3.1% and 2.4% of GDP, respectively (3.2% and 2.4% in the euro area).

The EU debt-to-GDP ratio fell to 85% of GDP in 2022, from the record high of 92% in 2020 during the pandemic. It is projected to decline further to below 83% of GDP in 2024, but to remain above the pre-COVID level of around 79% –  this was the 2019 figure. In the euro area, where debt peaked at 99% of GDP in 2020, it is projected to dip just below 90% by 2024.

While inflation can support the improvement in public finances in the short term, this effect is bound to dissipate over time as debt repayment costs increase and public expenditures are progressively adjusted to the higher price level.

In 2023, several Member States are still projected to see a deterioration in their general government balance. While falling energy prices are helping to contain the cost of existing support measures, many governments have introduced new measures or are extending existing ones.

In 2024, the deficit reduction is broad-based across countries, driven by the almost complete phasing out of energy support measures, currently projected for next year.

The number of countries with a deficit exceeding 3% of GDP is set to increase from 11 in 2022 to 14 in 2023, before falling again to 10 Member States in 2024, based of course on unchanged policies.

The balance of risks has tilted back to the downside. While the baseline projections for the EU economy has slightly improved since our winter forecast, downside risks have increased. So a better outlook but a balance of risks tilting to the downside.

Core price pressures could turn out more persistent if wages accelerate more than currently projected, and without adjustment in profit margins.

Higher-than-expected core inflation would lead to a stronger reaction of monetary policy, with broad macroeconomic ramifications for investment and consumption.

Risks related to the EU’s external environment remain elevated. New uncertainties following the banking sector turbulence, or related to wider geopolitical tensions, compound the long-standing concerns about the impact of rising interest rates on vulnerable emerging markets.

And of course, Russia’s war of aggression against Ukraine continues to cast a long shadow of uncertainty over the economy. This is not only a human and geopolitical problem, it is also and broadly a big economic risk.

On the positive side, more benign developments in energy prices or a faster transmission of wholesale energy price declines to consumers would lead to a faster decline in headline inflation, with positive spillovers on domestic demand.

Let me conclude by highlighting four key takeaways from today’s Spring Forecast:

First, I think we should be proud that the European economy is showing such remarkable resilience. This is no small achievement given the nature and magnitude of the shocks experienced. Management of the energy crisis, coordination of fiscal policies and impact of the RRF: all of these have contributed to a much better than expected scenario. If we look back to what we were expecting last autumn, the scenario is much better.

Second, this is no reason for complacency. Inflation  remains high. This means we must ensure that fiscal policy is consistent with our policy priorities. In the same vein, it is important to maintain the momentum in the implementation of the Recovery and Resilience Plans.

Third, the forecast illustrates remarkable country differences concerning public finance, but also growth and inflation. It is important to monitor these divergences to avoid that they become entrenched.

And finally, our forecast vindicates the more country-specific approach to fiscal surveillance that is at the centre of our proposed reforms to the EU’s fiscal rules. And this is a further incentive to reach agreement on this reform by the end of the year.