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Eurozone recovery on track, policy support remains essential

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Eurozone recovery on track, policy support remains essential

The eurozone economy is recovering from the pandemic and inflation is now consistent with the ECB’s objective, yet the outlook is still uncertain. Stefan Gerlach and GianLuigi Mandruzzato look at the prospects for monetary and fiscal policies.

Stefan Gerlach
Stefan Gerlach

The news from the eurozone economy is encouraging, as evidenced by PMI surveys and the EU Commission’s Economic Sentiment Index reaching their highest levels in several years. The EU Commission raised its GDP growth forecasts to 4.3% in 2021 and 4.4% in 2022 from the 3.8% in both years expected in January. Despite the improved outlook, differences in economic performance among eurozone member countries are evident. Economies in the “core” and in Eastern Europe will close the pandemic-induced activity gap faster than those in the “periphery”. This disparity highlights the importance of the Next Generation EU plan, including the Recovery and Resilience Plan, in reducing growth differentials.

Looking forward, the eurozone will benefit indirectly from the Biden administration’s fiscal stimulus in the USA and from solid growth in China. Demand from eurozone’s export markets will grow in excess of 7% on average in 2021-22, driving exports and fixed investments. The outlook for private consumption hinges on how households will dispose of the savings accumulated since the start of the pandemic.

Turning to fiscal policy, the EU Commission estimates that the fiscal impulse will be close to 3% of GDP in 2021, a slight increase from last year. Based on current legislation, fiscal policy is expected to be less expansionary in 2022, i.e. the public deficit will be smaller. The EU Commission has recently announced that the Stability and Growth Pact will remain suspended in 2022 as downside risks to growth remain.

Regarding monetary policy, eurozone inflation pressures have been rising and so there have been calls for the European Central Bank to consider when and how to reduce policy accommodation. However, two considerations urge caution. First, the jump in annual headline inflation from -0.3% in December 2020 to 0.9% in January 2021 was disproportionally impacted by the surge of headline inflation in Germany from -0.7% to 1.6%, amplified by a number of one-off factors. Second, forecasts suggest that HICP annual inflation is evolving much as expected after January.

The ECB has made clear it will look through the current temporary rise in inflation as it aims at maintaining a high degree of accommodation until it is confident that inflation, including core inflation, is “robustly” converging towards the objective of "below, but close to, 2%". Furthermore, a major shift in ECB policy seems unlikely before the outcome of the ECB's strategy review has been announced. Most obviously, if that leads to the adoption of compensation mechanisms for the low inflation of recent years, any plans for a substantial tapering of bond purchases are likely to be delayed.

In the meantime, the Governing Council will seek to ensure the "favourable financing conditions" necessary to promote recovery. The role of the PEPP therefore remains central and the barometer of the ECB's monetary policy stance is the pace of weekly bond purchases. The measure was only partially successful, at least judging by the moderate increase of eurozone government spreads and German bond yields relative to the US. However, it seems likely that the Governing Council will reiterate its commitment to keep PEPP purchases high also in the coming months to consolidate the economic recovery.

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