In our Global Outlook, Autumn 2024, we argued that the euro area was much more likely than the US to go ‘Back to BC (before COVID)’, with interest rates, inflation and economic growth rates converging more rapidly towards their pre-pandemic levels. Emerging data since we put that forecast together do not challenge this view.
One of the key characteristics of the pre-pandemic economic environment was real (inflation-adjusted) interest rates in negative territory. Rates went even further below zero during COVID as inflation rose, forcing a synchronised policy-tightening by major central banks. However, as the chart below shows, the expected real interest rate over the coming two years, implied by financial market pricing, never rose as much in the euro area as it did in the UK or US. Moreover, that figure has been trending down.
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We can decompose the implied real interest rate into expectations about both interest rates and inflation. As the chart below shows, investors expect that the period of above-target inflation is now mostly in the rearview mirror. Admittedly, this reflects geopolitical status quo – and does not fully reflect a severe escalation to tensions in the Middle East that could push up global crude prices substantially. For the moment, however, investors expect that price increases over the coming quarters will be consistent with the European Central Bank’s (ECB) 2% target. That decline in inflation expectations helped to push the expected interest rate over the next two years down by around 40 basis points in September. As recently as this week Christine Lagarde, the ECB president, said recent developments “strengthen our confidence that inflation will return to target in a timely manner”.
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The decline in both inflation and interest-rate expectations reflects a more subdued growth outlook for the currency bloc. The euro area composite PMI for September came in at 49.6, which was a little higher than the consensus expectation for a 48.9 figure. That was aided by a better-than-expected services reading of 51.4 (Reuters poll: 50.5). The manufacturing sub-index, meanwhile, was 45.0, which is well below the 50 threshold that separates contraction from expansion. That level is consistent with Fathom’s view, where GDP growth in the coming year remains positive but subdued.
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A major difference that we identify between the euro area and US is in fiscal policy. The US continues to run large deficits, even with an historically low unemployment rate and solid growth. There is little time for what is seen as profligate fiscal policy in the euro area. As the chart below shows, the US primary balance (as a per cent of GDP) expanded by more during the pandemic than in the euro area. Looking forward, France is alone among the major euro area economies in expecting to run a primary deficit in the same range as the US in future. And Paris is coming under pressure to do more to reduce spending or increase taxes. Michel Barnier, recently installed as France’s Prime Minister, released plans on that front this week.
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A policy backdrop that includes less active fiscal policy is one reason that inflation and interest-rate expectations are normalising more quickly in the euro area. Fathom would echo the recent call from Mario Draghi, the former ECB president, arguing for co-ordinated borrowing to fund a large, euro area-wide investment drive. Fathom has long argued that government borrowing should be separated between current and capital spending. Increased debt that is well targeted, including to fund R&D, would be pro-growth and eventually pay for itself. For the moment, however, there seems to be little consensus to move forward with such a plan among member states. As a result, euro area governments can look forward to lower inflation and lower interest rates. However, they may not look so favourably on the lower economic growth rates that are likely to accompany it.
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The views expressed in this article are the views of the author, not necessarily those of LSEG.
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