Western Europe Outlook: Economies Slip on Oil

Our Forecasts

Source: Continuum Economics

Risks to Our Views

Source: Continuum Economics

Weakening Even Before the War?

It is notable that, despite being far from similar in terms of their economies, there have been clear similarities in terms of recent real sector performances among the W Europe countries as well as clear contrasts.  For a start, there are signs that their respective economies were weaker than many had anticipated into early 2026.  Indeed, the UK and particularly Sweden have seen very weak GDP readings in the new year, despite apparently better retail sales numbers.  No such monthly GDP readings are available for Norway or Switzerland but both show signs of retailing growth ebbing.  Company credit growth is generally moving sideways save for the UK, while there seems to be general trend towards a weaker housing market in all but Switzerland. 

But perhaps the clearest are of parallels is in their respective housing markets, where price growth seems to be slipping and also in their labor markets where, in spite of a little volatility, a trend towards higher jobless rates still seem to be the order of the day.  Jobless rates can swing for several reasons, ie not just employment falling but participation rising, the latter seemingly a clear factor at play in this regard.  Either way means a looser labor market, this being a key factor why we see the Middle East conflict not causing clear and persistent second round effects via wages! But the main reason is the current monetary stances are very much different to those of the 2022 energy shock, with real policy rates very much in contrast to four years ago (Figure 1).

Figure 1: Real Policy Rates Now Much Higher?

Source: CE, %

UK: BoE Perplexed?                                                                                                          

Even without the Middle East impact we were suggesting a sub-consensus 2026 GDP picture, which now has even greater downside risks attached.  In fact, while recession may be avoided, the economy was already weak and may be even weaker ahead as the backdrop and outlook has clearly changed and we have highlighted several scenarios as to how the Middle East conflict will pan out.  But under what we consider the most likely outcome (which envisages a 4-8 week war) we see oil prices largely falling back to the pre-war levels within a year, but gas prices falling back more slowly, the latter being a key variable for the UK.  Even so, this still results in UK CPI inflation ending this year at 2.75% with an average rate of 2.8%, some 0.6 ppt higher than previously envisaged.  We are also skeptical about meaningful second round effects occurring.  Indeed, even if household inflation expectations rise afresh this is unlikely to result in higher wage pressures given the seemingly ever-looser state of the labor market and the likely squeeze on profit margins firms may now face.  Indeed, the pre-war backdrop has been soft enough already to have seemingly delivered much softer wage pressures (Figure 2) to rates consistent with the BoE inflation target.

As a result, while stressing upside risks, we have raised the 2.0% 2027 CPI projection just a notch to 2.1%. This will be a reflection of an economic backdrop where GDP growth may be as low as 0.5% this year, ie almost half the BoE’s pared-back projection made last month, though only a notch lower that projected three months ago, mainly due to a better-than-expected end-2025 base effect.  However, it now looks more likely that growth this quarter will be no better than the 0.1% q/q seen in H2 last year, less than consensus. This reflects already weak demand which we think at least partly reflect tight(er) financial conditions – this partly reflecting what we think will be continued but deferred BoE rate cuts and partly evident in what seems to be clearly cooling housing market.

Notably, the latter masks a gradual but pared-back q/q improvement through the year so that end-2026 growth is around 0.75%.  That puts the higher 2027 picture we now have with growth of 1.2% in better perspective and where the impact of both (deferred) monetary and fiscal easing is reflected but with the risks we highlight below. Regardless, uncertainties remain high and twofold.  Firstly, given diverging and conflicting data between hard and soft numbers, we remain unsure as to the current state let alone how activity may pan out. 

But, secondly, over and beyond what are likely to be persistent trade worries and uncertainties, the main factor is of course the growing evidence that recent tax rises and fiscal swings have curtailed, if not reversed, hiring.  Moreover, partly given the jump in gilt yields, the risk is growing that the fiscal tightening now envisaged from late 2027 may do little to rein a budget gap of nearly 5% at present, let alone prune it back to below 2% as the official projections suggest, thereby also risking flouting the fiscal rules.  Admittedly those rules could yet be diluted by political tensions within the ruling Labour Party, especially if a chorus grows calling for support to households from the emerging energy spike. The question being whether this would be counter-productive as an adverse gilt market reaction to a budget deficit staying above 4% would compromise the falling debt rule and may merely lead to a further tightening in financial conditions. 

Meanwhile, an added headwind, and possibly now more forcefully, is provided by a weaker overall European growth backdrop, most notably for the EZ although this may be more short-lived that previously envisaged given the fiscal and defense initiative the EU is trying to put together.  Regardless, we see UK imports recovering (further) which, together with the fragile export picture, points to a wider current account deficit than that seen in 2024 (ie around 2.75% of GDP) or 2025.

One hardly new but emerging factor that may affect and/or complicate the outlook is the possibility of the UK undoing Brexit – at least to some degree with the issue possibly gaining momentum in the coming two years. But any attempt to persuade the EU on greater regulatory alignment would continue to be met with demands that the UK accepts greater obligations, including financial payments and freer movement of people.

Figure 2: Weaker Wage Pressures Increasingly Evident?

Source: ONS, CE

As for the BoE, the BoE kept rates on hold this month with no dissents as it understandably waits for more information about the length, breadth and repercussions of the Iran war.  The individual MPC member statements (as expected) showed diverging views as to the extent and reaction of what are now unfolding risks.  But the MPC at least put to one side, the previous easing bias which pointed to further easing, instead reviving a more neutral stance, while the minutes made clear that this is symmetric that policy may have to be more or less restrictive depending on the economic impact. What is notable is that this energy shock is justifiably viewed as being different to that of 2022, occurring at a point when the economy is operating with a margin of spare capacity and where real policy rates are much higher than the effective minus 5%-plus setting of four years ago (Figure 1).  We think this very much reduces the chances of second round effects.  Given ever tighter financial conditions, we still see at least two and probably three more 25 bp rate cuts ahead but now deferred to starting no sooner than late in the year and now more extending into 2027.

Sweden: Clear Consumer Price Resistance

The backdrop and outlook in Sweden is increasingly unclear, this having been the case even before the Middle East conflict broke out.  Notably, there is a saying that one should be careful about what you wish for.  In this regard, the Riksbank aspiration of a strong(er) currency and low inflation is being more than met.  Although it has backed off a little of late, the currency has risen strongly this year and is certainly a key factor in the current on-going disinflation, with imported consumer goods actually negative in y/y terms (Figure 3).  Regardless, the overall underlying price picture (including domestic pressures) has been very soft as smoothed adjusted m/m figures (not as prone to volatility via base effects) show most measures of core inflation are consistent with the inflation target or below. Even so, the inflation undershoot (relative to Riksbank thinking rather than the 2% target) is modest, with CPI-ATE ex energy at 1.4% in February, 0.3 ppt below the December Board projections.  The question is the extent to which the strong currency has also been weighing on real activity.

In this regard, the real economy backdrop is still puzzling and meriting more of a reassessment.  Despite an apparent 2%-plus GDP jump in the last three quarters of 2025 (twice Riksbank thinking), the economy still looks soggy, not least in the labor market.  Admittedly, much of the recent rise in unemployment to around 9% of late looks to be a result of increased participation, but does this reflect a need to boost what have been damaged (real) incomes; if so then there may be little respite with the jobless rate staying around current levels for at least the rest of this year. Moreover, business surveys are mixed to soft while the Riksbank will note the results of its own survey (taken in early February), which even then underscored that ‘companies envisage that the recovery is both slow and hesitant. The uncertain global environment has had a significant impact on household consumption and business investment, making companies cautious looking forward’. This all shows up in early year growth data (ie for the period before the war broke out) that suggests GDP will contract in the current quarter.  And then there is the spill over from the Middle East conflict.

Figure 3: Krona Accentuating Disinflation?

Source; Riksbank, Stats Sweden, % chg y/y – KIX is trade weighted exchange rate,  

It is against this background where we now see a GDP growth outcome nearer 1.2% for this year, with weaker exports causing clear damage that, alongside the likely Q1 drop, have warranted what is a 0.6 ppt downward revision compared to three months ago.  Helped by fiscal policy and the anticipated fall back in energy prices we see GDP growth outcome nearer 1.7% next year.  This very much suggests a negative output gap, at least until 2028.

Admittedly, even given higher energy prices and mortgage related base effects, soft inflation numbers look likely to remain the norm, though with less of drop likely later H1 2026 due to a now scheduled cut in VAT for food in April 2026.  This will knock some 0.5 ppt off all main inflation measures until it is reversed at end-2027. But it is the run of downside surprises that has meant we have actually pared back this year’s CPI projection. And we see targeted inflation (CPIF) staying well below 2% through 2026.  Regardless, this picture is being acknowledged with that same Riksbank survey noting ‘that households' price consciousness is dampening pricing plans.

As suggested earlier, fiscally, September’s looming general election has triggered even more fiscal stimulus, this also seeing a one ppt upgrade of defence plans which now envisage it rising to 3.5% by 2030. However, if so, any domestic bounce may precipitate a steeper than otherwise recovery in imports, especially given the strong currency.  There is a risk of more fiscal support, but at this juncture, a budget gap of around 1.5 % of GDP last year is poised to almost double in 2026, meaning that, the government debt ratio is now likely to rise some two ppt toward 36% of GDP.  One medium-term question is whether the politics and the economy allow the fiscal gap to be reined in from 2027 as the recent Budget envisages. We are skeptical but pencil in a 1.5% budget gap both headline and on a structural basis for 2027!

As widely expected, the Riksbank kept its policy rate at a cycle low of 1.75% this month.  However, what was more important was its rhetoric.  In this regard, it repeated its assertion of no change for some time to come but qualified it somewhat by noting that, amid Middle East conflict making the forecast very uncertain, it could adjust monetary policy in either direction if needed.  Otherwise, and as we have suggested repeatedly, the Riksbank GDP projection for this year is overly optimistic, and at 2.5% possibly by a factor of two, with the Board having revised it down a mere notch. As a result, the Board promise of no change for some time to come is likely to be met and maybe with a clearer downside risk that upper.  More likely, we still do not see any looming policy reversal, as we see this current policy rate staying in place through 2027, ie a little longer than the Riksbank which envisages the first hike probably at end 2026.

Switzerland: Less Punitive But Still Punishing Tariffs?

Any relief that the U.S. has agreed that the 39% tariff will be cut back to the 15% level that most of its European neighbors (and competitors) face may be short-lived, now that the country faces the U.S. sponsored Middle East conflict.  Notably, the economy is partly shielded from the energy price effect as nuclear and hydro-electric produce 40% of domestic power consumption. But there will still be an impact on both inflation and the real economy – and the currency.  As for the Iran war energy price rise, some boost may even be welcomed by the likes of the SNB given that headline CPI has been running near zero which alongside the strong franc has reignited the possibility of negative policy rates (see below).  In fact, we have raised our CPI projections by 0.2-0.3 ppt but still only to 0.6% this year and 1% next.  This reflects reflecting a strong currency persisting and the continuing complete absence of domestic price pressures, with adjusted m/m data suggesting the latter is now running at just above zero, actually softer than the main core CPI measure.

This slightly higher inflation outlook will have some impact on the real economy but the main effect will be on industry.  Firstly, over and beyond the simple statistic that the Swiss economy is very exposed to (what will clearly be more-damaged) global trade with overall exports representing some 68% of GDP, there is also the banking sector.  Indeed, it is also possible that the tariff threat has already been making banks wary about lending, this possibly explaining clearer softening in private sector credit, especially outside of mortgages.

Thus given global uncertainties and relative weakness in nearby trading partners, we have downgraded the 2026 outlook a couple of notches to 0.8%, but which would have been more negative were it not for the likely boost from sporting events (FIFA World cup and Winter Olympics are likely to boost headline GDP by over 0.3 ppt). In other words, sports adjusted GDP growth this year may be no better than 0.5% and thus some one ppt below potential.  The result will be a further rise in the jobless rate to over 3% next year. Even so, so, this means that the modestly downgraded 1.0% penciled in for 2027 is actually somewhat firmer on an underlying basis, given the lack of sporting event in 2027.

But far from boosting consumer thinking, weak inflation and the worsening labor market are still weighing on household sentiment, reflecting continued worries about family finances and elevated price expectations (Figure 4).  Especially with employment growth now zero, this will hurt spending plans.    

Regardless, the increasing strength in the Swiss Franc is causing reverberations.  More a reflection of U.S. dollar weakness than that of the euro, the nominal trade weighted Franc is hitting new highs.  But while this strength in impairing competitiveness – vital to an economy where exports account for 75% of GDP – this is not the whole story despite what are increasing complaints from high profile Swiss companies.  Instead we would argue that with the strong currency also reducing import and producer prices, Swiss companies are enjoying a clear reduction in their cost bases.  Moreover, this is even allowing a rise in profit margins as falling costs contrast with CPI inflation currently around zero.  This is important in assessing competitiveness too as compiling a real or inflation-adjusted effective exchange rate shows a far less sizeable appreciation when deflated by producer prices rather than those for the consumer. 

Figure 4: Consumers Still Have Higher Inflation Mindset

Source: SECO

As for the monetary policy outlook, the SNB maintained the policy rate at zero at this month’s assessment, with a 0.2 ppt increase in 2026 CPI inflation due to the Iran war but 0.1 ppt lower at 0.5% next year due to CHF strength since the December meeting.  The emphasis in the statement on guarding against the disinflationary risk from more CHF strength suggests that the easing bias remains in place, as a tool against more substantive CHF strength.  Indeed, it was noteworthy that even in noting the risks that energy prices could rise more strongly than expected in the baseline scenario, which would considerably increase inflation, it underscored that this would substantially constrain economic growth as would any ensuing potential supply chain disruptions and heightened uncertainty.

However, the bar to actually cut rates is higher given the uncertainty over the Iran war and we forecast no change in policy rates in the remainder of 2026 and probably until at least mid-2027.

Norway: Break Rather Than Accelerator

For some time, we have argued that the Norges Bank’s fixation with apparently resilient inflation was overdone, resulting in overly cautious policy-making, the latter also fixated by the exchange rate.  This inflation caution has intensified of late both by what have been some upside CPI surprises and of course by the likely impact of the Middle East conflict.  The latter will take a toll on the real economy even though it will improve aspects of the oil-based economy, not least in boosting the current account to possibly over 15% of GDP this year, though falling back in 2027 to the circa-14% that probably occurred last year.  Even so, it is the case that oil investment has peaked.  This is based on our underlying assumption of 4-8 week war in the Middle East, which as a result we see oil and gas prices largely falling back to the pre-war levels within a year.  This still has a clear adverse impact on mainland GDP growth – although it is possible that the government will use some of the proceeds from higher oil revenues to temper the impact of higher energy prices at last on consumers – the latter already partly protected by government subsidies on electricity.  Even so, we have downgraded the GDP picture to one that sees 1.2% growth this year, this being a bare 0.1% below our thinking of three months ago, though this modest downgrade largely reflecting positive base effects from better-than-expected growth last quarter.  But we have upgraded the picture for next by the same amount to 1.6%, this still weak reading helping to rationalize the continued underlying disinflation we still foresee and which will persuade a cautious Norges Bank into further easing – though somewhat more deferred than we previously projected (see below).

Indeed, we highlight (Figure 5) that despite consternation to the contrary, there are signs that underlying inflation (ie ex food and energy) has been well behaved and largely in line with the 2% target, as opposed to the targeted measure of CPI-ATE which just excludes some energy products.  This soft recent trajectory explains why we think that our energy induced 0.4 pp upgrade to the CPI rate to 2.6% will be temporary and that inflation will come down to average 2.2% next year, admittedly a little higher than previously envisaged. 

But, as we highlighted three months ago, our inflation outlook is also a result of a possible stronger potential growth backdrop.  This was hinted at by both seemingly better productivity data and a further rise in participation (which has seen a circa-three-point rise to 73% in the last five years).  We suggested last time that this implied overall capacity utilization may actually not be too far away from normal.  But it now seems as if it may actually below average.  According to the just-released Norges Bank's Regional Network, capacity utilization fell further compared with the preceding surveys in 2025 while there are less recruitment difficulties.  This means economic slack remains enough to help underlying disinflation.

Moreover, this disinflation is occurring against a backdrop of a still clearly restrictive monetary policy.  Recently , the Norges Bank has updated its thinking regarding the real neutral rate. Its models estimate it is around 0.4%, which indicates that an assumed inflation on target would mean policy is currently very restrictive, by almost two full ppt!  Thus may explain what seems to be an increasingly clear slowing in house price inflation, very much undershooting Norges Bank expectations.

Figure 5: Underlying CPI Inflation Actually Well Behaved

Source: Stats Norway and CE – Core is ex food and energy, % chg y/y

Regardless, while no change in policy is expected from the Norges Bank’s verdict due later this month, a clear shift in rhetoric is almost inevitable.  It may very well drop its recently repeated assertion that ‘the policy rate will be reduced further in the course of the coming year’.  The question is whether it will suggest that the next policy move may be in either direction or even suggest a hike is now more likely, though being deliberately vague as to any possible timeframe.  Such vagueness would be understandable but any clear warning of hiking would be premature to say the least – NB the softening in house prices alluded to above is very probably a reaction by households to the reining in of rate cut expectations in recent months.

Regardless with underlying inflation dynamics being far from unfriendly (see above) and seemingly downside economy risks materialising, we still think that the Norges Bank has already been far too cautious as it existing plans point to keeping policy very restrictive through the projected timeframe out to 2028, ie the policy rate stays above 3%.

Given Norges Bank caution, we remain far less confident about the extent of easing into 2026 and have scaled back our projections at least for the current year.  But we envisage two further 25 bp cuts in H2 and then 100 bp of cuts through next year.  At 2.5%, that would still leave the policy rate still within the neutral rate range estimated by the Norges Bank.  In other words, the Norges Bank will be merely taking its foot of the brake, rather than pressing on the accelerator.