Western Europe Outlook: Policy Peaking

Our Forecasts

Source: Continuum Economics, Office for National Statistics, Eurostat, Swiss Secretariat for Economic Affairs, Statistics Norway

Risks to Our Views

Source: Continuum Economics

A Riskier Score for 2024

There a several common themes across Western Europe’s economies that are evident at present and may continue to be the score into 2024, all inter-related.But to us the most notable are the downgrades we have made to 2024 for all four economies, mostly reflecting actual or near recession conditions in H2 this year.And the risks are that this could extend into 2024 as the growing actual and anticipated further impact of rising interest rates bites – this effectively having added to, if not replaced, energy as the concern for beleaguered consumers.The second theme is that the acknowledgement of these risks, more implicit that explicit, has meant that the respective W Europe central banks have become more wary about further hiking, very clearly so in the cases of the SNB and BoE, both pausing in decisions this month while the Riksbank and Norges Bank hiked further. All retained tightening biases, but with a clear hint that policy may have peaked with the exception of the Norges Bank which is advertising one final move in December.This brings up the third theme and possibly the explanatory factor for the slightly different behavior, namely recent core inflation dynamics.In order to capture these dynamics on a short-run basis we have computed seasonally adjusted core CPI rates for all four economies.Aware that any single-month reading may give an aberrant reading we have smoothed the m/m data via three-month moving average as seen in Figure 1, all of which show clear signs of softer underlying price pressures.What is clear is that for the SNB, the underlying inflation picture has never been that intense and has eased nonetheless of late.For the UK, the narrow MPC vote to keep policy on hold may partly reflect the manner in which softer price pressures signs have arrived only of late, this also very much being the case for the Norges Bank and the further hike it is flagging.

This brings up to what we would regard as the fourth theme, albeit one based on extrapolating the softer core price signals seen in Figure 1, this being something we think is sensible given the downside activity risks we see in H2 this year and into 2024. Indeed, this recession-like picture not only reinforces an outlook likely to see collective price pressures dissipating further but also means that central banks are likely to see a real economy backdrop into 2024 that surprises on the downside. The result is theme five, namely that all four central banks will have both the scope and rationale to start cutting rates by mid-2024, although the SNB may be reluctant to do so as it has already shown a willingness to decouple from the ECB and has cumulatively tightening by less on official rates!

Figure 1: Short-Run Core CPI Trends

Source: Datastream, seasonally adjusted core m/m measures, smoothed

UK: A Fresh Recession?

Not only are downside economic risks clearly growing amid the ever-tighter monetary stance, but those risks also now seem to be materializing, as softer business survey signals suggest. This, thereby, accentuates and/or prolongs what has been a very negative domestic backdrop which looks increasingly likely to extend into 2024. As a result, while we have upgraded the GDP outlook for this year by 0.3 ppt to 0.2%, we see a fresh and formal recession in the current half year that could continue into 2024. At present, we see a fragile and anemic recovery through 2024, but where the average growth rate of the same size as this year, this an effective 0.2 ppt downgrade from what we envisaged three months ago and (as suggested above) with downside risks that includes an even clearer and more protracted correction in housing, both in terms of prices and turnover. 

This scenario may seem to be in conflict with GDP data that has seemingly shown some degree of resilience in the last two quarters. But this masks commonly overlooked details that show domestic demand having dropped by over 1% y/y in Q2. There are supportive factors: not least the marked drop in wholesale energy prices which will filter through in another bout next month and where the fiscal situation is going to be little more supportive than previously envisaged. But businesses are losing much of the energy support cushion and this will be even more the case in 2024.However, the main concern is clearly the impact of the more sizeable tightening in monetary policy that is already causing tighter financial conditions that will increasingly bite the economy through the credit channel, this very much highlighted by unprecedented declines occurring in both the level of bank credit and bank deposits (Figure 2).This fragile outlook is very much led by the consumer, the most exposed to likely outright damage from the housing market. In perspective, this will involve consumer spending falling modestly in 2023 and slipping a little further in 2024

This consumer weakness has help curtail imports but the latter will recover somewhat from current depleted levels, while Brexit related distortions and a slower global economy weigh on exports. As a result, the likely less-negative current account deficit we see this year (down to 3% of GDP) may partly reverse back towards a 4% gap in 2024.This will be part of a double-deficit as government borrowing likely to be over 4% of GDP at least until planned fiscal tightening measures fully kick in 2025, in turn preventing the government debt ratio from falling. The likely general election and probable change in government that should occur in the next 15 months is unlikely to change this outlook. But solid imports will act as a safety-valve in helping restrain domestically generated inflation, the latter having started to show more definitive signs of slowing of late given the drop in the core and in gauges of persistent price pressures and m/m measures (see above).Most likely this may reflect ever-clearer signals that the labor market has loosened, with the jobless rate seen back towards 5% into 2024. The combination of the above will bring CPI inflation down clearly, this causing the largely unrevised CPI outlook where we still see a rate of 2.5% in 2024.

Figure 2: Bank Credit and Deposit Weakness Unprecedented

Source: BoE, £ billion

As for the BoE, after 14 consecutive hikes, dating back to December 2021, and encompassing 515 bp of cumulative tightening, the BoE decided not to hike at this month’s MPC meeting (here).While the decision was finely balanced, there does seem to be growing wariness that the economy is facing the kind of risks picture discussed above.While it was not surprising that the MPC retained its tightening bias, it is likely that the upside risks it perceives relative to its inflation outlook may be tempered in the November Monetary Policy Report.We are even more of the view that policy has peaked and as these downside risks materialize, the BoE will be forced to start easing in Q2 next year.

Sweden: Persistent Contraction

Perspective is everything. Thus it is worth underscoring that we see the current contraction in Swedish GDP persisting into 2024 and that the cumulative drop will be almost 2%.That assumes a modest recovery from Q2 next year, albeit where the risks are skewed to the downside, not least given the emerging weakness in neighbouring economies. There will be no boost from fiscal policy, the slight opposite given the recent Budget Bill for 2024. Indeed, we have downgraded our GDP outlook, as ever tighter Riksbank policy bites ever harder. The downgrade is partly mechanical as well as underlying, relating to the sharp Q2 GDP negative outcome which reflected some one-off factors. As a result, we now see a circa-consensus 0.6% 2023 GDP drop (down from the zero picture we envisaged three months ago) but where the real ‘story’ is that of a somewhat weaker 2024 picture, this downgraded by 0.8 ppt to a well below-consensus fall of 0.1%, albeit not dissimilar to revised Riksbank thinking (see below).

As for consumers, the erosion of households’ purchasing power has contributed to a trend decline in household consumption since H1 2022 and with a 2%-plus drop on the cards for this year.Some recovery will emerge in 2024 as inflation falls but the 2024 pace may be barely positive, impaired by the emerging rise in unemployment with the rate moving decisively back above 8% in 2024. This may mean that wage growth next year may fall from this year’s 4%. As telling is the likelihood that housing construction (which has already has fallen steeply due to lower house prices, higher construction costs and more expensive financing) continuing to contract next year, especially as mortgage rates may rise somewhat further. As a result, house prices (already down some 15% from the peak of early-2022) may drop further but perhaps the clearest housing impact coming from reduced turnover.

Notably, survey data point to more broad based weaker demand – both domestically and more widely – during H2 2023 and maybe into 2024. Thus, resilient business sector investment levels (excluding housing) may become more suppressed levels of investment moving forward. Overall, the risk, if not likelihood is that the economic recovery will not get any real momentum before 2025, when easier monetary policy will start to have clearer effect.Of course the opposite is the case at present as Riksbank conventional policy tightening is biting even more clearly and rapidly as unlike many other economies, a large share of the mortgage stock (up to 80% in fact) is tied to variable interest rates.This means that much of the rate hiking has filtered through.But there also seems to be a further avenue through which Riksbank policy may be biting, through the reduction in its balance sheet where the reduction in its bond portfolio is set to continue through 2024 and beyond, having already helped cause an unprecedented drop in bank deposits, with the latter now seeing a very sharp slowing in private sector credit growth as well as a marked reversal in broad money growth (Figure 3).

But exports will also fare less well into 2024, but with still soft imports meaning that with the current account surplus possibly rise above 4% of GDP this year persist in to 2024 due to weaker imports. All of which will result in an output gap of over 2% appearing through 2024, effectively a 4 ppt swing in two years! 

Figure 3: Swedish Credit Succumbing to Deposit Drops

Source: Riksbank, % chg y/y

Thus should accentuate the recent signs of a broader fall in inflation, this very evident in seasonally adjusted m/m readings (Figure 1) which has showed a much softer profile of late, even excluding energy. Thus, the risks may be that inflation returns to target earlier and possibly undershoots target than that thought by the Riksbank from still pointing to return to the 2% target in the coming year – we still see the rate averaging 2.5% next year.

As for the Riksbank, more mixed recent data were clearly not nearly weak enough this month to dissuade it from hiking again by a further 25 bp (to 4.0%).There was a clear concern about a weak currency, possibly explaining the lack of any dissent among the Board. Regardless, the Riksbank inflation outlook was largely retained, an implicit, if not explicit, reflection that policy is restrictive, as the Riksbank took policy to a terminal rate of around 4% it signalled in June and that this will be adhered to well into 2025. The Riksbank is somewhat equivocal about whether rates have peaked but is also not suggesting any near-term policy reversal. We think instead that rate cuts will likely emerge by mid-2024, however and we have pencilled in 75 bp for 2024.

Switzerland: SNB Decouples as Growth Risk Rise? 

The somewhat surprising (to some) stagnation in GDP growth in Q2 may be a taste of things to come, the weakness it flags certainly on the cards for the rest of this year and very possibly into 2024.Indeed, survey data are weak (Figure 4) and actually falling to a degree that even threaten (an admittedly shallow) recession, very much consistent with the downside risks that beset our projections and persist into 2024 and beyond.They range from the risk of property and financial market corrections; the transmission of monetary policy turning out to be stronger than currently assumed; even more spill-over from weakness in Germany and also a possible energy shortage in coming winter 2023/24 albeit where Switzerland is partly insulated from this given its large nuclear and hydro reliance.

At the current juncture, we largely adhere to our (June) GDP projection for 2023 of 0.6%, this slightly below consensus and very much under the recently unrevised SNB projection. But reflecting what we think will be a weak EU and particularly German recovery into next year, we now envisage nothing more than 0.8% in 2025, 0.5 ppt lower than we thought three months ago and a second successive year well below trend type growth for 2024.This weak 2024 reading is even with the likely boost that next year’s Olympics will provide. In terms of detail, consumer spending is likely to provide some support, given the sound labour market situation although we do see the jobless rate inching higher into 2024. However, spending power will be merely preserved, with inflation falling a little further, our 2024 outlook remains that the CPI headline rate will average 1.4% next year.Even so, real wages may rise only modestly given that nearly all economy sectors are anticipating wage rises of no higher than 2% in the coming year. Otherwise, the Swiss franc's recent strength, coupled with sub-par global demand, will hurt goods exports, while declining capacity utilization and rising interest rates will curb investment activity, with the risk that the expected decline in construction investment for 2023 spills over into 2024.

It remains the case that the SNB believes that the risks related to Credit Suisse furor have been contained but not eliminated as banks with a poor record still being tested by markets. Such risks may be more an issue for next year and beyond, but regardless the banking sector is still showing some fragilities, most notably in terms the clear slowing in private credit. 

Figure 4: Swiss Growth Under Threat

Source: Datastream, SECO

As for policy, the SNB surprised with no change at this month’s assessment, the first pause in over year in which official rates have risen some 225 bp. This probably reflected several factors, not least that core inflation has been under better control. Indeed, seasonal adjusted data suggest recent monthly core trend nearer zero (Figure 1).  Against this backdrop it is not surprising that the SNB CPI projections into 2025 are noticeably lower than in June and with the 2% inflation objective being achieved in 2025. The question is whether the pause is now the end of the tightening cycle. The SNB statement does retain a tightening bias remains but with unconventional tightening continuing, however, via a rundown of FX reserves and the September statement makes clear that this will continue.  Overall, we see the SNB cycle having peaked and a period of current policy rate will exist through the winter, if not beyond.  It is noticeable that the SNB did not follow the ECB in hiking in September and the decoupling is a combination of the SNB more aggressive balance sheet rundown and better controlled inflation than in the EZ. 

Norway: Avoiding Recession – Just!

The economy has continued to surprise on the upside even into the early part of this quarter, but we do not see GDP being able to avoid the downside pressures being exerted by both monetary tightening and the weakening growth elsewhere in W Europe and beyond.Thus, while we have upgraded the current year GDP outlook to 1.1% compared to the 0.7% projection of three months ago, this is entirely offset by a 2024 0.4 ppt downgrade to 0.3%, a picture similar to those made this month by the Norges Bank, but with next year’s outlook very much below what may be an out-of-date consensus.This view very much reflects that, after what most agree will be a clear fall in consumer spending this year, we do not see any recovery in 2024, with every possibility of another but more modest contraction, especially if the recent stabilization in house prices falters and unemployment starts to rise (as is likely).Indeed, reflecting this, consumer confidence remains near a record-low, not surprising given a likely drop in real disposable incomes of around 4% this year. This is in spite of the faster fall in inflation we envisage (at least compared to the consensus, but particularly the Norges Bank).Admittedly, we have raised the inflation outlook into 2024 by 0.2 pp to 2.7% but this is more a result of the recent rise in energy prices and, regardless, still encompasses the headline rate hitting 2% in the H2 next year.Indeed, more reassuring signs are already emerging not only on the headline but even the core, where downside surprises have been seen in recent months in underlying inflation. But the recent recovery in the krone, which the Norges Bank is clear nurturing with its policy rhetoric, should mean that into 2024, imported price pressures subside, thus adding to recent softer domestic signals. This strengthens the impression that inflation has peaked, something that seasonally adjusted data underscores too (Figure 1). As a result we think the Norges Bank is too gloomy is assessing inflation still being above target even out to 2026!

Overall, monetary tightening is biting, albeit the impact mitigated somewhat both by the boost to the economy from higher energy prices and (we would contend) a lack of balance sheet reduction from the Norges Bank.All in all, we believe a modest recession is a risk rather than strong likelihood but it will be close as the economy may contract next quarter and stage a feeble bounce though 2024. This outlook is still consistent with a marked negative output gap emerging by end-2023 and which may extend to of almost 1% of GDP in 2024 (Figure 5).

Figure 5: A Sizeable Output Gap

Source: Norges Bank, last two Monetary Policy Reports (% of GDP)

As for the Norges Bank, it hiked is policy rate by a further 25 bp to 4.25% earlier this month, flagging another but final move at the December meeting driven by what the Bank sees as a persistent overshoot of the inflation target. In this regard we are puzzled by the more upbeat picture the Bank is penciling for H2 this year and into 2024, especially given the downside risks increasingly seen by neighboring policy makers. Possibly this may reflect the Norges Bank wanting to cement conditions that will sustain the recent krone appreciation. But it gives clear and possibly greater scope for the Bank to face a downside surprise. As suggested above, the view that downside risks will materialize is very much our view and enough that makes us still think that rather than further hike, rate cuts will likely arrive mid-2024 rather than the Bank’s aspiration to pursue a policy envisaging rates staying as high for a long time. We forecast 100 bp of rate cuts in 2024.