Barclays: Deep and long recession the main scenario for the Eurozone – Stop interest rate hikes within 2022

Her Eleftherias Kourtalis

Real GDP growth in the Eurozone in the first half of the year and inflation in July support Barclays’ estimate that the ECB will proceed with another aggressive rate hike of 50 basis points in September. However, the Bank of England’s baseline scenario for a mild recession in the Eurozone is changing to the optimistic scenario and now sees a deep and longer recession – following this “turn” made by Citigroup last week. With these data, he believes that the ECB will stop the tightening cycle before the end of 2022.

Strong growth but pushing inflation higher

Real GDP growth was strong in the second quarter in France, Italy and Spain, where the tourism and hospitality sectors contributed to the significant positive surprises against expectations, both for Barclays and the broader market. In Germany, growth was essentially flat, but first-quarter real GDP growth was revised upwards. Based on these preliminary announcements, euro area real GDP is now 1.4% above the pre-COVID-19 level, but remains below the pre-pandemic trend, suggesting a negative output gap.

Inflation accelerated further in July to 8.9% y/y and core inflation moved to 4.0% y/y, with notable upside surprises in France and Spain, particularly in services, as strong seasonal demand allowed businesses to pass on higher costs to consumers.

Energy and food inflation remain at the forefront and, given the sharp rise in future gas prices, inflationary pressures are likely to remain high in the coming months, with the risk that inflation will be more persistent than forecast. at the moment, as Barclays warns.

However, despite strong inflation, there is still no sign of a “wage-price spiral” nor of a change in inflation expectations.

At the same time, as Barclays notes, investigations by the European Commission have continued to worsen and consumer confidence indicators have reached historic lows. Households and businesses are not only pessimistic about the current economic outlook, they are even more concerned about the outlook 12 months ahead. Weakness is broad-based across all business sectors (manufacturing, construction and retail) and indicators, including those on employment expectations.

A deep and more prolonged recession is now possible

The drivers of growth in the second quarter, July PMIs, confidence indicators, very high and persistent inflation, a sharp tightening of credit conditions all point to a contraction in economic activity after the summer, as the Bank of England points out. Its depth will be largely determined by the Russia-Ukraine war and the flow of Russian gas to Europe.

Last week, EU countries agreed to voluntarily reduce gas consumption to build reserves for the winter. But with Russia cutting gas exports to 20% of Nord Stream 1 capacity, there is a clear risk of some form of energy rationing this winter.

In any case, the rise in natural gas prices is now in line with Barclays’ scenario of a 1% contraction in real GDP over a 12-month horizon, a stronger contraction than the baseline forecast to date of a 0-point recession. 2% and 0.1% in the fourth quarter of 2022 and the first quarter of 2023 respectively. Any rationing that leads to limited levels of output will further reduce real GDP.

ECB: Stop interest rate hikes

Against this background, at the September meeting the ECB will again revise upwards its inflation forecasts for 2022 and 2023. Although it is also likely to revise growth downwards from the third quarter onwards , upside real GDP surprises in the first half of the year will allow the ECB to maintain an above-trend growth forecast in 2022, while possibly avoiding a recession scenario, according to forecasts by the European Commission and other international organizations.

Based on these qualitative changes in its forecasts, Barclays believes that the ECB will stick with a large increase in policy rates (+50 basis points) at the September meeting. However, as more data is released and a recession scenario becomes more likely, the pace of tightening will be limited and policy rates will rise by 25 basis points in October.

“Until the December meeting, we expect the ECB to hold off on rate hikes, as tapering until then will require policy rates to remain below the neutral rate (whatever that is) and monetary policy to remain accommodative,” as stresses Barclays. As he warns, further tightening of monetary policy would risk medium-term inflation falling below the ECB’s 2% target.