The Euro-zone economy is on the precipice of facing its biggest challenge since the inception of the currency. A combination of higher interest rates and renewed government spending restraint threatens to stifle growth and increase the risk of a severe recession. The delayed impact of last year's rate hikes will reach its peak in 2024, when it is projected to cause a 3.8% contraction in the economy, as per Bloomberg Economics' SHOK model. Depending on energy prices, the removal of support measures could amplify this impact to almost 5%. This double blow to growth is a result of the European Central Bank's tightening measures, coupled with the tightening of government spending, particularly led by Germany. The consequences of high interest rates, along with limited government capacity to support growth, may trap the euro zone in a precarious situation.
The concern lies in the fact that the economy's resilience so far could lead to complacency, resulting in a delayed and forceful impact of monetary tightening measures. By the time governments are compelled to stabilize the economy, it may be too late. This presents a worrying scenario for the euro zone, in stark contrast to the Federal Reserve's expectation of a soft landing for the US economy. The impending squeeze on the euro-zone economy, illustrated by these calculations, points to diminishing prospects for a comparable outcome in the region.
The potential consequences of this situation could surpass those of the previous tightening cycle before the global financial crisis, rivaling the fallout from the sovereign debt crunch a decade ago. The critical question now is whether the economy is strong enough to withstand this pressure without succumbing to a damaging recession. This dilemma confronts both the European Central Bank and finance ministers, who are currently avoiding openly acknowledging this possibility. Though options markets suggest policymakers may eventually reduce rates, the ECB's official position maintains a prolonged period of higher borrowing costs.
The economy now finds itself squeezed between monetary tightening and a reduction in government support, which presents a challenging situation as policymakers attempt to combat inflation. The ECB has already faced criticism for a delayed start to tightening, and there are concerns about the pain inflicted by rate hikes. Yet, the economy has proven resilient thus far, even during a record bout of tightening and the gradual withdrawal of government-funded support during the energy crisis.
The euro zone managed to avoid a winter recession and experienced a rebound in the second quarter, albeit with uneven performance as Germany stagnated and Italy contracted. However, as ECB President Christine Lagarde acknowledged, the immediate economic outlook has worsened. January 2024 marks 18 months since the first rate hike, which conventional economic wisdom suggests is the peak of its impact.
In the same month, the European Union's suspension of fiscal rules limiting debt and deficits will come to an end, imposing restrictions once again. While negotiations for a new framework are ongoing, it is certain that some form of limits will be reinstated. Just last month, euro-zone finance ministers agreed that "gradual and realistic fiscal consolidation is warranted."
This convergence of monetary and fiscal tightening within the next 12 months is cause for concern. The key issue under debate is whether the rules will be flexible enough to allow governments to adapt during periods of economic strain. This has revived divisions between northern and southern European countries, with Germany advocating for automatic limits while others, including France, advocate for flexibility.
Furthermore, the ballooned debt levels from the Covid era, coupled with higher borrowing costs and ongoing market scrutiny, may leave limited room for action in the event of an economic slump. Consequently, the ECB would bear the brunt of political criticism, especially in the run-up to the European elections in June 2024. Although the central bank is independent, attacks on its policy stance will be uncomfortable to endure.
The uncertain part for central bankers is how rate hikes will ultimately impact the economy. Some policymakers warn that the drag will not be any smaller, rather it has simply been delayed. Moreover, the pressure from higher rates will intensify as companies continue to battle headwinds such as rising energy costs, a struggling real estate sector, and a decline in consumption following the surge in inflation.
"When you're hit by a rate hike when everything is going ok, you can digest it more easily," said Germain Simoneau, head of the finance committee at the French small business federation CPME. "These hikes might be felt differently." Bloomberg Economics' Jamie Rush suggests a soft landing as the best-case scenario for 2024, but the signs are not encouraging.
"The danger is that higher interest rates eventually hit the economy as hard as models predict," he says. "And governments with high debt burdens facing severe fiscal constraints are unable to perform the stabilizing role we became accustomed to."