Europe Confronts a Worse Inflation Than the US

Across the Atlantic, price pressures are receding without a recession or massive job losses. The euro zone’s export-led economy is weak, consumers and businesses are borrowing less, and higher borrowing costs mean there’s further pain to come.

The contrasting fortunes of Christine Lagarde, president of the European Central Bank, and Jerome Powell, chair of the U.S. Federal Reserve, can be summed up in two numbers. The U.S. inflation rate in July was 3.2%, while GDP grew 2.1% year-on-year in the second quarter. The equivalent figures for the euro zone were 5.3% and 0.6%, respectively.

It is a tale of two economies. In the United States, the Fed’s steep increase in interest rates appears to have succeeded in guiding inflation towards the central bank’s 2% target without causing a recession. The ECB’s similarly aggressive tightening has been less successful in cooling growth in consumer prices, yet risks tipping the bloc into a downturn.

The 20 countries that share the single currency narrowly escaped a recession – usually defined as two consecutive quarters of shrinking GDP – earlier this year. Though economic output in the euro zone contracted by 0.1% in the final three months of 2022, the bloc recorded zero growth in the first quarter of this year, avoiding the technical definition of a recession by the narrowest of margins.

Yet recessionary risks are still lurking. The euro zone’s manufacturing sector, which brings in around a fifth of GDP, is already shrinking. Factory activity in July fell at the fastest pace since the height of the pandemic in May 2020, according to a survey of around 5,000 firms by S&P Global. It recovered slightly in August but it remains at levels consistent with a recession. Weak demand for exports from China and the end of the post-Covid consumption spurt are forcing Europe’s industrial firms to batten down the hatches. Germany’s export-led economy, the euro zone’s largest, will see GDP fall by 0.3% this year, according to the International Monetary Fund.

Activity in services, which make up the lion’s share of the bloc’s output, is also sinking, touching a 30-month low in August, according to the S&P Global survey. That’s because demand for services like travel and entertainment, which boomed after the pandemic, is waning. As governments removed fiscal support and higher prices and borrowing costs hit consumers’ finances, services firms suffered the worst slump in new orders since May 2013, excluding the pandemic years, in August.

The nine consecutive hikes in the ECB’s policy interest rate since last year are also making credit scarcer and less desirable. The central bank found that companies’ demand for loans in the second quarter was the lowest since its records began two decades ago. That’s not surprising considering that benchmark interest rates are at their highest level since 2000, while banks are charging companies and households the most for loans since 2008 and 2012, respectively.

These grim economic indicators suggest the bitter medicine dispensed by Lagarde and her colleagues is working. Euro zone inflation has halved from the 10.6% peak it reached in October 2022. However, prices are still rising at more than twice the ECB’s 2% target and the central bank expects them to remain above that level until at least 2025. Policymakers in Frankfurt have hinted that, even if rates stop rising soon, they will remain elevated for a while. That will put more downward pressure on the economy.

To be sure, neither the ECB nor professional forecasters in the financial services sector expect a recession this year. The central bank has pencilled in GDP growth of 0.9% in 2023 while economists polled by Reuters, on average, reckon the bloc’s output will expand by 0.5%.

One bright spot is the region’s workers. The euro zone’s unemployment rate is at an historic low of 6.4%, largely because companies embarked on a hiring spree to meet the spike in demand for goods and services after Covid-19. And they are not done yet. Around 3% of available jobs in the bloc are currently vacant, close to the 3.2% record reached in the second quarter of 2022. At the current pace, it will take until 2026 for the vacancy rate to return to its pre-Covid level, reckons Capital Economics.

Though a recession would lead to increased layoffs, the resilient job market suggests a short and shallow downturn could avoid mass unemployment. European labour regulations and strong unions, which make it harder for companies to fire people in a recession, would also limit the damage.

That in turn could allow the ECB to enjoy some version of the “immaculate disinflation” playing out in the United States. The problem for Lagarde, however, is that workers’ increased bargaining power is feeding through into higher pay. Labour costs in the euro zone rose 5.0% in the first quarter of the year compared to the same period in 2022. That’s hardly compatible with bringing inflation back down to 2%. Europe faces a longer and dirtier fight to tame rising prices.