And the deflationary adjustment in the periphery that drove weak euro-area inflation over the past decade is over — domestic inflation has risen above the core level for the first time since 2012 and will be boosted over time by NGEU recovery plan spending.
Market expectations for how high ECB will hike rates have risen significantly, but if we combine our outlook for growth and inflation and apply a simple Taylor Rule — which suggests that to dampen inflation, the real rate needs to rise commensurately — we require a peak rate in the euro area as high as 5% – 6% compared to the 3% priced today. Put another way, without those hikes, it would take a deep contraction of around 6% in GDP next year to get inflation back to the 2% target. It won’t be a straight line there — the ECB is not as singular as the US Federal Reserve (Fed) in delivering its inflation target and has one eye on preventing a disorderly widening of peripheral spreads. Therefore, it may take signs of stabilisation before the ECB even engages with the idea of hiking further, but the inflation fundamentals are consistent with a significantly higher terminal rate.
Pockets of vulnerability
The ECB’s balance-sheet reduction is likely to outpace both the Bank of England and the Fed in 2023 as the loans linked to its targeted longer-term repo operations (TLROs) mature and quantitative tightening begins from early 2023. Combined with large issuance plans, this should put more upward pressure on term premia next year. There are two pockets of leverage in Europe that look vulnerable in this context. The first is Italian sovereign debt, which now exceeds 150% of GDP. Although the new government has presented a relatively sensible first budget, the risk is skewed to higher borrowing than expected. Energy subsidies have only been rolled for one quarter, so if energy prices stay high, the government will be under pressure to keep them going for longer. A second pocket of leverage is the high level of household debt in Scandinavian countries. That should constrain the hiking cycles in Sweden and Norway relative to others and increases the risk of a very sharp downward adjustment in house prices in both countries. We are already seeing evidence of that playing out in Sweden. It also implies a need for weaker currencies as both economies diversify away from domestic-demand-led growth.
A difficult path ahead for the UK
The UK economy also appears vulnerable to further challenges as we head into 2023. The Liz Truss administration was exceptionally short-lived thanks to its “mini-Budget” — a substantial fiscal policy package that was poorly planned, communicated and executed. However, at its heart, the failed mini-Budget tried to address two structural problems the UK has long been grappling with: it has seen virtually no productivity growth since the financial crash of 2008 and its capex spending since 2016 (Figure 2) has been flat or declining.