The euro area economic outlook is subject to extreme uncertainty, despite unprecedented monetary policy accommodation and several rounds of fiscal stimulus
The pandemic is having a big impact on economic activity and inflation. Real GDP contracted by 9.4% in H1:2020, before advancing by 5.2% in semi-annual terms in H2, according to our estimates, leaving the full year 2020 GDP growth at -7.1% yoy. Overall, we expect a partial recovery in 2021 of +4.4% yoy, followed by +4.6% yoy in 2022, with output returning to its pre-pandemic level in mid-2022. We view the risks to our baseline scenario as balanced, albeit the outlook is subject to extreme uncertainty, mainly linked to pandemic developments.
Inflation remains subdued due to restrained consumption, with the headline growth in negative territory. According to our estimates, core CPI inflation will bottom out as of January 2021 (to average 0.5% yoy in Q1:21) due to the expiration of the VAT reduction in Germany and will normalize towards 1.1% yoy by end-2021. Regarding headline inflation, we expect it to average +0.5% yoy in Q1:21, before picking up further in the course of 2021, to average 1.3% yoy in the year, vs +0.3% yoy, on average, in 2020, also supported by the anticipated recovery for energy prices.
Monetary policy is expected to remain ultra-accommodative in 2021, as the European Central Bank appears determined to remain “active”, until the pandemic crisis ends and economic activity returns to norm. Overall, the ECB’s balance sheet amounts to €7.0tn from pre-pandemic levels of €4.7tn, while it is set to reach circa €8.4tn (70% of euro area GDP) by March 2022. In addition, policy rates are expected to remain close to or below zero at least until 2022.
The combination of monetary and fiscal support, has provided vital support to the euro area economy. Discretionary fiscal measures including tax cuts and increased government spending via extensive short-time work schemes and wage subsidies, amount to circa 5% of euro area GDP. Further fiscal measures have been employed at the national level since end November and more are expected as the Covid-19 wave evolves, followed by more support via the NGEU, likely as of H2:2021, suggesting that fiscal policy should turn to a modest thrust.