Economic Perspectives March 2024

• Houthi hostilities continue to disrupt global supply chains, though the disruptions are mild for now. The global supply chain pressure indicator has only edged up slightly since the outbreak of the hostilities. Oil prices also remained broadly stable last month at 82 USD per barrel. The extension of OPEC+ supply cuts is putting upward pressure on oil prices in March, however. Gas prices on the contrary dropped 17% last month to 24.8 EUR per MWh thanks to milder winter weather and sky-high reserves. Global food prices slightly declined thanks to successful cereal harvests.
• In the euro area, inflation fell from 2.8% to 2.6% in February, thanks in large part to lower food price inflation. Core inflation dropped from 3.3% to 3.1%, thanks to lower goods inflation. Unfortunately, service inflation remains stubbornly high, as tight labour markets are driving up wages. We thus upgrade our 2024 forecast from 2.1% to 2.4% and our 2025 forecast from 1.9% to 2%.
• In the US, inflation rose from 3.1% to 3.2% in February, due to a spike in energy prices. Food prices remained unchanged.  Core inflation declined slightly from 3.9% to 3.8% last month. On a monthly basis, core inflation increased by 0.4%. Goods prices increased slightly, while both service and shelter inflation remain too high. Given the continued stickiness of US inflation, we upgrade our 2024 US inflation forecast from 2.8% to 3.2% and our 2025 forecast from 2.3% to 2.5%.
• Higher-than-expected inflation prints (especially in services inflation) are making central banks and, in particular, the Fed more cautious and are likely to slow the easing cycle. Though we still believe that both central banks will start cutting rates in June, we now expect both central banks to cut their policy rates only four times this year. Meanwhile, the ECB’s new operational framework will significantly reduce the margin between the deposit and refinancing rate (from 50 bps to 15 bps), lowering our forecasts for the latter.
• In the euro area, growth remains lackluster. Investment is weakening, while consumer sentiment is only slowly recovering. The situation remains especially problematic in Germany, where the industry is struggling and household consumption underperforms in the aftermath of the energy crisis. We continue to expect a very gradual bottoming out of the euro area economy and a gradual recovery. We slightly downgrade our 2024 forecast from 0.5% to 0.4% but maintain our 1.3% 2025 forecast.
• In the US, economic indicators softened last month as consumption and industrial production weakened. The labour market is also becoming somewhat less tight. Though 275k jobs were added in February, the unemployment rate increased from 3.7% to 3.9%. For the coming quarters, we remain bullish on the US economy, thanks to the positive supply shocks caused by higher productivity and strong migration. We thus slightly downgraded our 2024 forecast from 2.5% to 2.4%, while maintaining our 2% 2025 growth forecast.
• For China, we have modestly upgraded the GDP growth outlook for 2024 from 4.5% to 4.7% on the back of much stronger than expected industrial production figures in January and February. The recently confirmed 5% growth target for 2024 is therefore closer in reach, but significant uncertainty and headwinds still remain.

Introduction

February data showed that the fight against inflation is far from over. In both the US and the euro area, inflation remains stubbornly high and persistent. The evolution of services inflation (and shelter in the US) is especially concerning and shows that the path to the 2% target will not be smooth. This will push central banks to slow the pace of the rate cutting cycle. Surprisingly, inflation also resurged in China, thanks to higher food and recreation prices. This brought inflation back into positive territory.

On the growth front, there is more divergence. The US economy remains the clear outperformer, as it is benefitting from positive supply shocks such as high migration and high productivity growth. Euro area economic growth remains sluggish. Germany in particular is dragging euro area growth downwards. Meanwhile in China, the 5% growth target will be hard to reach. The real estate crisis remains a drag on its economy, while government support remains insufficient.

Middle East conflict is causing mild disturbances in global supply chains

Yemeni Houthi strikes on commercial ships in the Red Sea continue unabatedly. Strikes by a US-led coalition on Houthi targets have not put an end to the hostilities. The Houthi strikes have forced many commercial ships to reroute in order to avoid the Suez Canal. For now, the disruptions are not putting excessive strains on global supply chains. The Global Supply Chain Pressure Index, which integrates several metrics including shipping costs, airfreight costs and supplier delivery times, has only ticked up a bit since the outbreak of the hostilities late last year (see figure 1).

The disruptions also only had a limited effect on oil prices. They were broadly stable in February, rising 1.6% to 82 USD per barrel. OPEC+’s decision to extend voluntary cuts by three months (until June) has put upward pressure on oil prices this month, however.

Gas prices declined by 17% last month to 24.8 EUR per MWh, close to the historical average of 20 EUR per MWh. Prices are 48% lower than a year ago. Softer winter weather in the Northern Hemisphere have lowered demand for natural gas and allowed European gas reserves to remain well-filled. At 60% filled, EU gas reserves are now 20 percentage points higher than historical averages at this time of the year.

Global food prices also declined by 0.7% last month thanks to successful cereal harvests. Global food prices are now 10.5% lower than a year ago.

Difficult inflation cooling in euro area

In the euro area, inflation fell 0.2 percentage points to 2.6% in February. Core inflation slowed to 3.1% in February from 3.3% in January. The latter was mainly caused by the rate of price increase of non-energy goods. It decreased from 2.0% in January to 1.6% in February. Services inflation slowed by just 0.1 percentage points and still stood at 3.9%. Services inflation thus surprised to the upside both in January and in February. The important observation to make here is that the short-term dynamics of inflation were again higher in the first months of 2024 than in the last months of 2023 (see figure 2).

This confirms that the cooling of core inflation is an uphill and relatively long-term process and is likely to remain so for some time. New figures on wage and profit developments confirm that wage growth may have peaked, and that, as expected, profit margins are partially absorbing wage cost pressures. But the pace of wage growth is still quite high, and information recently published by the ECB on the subject suggests that, according to the wage agreements already concluded, the pace is likely to slow only slightly in the course of this year. Incidentally, wage negotiations are still taking place for a large group of workers in the first half of 2024. This makes the future wage development, and consequently that of service inflation, still uncertain to a large extent (see the KBC Research Report of 28 January 2024 in this regard).

Fortunately, food price inflation is cooling sharply (from 5.6% in January to 4.0% in February) and energy prices have dropped sharply (compared to autumn 2023 and certainly compared to peak levels in 2022). While the large downward impact that energy prices had on inflation in 2023 has largely dissipated, there will likely be no upward inflationary pressure from energy in the near future either. This is also evident from energy prices in futures markets. All this means that the fundamental inflation trend will remain downward in the coming months, although there are likely to be quite a few upward and downward swings around that downward trend. 

Against this backdrop, we continue to expect further inflation cooling but have nevertheless slightly raised our forecast for average inflation from 2.1% to 2.4% for 2024 and from 1.9% to 2.0% for 2025. The main reasons for this are somewhat higher-than-expected services inflation in January and February 2024 and the expectation that services inflation will remain slightly stronger in the coming months than factored into our previous forecast. Going forward, we expect much more volatile inflation as shocks start dominating inflation dynamics again.    

US inflation rises again in February

US inflation rose from 3.1% to 3.2% in February. Energy prices were a major driver of this increase as they rose 2.3% last month. Food prices on the contrary, remained flat last month.

Core inflation continued its slow decent, declining from 3.9% to 3.8% last month. On a monthly basis, core inflation increased by 0.4%. Within core components, core goods prices increased by 0.1% last month, due to higher apparel and used car prices. This was the first monthly increase since May 2023. Core goods inflation could remain more elevated in the coming months. Producer prices have accelerated in recent months (see figure 3). Core producer prices increased by 0.3% last month.

Shelter prices also came out strong, increasing by 0.4% last month and by 5.8% since a year ago. Unfortunately, the Zillow Observed Rent Index, a leading indicator, has increased at a strong pace in the last five months, suggesting shelter inflation might remain elevated in the months to come.

Core services (ex. shelter) also remain strong, rising by 0.5% last month. The strong figure was primarily driven by a strong acceleration of transportation services (a volatile component). In contrast, medical care services surprisingly declined. Furthermore, average hourly earnings, a key driver of services inflation, only increased by 0.1% last month, suggesting somewhat softer services inflation ahead.

Given the upside surprise this month (and last month) and the stickiness of shelter prices, we upgrade our 2024 US inflation forecast from 2.8% to 3.2% and our 2025 forecast from 2.3% to 2.5%.

Growth differences in the euro area

The latest update of euro area GDP figures confirmed economic stagnation in the second half of 2023, with nevertheless notable differences between euro area countries. In Germany, real GDP in the fourth quarter was 0.3% lower than in the previous quarter, while in Spain it was 0.6% higher. The Italian economy's fourth-quarter growth was confirmed at 0.2%, and that of France was revised slightly upwards to 0.1%. The relatively sharp decline of the Dutch economy in the first three quarters of 2023 (cumulative decline of 1.1%) came to an end with a 0.3% increase in the fourth quarter. 

The growth differences between euro area countries over the past year are still best reflected in the comparison of fourth-quarter 2023 GDP figures with those of the last quarter of 2022 (see bars in figure 4). Strong growth in the Iberian Peninsula contrasts sharply with the – sometimes sharp – economic downturn in more northern economies. The relatively strong growth of the Belgian economy also stands out. 

The growth differentials in 2023 reflect, among other things, the different impact of the covid pandemic and the energy crisis on national economies, as well as the policy responses to them and the speed and extent to which economies have already recovered from those shocks. For instance, the strong growth of the Spanish economy in 2023 is mainly due to a late catch-up to the post-covid recovery. Indeed, compared to the fourth quarter of 2019 – just before the pandemic outbreak – the Spanish economy's growth was in line with the euro area's average growth (see bullets in figure 4). Looking back at the period since the pandemic outbreak especially nuances the recent economic downturn in the Netherlands. Indeed, compared to the end of 2019, the Netherlands experienced very strong economic growth. It is also notable that the recent relatively strong growth performance of the Belgian economy holds up even in this slightly broader time perspective, while the German economy has been in an economic malaise since the onset of the pandemic. The economy there has barely grown in the past four years, mainly due to structural problems in industry, accompanied by underperformance in many service sectors.

Leading indicators do not suggest a rapid, marked improvement for the German economy. Though we see a stabilisation of business confidence (at low levels), new orders in industry remain very weak.  Fortunately, there is still a large stock of industrial orders, and the labour market is holding up well, while the recovery of households’ purchasing power and of real wages is underway. This also makes a further sharp downturn in the German economy unlikely. We expect a struggling recovery after several more months of stagnation in early 2024.

This recovery would bring Germany in line with the rest of the euro area. Incidentally, the euro area's overall economic picture looks slightly better than Germany's. In particular, indicators of purchasing managers’ confidence (PMIs) have provided bright spots in recent months. Meanwhile, the European Commission's indicators on business and consumer confidence point to a bottoming out.

Against this background, we leave our growth outlook for the euro area unchanged. A difficult first half of the year will be followed by a gradual firming of growth. The slight downward revision to the euro area's expected average real GDP growth rate in 2024 (from 0.5% to 0.4%) is purely due to a change in the spillover from 2023 into 2024 due to the revision of historical figures. We expect growth to pick up to 1.3% on average in 2025.

US economy softens in February, but remains strong

Recent economic indicators point to a US economy that is softening but remains strong. Consumers pulled the brakes in January as real personal consumption expenditures declined by 0.1% in January (following very strong growth in November and December 2023). Retail sales for February also disappointed and consumer sentiment dipped. Manufacturing indicators were also weak recently. New orders for manufactured durable goods were down 6.1% in January. Industrial production also declined by 0.1%. Housing data have improved, however. New home sales grew healthily in January and last month, housing permits reached a high not seen since October 2022.

The February labour market report was also a mixed bag. Though the headline job growth figure was impressive (+275k jobs), downward revisions to the two previous months of a combined 167k jobs cast a shadow over this impressive figure. Furthermore, unemployment increased from 3.7% to 3.9%. More positive was the tick up in average weekly hours from 34.2 to 34.3. Business surveys also point to slower job growth ahead as the employment subcomponents in both the manufacturing and non-manufacturing ISM surveys declined notably. That said, as the ratio of job openings to job seekers show (see figure 5), the US labour market remains very tight, and the US is unlikely to experience massive unemployment anytime soon.

For the coming quarters, we remain convinced that the positive supply shock driven by higher productivity and migration inflows, along with the positive demand shock, driven by strong government spending and easing financial conditions, will keep growth healthy.

We thus remain rather bullish on the US economy and have only slightly downgraded our Q1 estimate in the wake of softer hard data. We now expect US growth to reach 2.4% in 2024 and 2% in 2025. 

China struggles to reach 5% growth target

Though the outlook for the Chinese economy remains clouded by significant uncertainty, we have modestly upgraded our forecast for 2024 GDP growth from 4.5% to 4.7%. The main driver for this upgrade was stronger-than-expected industrial production figures for January and February (combined) at 7.0% year-on-year. This brings our 2024 GDP estimate closer to the recently confirmed government growth target of 5%. However, reaching that target will still be difficult given the structural challenges facing the Chinese economy. Indeed, we are yet to see signs of any turnaround in the real estate sector, and consumer confidence remains especially weak.

The government meetings held earlier this month, known as the two sessions, did not herald any major changes or surprises to the economic policy landscape. The estimated budget deficit remains roughly the same as last year at 3.0% of GDP, with an additional 0.8% of GDP issuance of off-budget ultra-long-term special government debt. This brings the fiscal impulse in line with last year’s revised budget of 3.8% of GDP. Local government bond issuance for 2024 was increased modestly to 3.9 trillion yuan (3.1% of GDP) compared to 3.8 trillion in 2023 (3.0% of GDP). Questions still remain, therefore, as to how the government will boost lackluster consumption and whether the 5% growth target can actually be reached. We therefore note that despite the upgrade, downside risks remain.

Meanwhile, although headline inflation spiked back into positive territory in February at 0.7% year-on-year, after four months of deflation, the sharp monthly increase in food prices and “recreation, education and culture” prices likely reflects volatility around the Lunar New Year holidays. It is therefore too soon to confirm that China has turned its deflationary trend around. Our headline inflation forecast remains unchanged at 0.7% in 2024.

Central banks may moderate their expected rate-cutting cycle

Although the disinflationary trend is still on track, (core) inflation turns out to be stickier than previously expected. This underlying inflation pressure is, for example, reflected by the much stronger than expected February month-on-month increase of US PPI of 0.6% as well as the most recent uptick in CPI inflation to 3.2%. This contributed to a repricing of market expectations for the upcoming rate-cutting cycles by both the Fed and the ECB.

While the most likely timing for the first rate cut by the Fed still remains June, the risk that the disinflationary path going forward will be less smooth has increased during the past month. As a result, we now pencil in a cumulative 75 basispoints easing during 2024 (i.e., 3 rate cuts of 25 basis points each) resulting in a Fed funds target rate of 4.625% at the end of 2024.. For the time being, we confirm our scenario that the Fed will reach its ‘neutral rate’, that we estimate at 2.875%, by the end of 2025. Market expectations for 2024 are aligned with our scenario, and also consistent with the Fed’s updated March ‘dot plots’, i.e., the median view of the FOMC (Federal Open Market Committee) members. During its March meeting, Fed also confirmed that its balance sheet reduction (QT) will be maintained at the pace previously announced (i.e. currently at a pace of 95 billion USD per month), but that ‘fairly soon’ details of a planned slowdown of this run-down will be announced. 

We continue to expect the ECB to start its rate cutting cycle in June as well. Although the risk of a stickier-than-expected core inflation, and less future disinflationary impulses from energy prices, is also present in the euro area, we believe that the ECB’s forward guidance is sufficiently firm and based on a reasonable assessment of the short-term evolution of euro area wage agreements, which will likely imply that the current wage increases are, broadly speaking, a temporary ex post catch-up for past inflation and will not become entrenched structurally. We therefore confirm our expectation that the ECB will start cutting its policy rate in June, although it will probably only cut four times in 2024 by 25 basis points each, bringing the deposit rate to 3% at the end of 2024. This view is broadly in line with current market expectations. Despite this slightly slower expected easing pace in 2024 compared to our previous forecasts, we confirm our view that the ECB will reach its neutral rate (2.5% according to our estimate) by the end of 2025.

New operational framework

In March, the ECB communicated the results of the review of its operational framework. The result is a conceptual policy framework for the medium term, with an assessment planned for 2026 at the latest. The review has become necessary because of the current balance sheet normalisation policy, with an ongoing run-down of the ECB’s APP portfolio and, from 2025, of the PEPP portfolio. Excess liquidity in the market decreases, which at some point will cause the interbank money market interest rates to start moving away from the ECB’s deposit rate, potentially causing money market volatility. Moreover, the ECB must ensure that it provides sufficient liquidity at all times to satisfy structurally higher demand from the banking sector.

The result of the review essentially confirms the current so-called ‘floor system’, with a meaningful amount of excess liquidity in the market and the ECB’s deposit rate as the policy rate. The changes compared to the currents system are that the spread between the main refinancing rate (MRO rates) and the deposit rate will be sharply reduced to 15 basis points (from the current 50), from mid-September 2024 on. The (punitive) marginal lending rate will be 25 basis points above the MRO. These spreads are fixed parameters, meaning that the only de facto policy rate left will be the deposit rate. In the new operational framework, a sufficient amount of excess liquidity will be provided by classic repo operations (MRO’s, LTRO’s, …) at the MRO rate, with full allotment and against broad collateral. This kind of liquidity provision is essentially demand-driven at the margin. The ECB expects that the 15 basis points extra cost to attract liquidity this way will not be high enough to stop banks from using it.

However, if demand for liquidity will at some point in time be insufficient to maintain the envisaged ‘floor system’ with the deposit rate as the policy rate, the framework includes the option for a direct liquidity injection by the ECB into the market by outright purchasing a so-called ‘structural bond portfolio’. Hence, the demand-driven aspect of the floor system will, if necessary, be backed up by a supply driven ‘policy back-stop’. In this new policy framework, the existing APP and PEPP portfolios will continue to be run down until they cease to exist.

Yield curve inversion likely to last a bit longer

US and German 10-year government bond yields have been relatively stable recently (despite some bouts of volatility) and are not expected to be much affected by the relatively minor changes in expected timings of the Fed and ECB easing cycles, especially since term premiums in both benchmark yields have also been relatively stable. This implies that we confirm our view that both the US and German 10-year bond yields are close to their peak, and will only marginally decline, if at all, during 2024. The somewhat slower expected easing path of short-term US and German interest rates means that the current yield curve inversion will remain in place somewhat longer and more pronounced than previously expected. We expect that, eventually, a bull steepening will revert yield curves to normal.     

Despite the recent limited depreciation of the US dollar, we confirm our view that the US dollar is still fundamentally overvalued against the euro. A structural depreciating trend from the end of 2024 on at the latest is therefore the most likely scenario.  

Intra-EMU sovereign spreads remain, in general, subdued. It is, however, likely that they will pick up again in the course of 2024 as electoral uncertainty will build and the budget preparation exercise for 2025 under the reactivated and stricter SGP rules will prove to be more difficult than markets currently price in.