After two years of falling output, the Eurozone is forecast to grow by 1.1% this year, followed by expansion of 1.5% in 2015 and a slightly faster pace in 2016-18, according to the Summer 2014 EY Eurozone Forecast (EEF). Exports are strengthening and a gradual pickup in domestic demand will drive a return to modest investment growth.

However, the threat of deflation persists. Inflation in the Eurozone was down to just 0.5% in May. Widespread deflation, or even a period of very low inflation, would add to the problems of sluggish growth by raising real levels of debt and by delaying spending and investment decisions.

Part of the reason for weak price growth has been the strength of the euro in recent months. In response the European Central Bank’s (ECB) package of measures earlier this month will have some impact, and with the US now moving toward tighter policy, the euro should start to weaken later this year and in 2015. As such, EEF expects inflation to start to pick up, easing deflationary fears and supporting the wider recovery of investment and consumer spending.

Divergence among Eurozone economies set to persist
The scenario continues to vary across the Eurozone. Although the past pattern of the core economies outperforming their counterparts in the periphery looks set to be less evident this year, EEF still expects intra-area divergence in economic performance.

Greece and Italy are likely to be among the weakest economies in the Eurozone, along with Cyprus and Finland. On the other hand, GDP growth in Spain and Portugal is expected to pick up quite sharply this year as the reforms implemented over the past few years begin to bear fruit.

While GDP growth in the latter two economies will probably be close to the Eurozone average, both economies are likely to outperform some of the weaker core economies such as France and the Netherlands, which have been slow to address their fundamental economic problems.

However, there are still large divergences in the amount of spare capacity in the region’s core and peripheral economies. The EEF estimates that Germany is now running close to full capacity. By contrast, GDP in Italy and Spain is still around 6% below potential and the size of the Greek output gap is likely to be significantly larger.

A weaker euro to help exports
In 2013, Eurozone export volumes grew by just 1.4%, the weakest annual gain since the global financial crisis. Although the further strengthening of the euro since the beginning of the year suggests that exporters may be set for another tough year, EEF expects export growth to accelerate to 3.5% this year and then to 3.8% in 2015 as global demand continues to rise.

Households are becoming less wary
Consumers and businesses face continued tight credit conditions in most Eurozone countries as banks to try to repair their finances ahead of the findings of the ECB’s asset quality review, due for release in October. Nevertheless, household spending, which started to inch up last year, looks set to gain momentum over the coming quarters.

The European Commission measure of consumer sentiment is now at its highest level since late 2007 and the ECB’s bank lending survey suggests that demand for loans from households is growing.

Unemployment rates remains a major concern
There are tentative signs that the labor market has now reached a turning point. Although the unemployment rate remains close to its record high, at just below 12%, employment is beginning to rise.

Despite some positive signs, a period of strong household spending growth seems unlikely in the region as a whole. The high level of unemployment will ensure that wage growth remains subdued by historical standards. Accordingly, real disposable income growth is likely to remain below the rates recorded prior to the global financial crisis.

Risks to the recovery
While the chances of a major re-intensification of the Eurozone crisis have continued to ease, risks arising from outside the Eurozone itself lie toward the downside. The most obvious near-term risk is from political tensions in Ukraine. Not only could this lead to higher energy prices and shortages if Eurozone energy supplies were disrupted, it could also impact negatively on business and consumer sentiment and prompt a reversal of the capital inflows into the peripheral economies. In such a scenario, it seems likely that the Eurozone’s fragile recovery would at least temporarily fizzle out.

Looking ahead
While weak or negative inflation may be a positive development for consumers in the near term, a sustained period of deflation would dampen spending in the medium term, as it would both encourage consumers to delay major purchases and would squeeze employers’ ability to increase or even sustain current wage levels. Falling prices would also raise the real value of households’ outstanding debts, potentially prompting them to try to pay down their debts even more quickly.


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About the EY Eurozone Forecast
The forecasts and analyses presented in the EY Eurozone Forecast are based on the European Central Bank’s model of the Eurozone economy. This model embeds state-of-the-art economic theory and techniques and is used by the ECB to produce its quarterly forecasts of the euro area.


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