Euro zone inflation falls but economy contracts

The euro zone economy shrank in the third quarter as 10 straight interest rate hikes from the European Central Bank (ECB) took their toll on demand, raising the prospect of recession across the bloc.

At the same time there was a larger than expected fall in euro zone inflation, dropping to its lowest level in over two years on the back of falling energy costs. Prices grew by 2.9 per cent year-on-year in October, the slowest pace since July 2021, from 4.3 per cent a month earlier, according to Eurostat’s flash estimate.

The latest reading on prices is likely to cement the market’s view that the ECB is done with raising rates as part of its fight against high inflation. Attention switched, however, to stagnating growth across the bloc, with GDP (gross domestic product) falling by 0.1 per cent between July and September.

The latest figures show Europe’s economy is being hampered by high interest rates, the ongoing cost-of-living crisis, and weaker demand from the global economy. The downturn has triggered speculation that the euro zone may dip into a technical recession (back-to-back quarters of negative growth) in the second half of 2023.

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Ireland had the dubious distinction of having the largest quarterly decline in GDP (-1.8 per cent) in the third quarter. The State’s highly volatile GDP numbers were cited as one of the factors in the overall decline. The Central Statistics Office linked the decline here to a fall-off in multinational exports when it reported the State’s latest growth numbers last Friday.

The Irish economy has now contracted in three of the last four quarters. The main driver of Europe’s stagnation, however, was the Germany economy, which contracted by 0.1 per cent, on the back of falling consumer spending

“Germany’s economy is once again teetering on the brink of a technical recession,” said Claus Vistesen, chief euro zone economist at Pantheon Macroeconomics. Germany’s export-led economy has been more adversely impacted by weakening demand globally and by the initial impact of higher energy prices.

The Eurostat figures show the French economy grew by 0.1 per cent in the quarter, while Italy’s GDP stagnated.

The two sets of data mean the ECB has almost certainly finished raising interest rates, which are now at record highs, and will watch the effect of its unprecedented streak of 10 straight hikes play out before making further moves. “The data leaves the ECB firmly on hold,” Dirk Schumacher, an economist at Natixis, said.

Headline inflation started falling sharply last month as the massive increase in energy prices recorded a year earlier set a higher base for the annual comparison – an effect set to fade or even reverse in upcoming readings.

But a measure of inflation that excludes energy, food, alcohol and tobacco also declined – to 4.2 per cent, its lowest level since July 2022, from 4.5 per cent.

That measure is viewed by the ECB as a more accurate reflection of the underlying trend, and is likely to cement its expectation that inflation will slowly head towards its 2 per cent target by 2025. The last mile may well prove the hardest, however.

“It’s now down to weaker demand grinding down inflation and that’s a slow process,” said’ Schumacher.

“It does look like the economic environment is weakening at the moment, but no sharp recession is in sight either,” said ING economist Bert Colijn. “Still, continued economic and geopolitical uncertainty alongside the impact of higher rates on the economy will weigh on economic activity in the coming quarters.”

Central Bank governor Gabriel Makhlouf said in a blog that “the incoming information broadly confirmed our previous assessment of the medium-term inflation outlook, with inflation still expected to stay too high for too long, and domestic price pressures remaining strong”. – Additional reporting Reuters