Is a Europe-wide recession now inevitable?

The price of 10 consecutive interest rate hikes – the most aggressive phase of monetary tightening ever undertaken by the European Central Bank (ECB) – is now looming large on the horizon.

With preliminary gross domestic product figures from Eurostat showing the euro area economy contracted by 0.1 per cent between July and September, there is a realistic chance that Europe will be in a recession by Christmas.

In technical economic terms, that’s back-to-back quarters of negative growth. The good news is that most analysts believe the recession – if it does come – will be shallow and short in duration. So not the type of growth-depressing, unemployment-driving event of 2010 but nonetheless a downturn. One that will probably trigger a further decline in Irish exports, a tick-up in unemployment and a deterioration in house prices, which are already falling in Dublin.

What’s most surprising is that it has taken this amount of monetary dampening to push the euro zone into the red, a testament to the strength of labour markets here and across Europe. Ireland, like other European countries, has been operating at close to full employment for several quarters. More people working means more people spending and consumer spending is the single most important metric in any economy, accounting for roughly two-thirds of domestic demand.

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[ Euro zone inflation falls but economy contracts, raising prospect of recession ]

[ Inflation in Ireland slowed to 3.6% in October as energy prices fell ]

Other factors have kept consumption rates higher than they might have been, most notably government spending. The Irish Government has attempted to shield households from the worst of the cost-of-living squeeze with two large, giveaway budgets, providing consumers with tax cuts, energy credits, additional childcare payments and more recently mortgage-interest relief.

ECB policymakers have, for some time, been complaining that their monetary policy objective of getting headline inflation across the bloc down to the 2 per cent was being undermined by looser fiscal policy in several countries.

Frankfurt’s aggressive sequence of rate hikes seems to have finally tamed inflation, however. The latest Eurostat figures indicate prices across the bloc grew by 2.9 per cent year on year in October, the slowest pace since July 2021, and down from 4.3 per cent a month earlier. Significantly core inflation, the price yardstick that excludes energy, food, alcohol and tobacco also declined to 4.2 per cent, the lowest level since July 2022, from 4.5 per cent.

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. The question will – from here on in – be when does it take its foot off the brake. Initial soundings suggest it could be the middle of next year before we see a downward move on rates. A sudden increase in oil prices linked to the Israel-Hamas conflict underscores that notion.

Ireland’s outsized GDP was once again blamed for dragging the rest of Europe into the mire. While noting the “slightly negative” euro zone figures made “a technical recession this half-year realistic”, ING analyst Bert Colijn said the Irish data “had a big impact on the number” but they were prone to big revisions.

“So it could well be that we end up at a flat reading for euro zone GDP. Broad stagnation it is for now,” he said.

Ireland reported the largest quarterly decline in GDP (-1.8 per cent) of any euro zone member. The Central Stastics Office here linked the decline 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.

[ German recession could be ‘even worse than feared’, economists warn ]

[ Irish exports hit by global slowdown and fall-off in demand for Covid vaccines ]

Perhaps the key to understanding the future economic trajectory of Europe is to look to its largest economy: Germany. It more than any other is driving the euro area into a recession. The Germany economy – it contracted by 0.1 per cent in the third quarter on the back of falling consumer demand – is in a rut. Exports and manufacturing output have slumped on the back of a weakness in demand globally while higher interest rates have adversely hit the construction sector there.

Germany took a much bigger hit from higher energy prices last year because it has so many big, energy-consuming manufacturing firms. Higher interest rates also appear to be suppressing consumer demand there to a greater degree while the dithering performance of the Chinese economy, Berlin’s biggest trading partner, has stifled exports.

Continued geopolitical uncertainty related to Russia’s war in Ukraine, violence in the Middle East and Washington’s faltering relations with Beijing, alongside the impact of higher rates on the economy, which by definition must weigh on economic activity, make economic forecasting more treacherous than normal.

The equivocal position is perhaps best summed up by Moody’s Analytics economist Kamil Kovar who says the euro zone is undergoing “what can be best described as stagnation”.

“Far from healthy growth, but neither it is an outright recession. That leaves plenty space for pessimists and optimists to see what they want to see,” he says.