Foreword

Economic growth in Europe has peaked in 2017. The European economy grew at its fastest pace in a decade last year, but growth has moderated since and the outlook is now less favourable. Barring major shocks, GDP should continue to grow at a moderate pace. The road ahead is however fraught with uncertainty and numerous, interconnected risks.

Last year’s exceptionally benign global environment helped to underpin economic activity and investment in the euro area. Although economic momentum has softened this year, mostly as a result of weaker external trade, domestic demand growth has remained sufficiently strong to support robust job creation. Over the next two years we expect GDP in the euro area to decelerate in line with a further slowing momentum of foreign trade as the global economy has entered more choppy waters. Domestically, the pick-up in inflation will weigh on household real income growth even though wages are finally increasing more visibly. The emergence of labour supply shortages in some Member States will make it more difficult to maintain the current pace of job creation over the coming years. However the euro area economy does not display real signs of overheating that could put an untimely end to growth. All in all, this is still a benign projection in which GDP growth gradually eases towards potential and the unemployment rate falls further.

That said, some of the risks identified earlier are materialising, e.g. trade tensions or turmoil in emerging markets. Further downside risks are growing and interconnected; they could lead to a significantly worse outcome than projected. Trade tensions continue to run high, even though so far they mostly concern USChina trade. Should extensive new tariff and non-tariff barriers emerge and spread, the negative impact on international trade and global growth would be sizeable. In a context of high corporate leverage, a combination of tighter-than-expected US monetary policy and an abrupt unwinding of the fiscal stimulus in 2020 could well provoke a brisk slowdown in the US that would spill over and weaken economic growth prospects in many parts of the world, including Europe. Many financial assets look vulnerable to a reversal of investor risk perceptions. A general and sharp retreat from risky assets would be detrimental to highly-indebted firms in advanced and emerging market economies and cause broader spillovers. In Europe, uncertainty about the outlook for public finances in Italy has led to higher interest spreads, and the interaction of sovereign debt with the banking sector is still of concern. Finally, the risk of a no-deal Brexit would entail abrupt changes in trade relations between the UK and the EU after April 2019 and harm the economies on both sides of the Channel. Under any scenario, the impact is expected to be much larger on the UK than on the EU27.

These risks could reinforce one another. Addressing them requires policy action on three fronts. At the global level, there is a need to improve the rules-based multilateral order that has underpinned world trade so far and that has, in particular through the G20, contributed to strengthening international financial and macroeconomic stability. In Europe, decisive progress needs to be made on EMU deepening, in particular through the completion of the Banking Union, to reduce uncertainty and enhance financial stability. Economic policy at this juncture needs to focus on strengthening fundamentals and enhancing resilience to less favourable circumstances. We need to continue to frontload reforms that foster potential growth and resilience and at the same time improve the equality of opportunity for all. The EU can facilitate structural reform, but the bulk of the effort must inevitably come from national authorities. Member States, particularly those with high debt levels, need to run prudent fiscal policies to ensure the sustainability of public finances and re-build policy space while prioritising expenditures that increase fairness and medium-term growth prospects.

OVERVIEW: LESS DYNAMIC GROWTH AMID HIGH UNCERTAINTY

Interrelated external and domestic risks are clouding the outlook

The EU economy is entering its sixth year of uninterrupted growth and all Member States are expected to grow over the forecast horizon. But the moderation of momentum since the start of the year and leading indicators both suggest that economic growth has peaked in 2017. The extraordinary impulse from the rebound in global growth and trade enjoyed by the European economy last year is already wearing off, as the outlook for global growth is weakening and trade tensions have risen.

The strength of Europe’s domestic growth drivers should however be sufficient to allow activity to continue growing and unemployment falling. The improving labour market, slightly stronger wage growth and expansionary fiscal measures in some Member States, should help to sustain consumption next year. In addition, investment should enjoy the continued support of still favourable financing conditions, even assuming the gradual normalisation of monetary policy. The outlook, however, is clouded by the presence of a number of interrelated downside risks.

From 2.4% in 2017, euro area GDP growth is forecast to moderate to 2.1% this year and 1.9% in 2019, slightly below the growth rate projected back in the summer. It is then expected to ease smoothly to 1.7% in 2020. Exogenous factors, such as fading world trade growth, rising uncertainty and higher oil prices should have a dampening effect on growth in general, while economic activity should also weaken as labour market improvements slow, slack diminishes, and supply side constraints become more binding in certain Member States.

After rising in synchronised fashion, GDP growth across the world is set to become more divergent, especially within emerging markets, as previously identified risks related to trade protectionism and financial vulnerabilities in emerging markets have begun to materialise. Global growth, however, is forecast to remain robust in the near-term as economic activity in advanced economies will benefit from buoyant momentum in the US boosted by a procyclical fiscal stimulus, strong labour markets and sentiment. Over the next two years, GDP growth in advanced economies (excluding the EU) is expected to moderate, as the economic cycle matures and less support comes from monetary and fiscal policies. In the US, the positive effect of the fiscal stimulus in 2019 is set to be partly offset by the negative effect of higher tariffs, and GDP growth is now expected to be moderately weaker than forecast in the spring.

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