• Euro area Q3 growth came in better than expected at 0.4% Q/Q. Germany avoided recession, activity in France was temporarily boosted by the Olympics and the Spanish economy continues to roar along. With survey data still weak it’s too early to say that the underlying fundamentals for the euro area as a whole are improving, but there are some encouraging signs. However, the outlook remains fragile with the possibility of tariffs in sharp focus (see here).
• In the UK, the BoE has a week to digest the implications of the new government’s expansionary first Budget (our take here). A November cut is still likely but the sudden rise in fiscal stimulus will certainly bolster arguments for a more cautious approach further ahead.

Good news on euro growth - but the outlook remains fragile

In the short gap between the ECB’s September and October meetings, the euro area data flow was almost entirely supportive of further easing with downside surprises on inflation and confidence. The ECB, with its data-dependent setting, duly went back-to-back with cuts despite giving little indication of the possibility of that in September.

We said at the time that upcoming data was likely to be more mixed (here), and there has been evidence of that this week. On prices, euro area inflation moved up to 2% Y/Y in October, from 1.7%, while core and services remained unchanged at 2.7% and 3.9% respectively. An uptick in the headline rate was expected after a strong energy base effect in the September figures, but there was also some upward pressure in these figures from higher food prices. We continue to expect that underlying pressures will continue to ease, but these figures were a reminder that the last mile of the disinflation process may well be bumpy.

On growth, the Q3 GDP numbers came in stronger than expected this week. The euro area expanded by 0.4% Q/Q, which is around potential. This was supported by the temporary boost from Olympic & Paralympic games in France. Spain remains the euro area’s star performer – and indeed one of the fasted growing advanced economies in the world – with another quarter of growth at 0.8%, supported by the tourism sector and government spending. Meanwhile, Germany avoided a technical recession with a mild expansion, but the Q2 estimate was revised down from -0.1% to -0.3% which leaves GDP in level terms slightly weaker than had expected. Italian growth, flat on the quarter, was lower than expected.  

We are sticking with our forecast for 0.7% overall euro area annual growth, which we’ve held since last year, but acknowledge that risks are tilted towards 0.8% after the stronger-than-expected Q3 figure. However, recent survey evidence remains consistent with weak growth and we would emphasise that it’s too early to say at this point that fundamentals are better. The big question on euro area growth is around the scope for a consumer-led recovery after the normalisation in inflation. The ECB sees real household disposable income increasing by 2.8% in 2024 yet household spending has not been a meaningful growth driver so far as households have increasingly opted to increase saving rates.

We still see it as a matter of timing. Consumer sentiment is gradually recovering and is now around the long-term average mark. The expenditure breakdown for the euro area as a whole is not released in the initial estimate but we have some indication of the trends from national releases. The breakdown of French GDP, which is available, showed 0.5% Q/Q growth in household consumption, although we wouldn’t read too much into that given distortions around the Olympics (indeed, we expect some payback and a small Q4 contraction in France). Meanwhile, the German statistical office highlighted growth in household consumption, which is encouraging.

Taking a broader view, we think that the euro area economy is now showing early signs of a cyclical improvement and we expect that stronger household spending next year will drive the expansion. But we would emphasise that it remains a fragile outlook with the possibility of a rise in protectionism being a key risk given the structural issues already facing European industry (see here). Turning back to the ECB, our view remains that the mixed data picture supports a continuation of the current pace of easing (25bp at consecutive meetings) rather than any move to more forceful cuts. The next meeting is on 12 December.

Chart 1:  Euro area growth picked up in Q3

Chart 2: Higher saving is weighing on consumer spending

Bank of England preview: Treading carefully

The BoE will have a week to digest the inflationary implications of the UK government’s plans for higher tax, spend and investment (see our take here). How much has the Budget changed the outlook? The measures were broadly expected and are consistent with the government’s earlier statements and pre-election pledges. That said, the plans involve slightly more debt issuance than expected, and spending, both current and capital, is to be increased rapidly. That has been reflected by a moderate gilt market sell-off since the announcement.

The OBR’s view is that growth will pick up quickly to 2% next year, above potential, and then fade gradually over the forecast horizon with public investment crowding out private capex and hence no meaningful supply-side benefit until the 2030s. As a result, the OBR sees measures announced in the Budget lifting inflation by 0.4pp in 2025-26, with headline CPI remaining slightly above target until 2029.

There’s a lot of uncertainty around these estimates, which is something the OBR acknowledged. The BoE may well have a different interpretation on the scope and timing of any supply-side improvements. There’s also uncertainty around the impact of the most significant tax rise of the Budget – the rise in employer national insurance – and how the effect of this will be divided between lower private sector pay settlements, lower profit margins and higher prices.

Chart 3: The OBR view on the inflation path

Chart 4: Public inflation expectations have edged higher

A rate cut next week is still highly likely. Last time out the BoE’s statement noted that “a gradual approach to removing policy restraint remains appropriate”. Since then governor Bailey has discussed the possibility of a shift to a more “activist” approach (see here). He also said last week that the disinflation process is happening faster than officials expected (headline inflation slipped to 1.7% in September, with the BoE’s August forecast for 2.1%). It’s also clear that the economy has also lost some momentum after the strong start to the year. All told, the data flow in recent months supports the case for monetary easing. We look for a 7-2 vote to cut to rates to 4.75% next week.

But the MPC is plainly very divided – the 5-4 vote to get the ball rolling on rate cuts in August showed that – and this Budget will certainly provide more ammunition for the hawks who will fear the effects of fiscal loosening in an economy with little spare capacity. Household inflation expectations have also edged higher. To our minds the chances of a back-to-back cut in December have certainly decreased, and, looking further ahead, the uptick in government investment will add further uncertainty to estimates of the neutral rate. Given that backdrop, there’s unlikely to be any urgency to dial back policy restrictiveness. Indeed, the current guidance of a “gradual approach” remains appropriate and may well be left unchanged.