The fires of inflation were kindled in the euro zone after demand forces came back strongly from the pandemic, and they started to spread when the Ukraine conflict sparked a surge in food and energy prices. The region has simultaneously been fending off a slowdown in economic activity since 2022, recording minimal growth in the first two quarters of this year.

When these two things happen together, economists know to mention the word “stagflation”, which refers to the bitter combination of high prices and a weak economy. It’s bitter for central banks because, if they approach the problem by hiking interest rates to snuff out inflation, the result could be a deterioration in unemployment levels. If, on the other hand, they elect to cut interest rates to jumpstart the economy, what could come out is more inflation.

It's also bitter for consumers because, just when their budgets are squeezed the most, the cost of a trip to the grocery store climbs up even higher. It happened back in 1980 in the USA, when Americans were faced with the twin challenges of, both enormous inflation of 14.6% and heightened unemployment at 14.5%, at the same time.

In August this year, Capital Economics’ Andrew Kenningham said, “I think most people would agree that it is already a reality in Europe”, referring to stagflation. Not everyone agrees, however. In September, the European Commission’s Paolo Gentiloni insisted that, “It’s too soon to say” this is the scenario facing the continent. Let’s spend a couple of minutes weighing up the issue.

Germany

Germany showed its resilience in enduring last winter’s economic downturn, but found itself unable to grow in Q2 2023, held back by lame manufacturing demand. Even the optimistic Gentiloni admits to the dire impact of this trend on a broad scale. “If the largest economy in the union is in negative – slightly negative – growth, this is affecting everyone”, he said. Q3 kicked off with another monthly drop in factory orders – the largest drop since 2020. Two other burdens Germany is carrying are the light tug of Chinese demand and its unsolved energy shortage.

The ECB

At their September meeting, the European Central Bank (ECB) went ahead and hiked interest rates for tenth consecutive time. It isn’t that inflation hasn’t been responding to their bitter medicine, because it’s consistently been coming down this year. The trouble is that, with the labour market so strong, services demand so high, and companies pushing their revenues ever upward, prices have not come down as much as hoped.

The central bank also renewed its economic forecasts in September, and not for the better. Their new call for euro zone growth for this year was 0.7%, down from 0.9% three months before. Their predictions for growth next year and in 2025 also declined. As to inflation forecasts for 2023 and 2024, they were both revised upward, confirming stagflation worries.

Other Headwinds

The ongoing Ukraine conflict presents a threat to Europe’s economy in particular, “given its proximity, both in terms of additional inflammatory commodity shocks and wider instability in the region”, explains Lan Ha of Euromonitor International. She also notes that Russia’s recent withdrawal from the Black Sea grain deal and the advent of unfavourable weather conditions might further exacerbate inflation rates.

Another issue is that the euro economy may not get the push it needs from consumer demand. “Consumer confidence is a little shaken right now and consumers are tightening their purse strings”, says Pattern’s Dallin Hatch.

At the end of last year, Deutsche Bank predicted the euro region would taste stagflation this year, and that a recession would set in in Q4, continuing into Q1 2024. They even used the word “polycrisis” in relation to the euro economy, by which they meant “interacting crises of different origins whose costs are greater than the sum of their parts”. One potential headwind they mentioned was political instability that may erupt from all the economic pressure building within European countries.

Chugging Along

Putting Germany aside for the moment, there was a pullback in services demand in France and Spain in August. Still, those nations are expected to be forces for the positive in Europe’s struggle to grow in months ahead. As to the Netherlands, the European Commission, in September, slashed their forecast for this year’s growth down from 1.8% to 0.5%, which indicates a fair deal of pessimism. The Commission went on to warn that “the impact of tight economic policy is set to continue restraining economic activity” in the euro zone into 2024.

Even the forex market seems to be conspiring against euro zone growth, because the euro has recently been losing strength against the US dollar. Forex traders driving this trend have been spying an economic slowdown ahead for both Europe and China.

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