Euro area forecast to grow 2.3% in 2018

We have upgraded our growth projection for this year and next. There are upside risks to our forecast that the ECB will start hiking rates in Q3 2019.

Taking account of stronger growth momentum, the carryover effect and upward revisions to past data, we have upgraded our euro area annual GDP growth forecasts to 2.3% both in 2017 and 2018. Our forecasts remain consistent with a very gradual slowdown in the quarterly pace of GDP growth, to 2% by end-2018. We view the likelihood of a domestically-generated recession as very low.

The main downside risks are exogenous, including a disorderly Brexit or a sharper-than-expected slowdown in emerging-market growth. Some volatility is likely to return around the Italian elections early next year. A moderate tightening of domestic financial conditions in the form of a slightly stronger currency, higher sovereign bond yields and/or wider corporate debt spreads may only slow growth momentum, but not bring it to a halt.

Importantly, we believe that the euro area has reached escape velocity in the sense that a self-sustained, credit-fuelled, job-rich expansion will prove to be more resilient to external shocks while deficits and imbalances are reduced over time.

Below the surface of strong headline growth, the business cycle is improving in terms of content with credit-fuelled investment spending leading to more self-sustained job creation, consumption, and deficit reduction. In turn, improved quality of growth should provide greater visibility to investors.

We have made no significant change to our inflation outlook as a stronger cyclical upswing is being offset by a weaker starting point in Q4 2017. We forecast headline inflation at 1.5% on average in 2018-19 as core inflation slowly rises from 1% in 2017 to 1.2% in 2018 and 1.5% in 2019.

We expect the ECB to terminate its QE programme by Q1 2019 and to start hiking rates in Q3 2019, with risks tilted towards an earlier move.

In terms of European integration, we expect a two-stage process, starting with the most consensual initiatives (security, banking union), followed by a roadmap for building a stronger euro area (joint investment plans; revamped European Stability Mechanism, fiscal capacity).

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