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The Commission’s Autumn 2018 Forecast

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Warnings about a possibly severe downturn have recently become more common (IMF 2018a, Frankel 2018). Focusing on domestic growth drivers, the situation in the euro area appears rather benign. GDP growth has shifted down a gear at the beginning of this year, as the support from a synchronised expansion in the rest of the world has started fading. Although households have also held back on consumption, domestic demand growth has remained sufficient to support job creation at a robust pace. In the coming quarters, employment growth is set to slow down as labour markets are tightening; at the same time, somewhat higher wage growth is set to support private consumption while also pointing to a gradual increase of core inflation. Still low financing costs and robust domestic demand

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Warnings about a possibly severe downturn have recently become more common (IMF 2018a, Frankel 2018). Focusing on domestic growth drivers, the situation in the euro area appears rather benign. GDP growth has shifted down a gear at the beginning of this year, as the support from a synchronised expansion in the rest of the world has started fading. Although households have also held back on consumption, domestic demand growth has remained sufficient to support job creation at a robust pace. In the coming quarters, employment growth is set to slow down as labour markets are tightening; at the same time, somewhat higher wage growth is set to support private consumption while also pointing to a gradual increase of core inflation. Still low financing costs and robust domestic demand continue to underpin investment, even though the prospect of slower trade growth is set to shave off some investment demand. Emerging supply-side constraints may set a speed limit to growth that is closer to potential, but there are so far no signs of overheating in prices or credit growth. On this basis alone, one would be tempted to project a 'soft landing'. But external drivers of growth are set to weaken, and recent policy developments outside as well as within the euro area cast a shadow over the positive picture. 

The Commission's autumn 2018 European Economic Forecast projects a gradual slowdown of GDP growth in the euro area from 2.4% in 2017 to 2.1% this year, 1.9% in 2019 and 1.7% in 2020 (Table 1). This is sufficient to reduce unemployment further. Inflation is set to pick up to 1.8% this year and next under the impact of higher energy prices. In 2020 it is set to ease to 1.6% in line with gradually increasing core inflation. The reduction of headline budget deficits is expected to be interrupted in 2019 as several Member States plan to adopt a more expansionary fiscal stance. Nonetheless, debt as a percentage of GDP is set to pursue its downward trajectory in the euro area as a whole. 

Table 1 Key figures of the autumn 2018 forecast 

The Commission's Autumn 2018 Forecast

The remainder of this column zooms in on the large and intertwined uncertainties and risks affecting the economic outlook. 

Structural uncertainty – pervasive in economic forecasts

Uncertainty about the underlying structures and events that generate an observed outcome is pervasive in economics and statistics.1 A case in point in the context of the autumn forecast is the puzzle of surprisingly low wage growth even as unemployment is approaching pre-crisis levels.2 Efforts to explain the sluggishness of wages have focused on the explanatory variables in the Phillips curve, namely, slack and inflation expectations, as well as structural shifts in the labour market that may have led to a 'flattening' of the curve by reducing employees' wage bargaining power.3 The autumn 2018 forecast takes a fresh look at the remaining slack in the labour market, and its distribution across Member States.  It confirms that slack is much reduced by now, while the share of firms that identify the supply of labour as a factor restraining production has increased since mid-2016 and stands close to record highs. The coexistence of some slack with indications of labour-market tightening suggests that the labour market's efficiency at matching job-seekers and vacancies has decreased (outward shift of the Beverige curve). Reflecting this, our forecast incorporates a step-up of wage growth as well as a gradual increase of core inflation. But the uncertainty concerning the drivers of wages in the past few years also affects their projected path. 

Figure 1 Factors limiting production

The Commission's Autumn 2018 Forecast

Source: DG ECFIN Business and Consumer Surveys.

Business survey data on factors limiting production reveal another interesting feature. In the last two quarters, the mentions of labour and equipment as limiting factors have retreated somewhat from their record highs. Simultaneously, the mention of demand, which was at a record low level, has picked up for two quarters. As seen in Figure 1, the series present rather low volatility. This could be interpreted as a sign of the cyclical expansion losing momentum. 

Another example of uncertainty related to the interpretation of observed events relates to the current volatility in industrial production and quarter-on-quarter GDP growth induced by sectoral developments. Production of motor vehicles in the euro area dropped sharply (17% cumulated) in July and August. With the sector counting for just below 2% of value added, this is set to have visibly impacted GDP growth in the third quarter. The prospect for a rebound in subsequent quarters critically depends on whether the production shortfall was mostly caused by delays in implementing a new emissions testing procedure or whether lower demand played a significant role as well. 

Substantial uncertainty is clouding the outlook

In addition to structural uncertainty, forecasting is by its very nature subject to uncertainty about future events (temporal uncertainty).4 This autumn forecast is subject to particularly large uncertainty, and the balance of the identified risks is tilted to the downside. This will be discussed in the following on the basis of three concrete examples concerning trade as well as financial markets. 

The trade conflict between the US and China is incorporated into the forecast baseline. Its estimated direct impact on the euro area, for which no additional tariffs are assumed, is very limited. However, as a comparably open economy that is well integrated in global value chains, the euro area stands to lose some external demand, which in turn is expected to negatively affect investment in export-oriented sectors.

A further, generalised escalation of trade tensions represents a downside risk to the forecast. This is illustrated by simulations with the Commission's QUEST model. The model distinguishes four blocks, the EU, the US, China and the rest of the world. It includes trade in intermediate goods reflecting value chains. In a hypothetical scenario of a generalised multilateral increase in tariffs by 2 percentage points, GDP is negatively affected in all four regions (Figure 2). Considering the direct trade impact, the loss of GDP (compared to baseline) is in the order of 0.1 to 0.2 percentage points after two years, but it is larger in China due to its reliance on exports. 

Should the tensions underlying the general increase in tariffs also affect confidence, the impact in year two would be roughly doubled. Moreover, exposure to external competition has a productivity-enhancing effect which higher tariffs would partly remove. The impact of this third channel is mostly felt in the long run, but it is in most regions as large as the direct effect of the tariffs. 

Figure 2 Real GDP (deviation from baseline) with generalised trade tensions

The Commission's Autumn 2018 Forecast

Source: AMECO, own calculations.

In relation to trade policies, general uncertainty has also increased (Davis 2018). News-based indicators of policy uncertainty attempt to measure uncertainty directly by measuring the occurrence of uncertainty-related key words in the media (Figure 3). They assume no well-specified scenarios and are not concerned about probabilities. It is therefore most straightforward to interpret them as proxies for Knightian uncertainty. 

Figure 3 Economic policy uncertainty and trade policy uncertainty in the US

The Commission's Autumn 2018 Forecast

Source: PolicyUncertainty.com

Uncertainty is known to affect economic outcomes negatively by providing incentives to delay or cancel planned investment and consumption of durable goods (ECB 2016, Balta et al. 2013). The uncertainty currently weighing on the outlook for world trade is already incorporated in to the forecast baseline, and partly responsible for the downward revisions of equipment investment growth in the euro area.  

Vulnerabilities and uncertain triggers in financial markets

A final example concerns financial market vulnerabilities due to high leverage and investors' search for yields. While it is possible – for example, through comparison with past episodes – to identify high asset valuations and leverage as vulnerabilities, the potential triggers of an adjustment and the timing at which it might occur are hard to pin down. This is somewhat analogous to knowing that smoking increases the probability of heart disease; it is not possible to make a reasonable prediction about if and at what moment it will strike.

As discussed in the spring 2018 forecast, ample liquidity has contributed to a search for yield, and investors have increased their exposures to equity and riskier bonds. The IMF's latest Global Financial Stability Report points to high nonfinancial sector leverage in advanced economies together with external debt in emerging markets as sources of risk for the medium term. As seen after the short-lived market tensions in February this year, as long as macroeconomic fundamentals are expected to hold up, bouts of volatility may not lead to a more pronounced correction of asset prices. However, a more substantial adjustment is likely once a critical number of investors change their assessment of fundamentals. The ongoing revision of the growth outlook for a number of emerging markets and advanced economies may lead to just such a reassessment. Adverse financial developments would in turn be likely to reinforce the economic slowdown. 

Intertwined downside risks could change the outcome for 2020 dramatically

The risks to the current economic outlook for the euro area that can be most clearly identified are interrelated in such a way that the materialisation of one of them may well have domino effects across the world economy. For instance, a faster-than-expected increase in US interest rates amid overheating and inflationary pressures would affect highly indebted corporates in the US, but also highly leveraged sovereigns and corporates in the global economy that rely on US dollar funding. At the same time, an overheating of the US economy would trigger additional imports that might aggravate protectionist pressures (pressures that would be unlikely to ease if and when a slowdown were to ensue). The Chinese authorities have been reacting to higher trade tariffs using domestic policy tools that, however, risk aggravating existing imbalances, in particular high debt.  Should higher US interest rates and trade disruptions combine with an abrupt increase of risk premia, it could affect also countries where debt is high, but not dollar-denominated such as China and some EU Member States. In the latter, tighter financing conditions and flight to safety could re-ignite the well-known bank-sovereign vicious circle. Such a scenario is more likely in 2020. Figure 4 visualises the overlaps and interlinkages of the risks.

Figure 4 Interrelated risks surrounding the central scenario of the autumn 2018 forecast

The Commission's Autumn 2018 Forecast

Source: DG ECFIN

To sum up, the baseline of the autumn 2018 forecast includes a slowdown of global growth and world trade as well as the trade policy measures already decided. On the domestic side, it incorporates the impact of uncertainty related to the global economic prospects in general and trade policies in particular on investment. The augmented discussion of risks in the current forecast round is motivated by the individual importance of the main risks identified and by their interrelatedness. The materialisation of one of the major risks discussed could thus well trigger the others. Figure 5 illustrates the distribution of the risks.   

Figure 5 Euro area GDP forecast: Uncertainty linked to the balance of risks

The Commission's Autumn 2018 Forecast

Source: AMECO, own calculations

Economic policies to focus on prevention and resilience

The presence of large downside risks that could cumulate and reinforce each other calls for policy action to reduce uncertainty, prevent the materialisation of risks and make economies more resilient. To reduce the risks to the global economy, the EU should work with its partners to strengthen the rules-based multilateral order that has underpinned the acceleration of world trade over the past decades and has in the aftermath of the crisis strengthened the rules and framework behind international financial and macroeconomic stability. In Europe, increasing resilience require decisive steps towards the completion of Economic and Monetary Union at the euro area summit in December. It also calls for efforts to increase growth potential through investment and efforts directed at education and labour-market inclusion. At the same time, it is now urgent to re-build fiscal policy buffers in countries with high public debt. Spending needs to be refocused on expenditure that is instrumental for medium-term growth prospects and increasing fairness.

References

Balta, N, I Valdez Fernandez and E Ruscher (2013), “Assessing the impact of uncertainty on consumption and investment”, Quarterly Report on the Euro Area 12(2): 7-16.

Davis, S (2018), “Trump’s Trade Policy Uncertainty Deters Investment”, Econbrowser, 12 August. 

Frankel, J (2018), “The next recession will be a bad one”, Vox Talk, 12 October. 

ECB (2016), “The impact of uncertainty on activity in the euro area”, Economic Bulletin 2016(8): 55-74.

European Commission (2018a), “Spring 2018 European Economic Forecast”, European Economy Institutional Paper 077. 

European Commission (2018b), “Autumn 2018 European Economic Forecast”, European Economy Institutional Paper 089.

Federal Open Market Committee (2017), Minutes of the Federal Open Market Committee, July 25–26. 

IMF (2018a), World Economic Outlook, September.

IMF (2018b), Global Financial Stability Report, October.

Endnotes

[1] Structural uncertainty affects the interpretation of data that are already known, for instance which of two indicators that apparently contradict each other should be trusted more, or how to distinguish noise in a high-frequency indicator from an actual signal. With some hindsight, it is usually possible to explain data constellations that at present look puzzling or to distinguish noise from signals. But for forecasters, who are required to form views in real time, structural uncertainty is a potential source of forecast errors and thus increases the uncertainty surrounding the projections.

[2] Cf. FOMC (2017) for the US and Box 1.2 in the autumn 2017 forecast for the euro area..

[3] For the US, but less so for the euro area, a trend decline of labour productivity growth is also found to play a role.

[4] Lack of knowledge about the future comes in various forms (cf. ECB 2016). For certain types of events, the forecaster is able to describe a trigger (say, an increase of the oil price to a particular threshold) and its expected macroeconomic consequences well, but for others (say, geopolitical conflicts) the possible future states of the economy are harder to describe. In the extreme the observer is completely ignorant about the range of possible future states of the world (ontological uncertainty). Similarly, probabilities for certain states of the world may be accessible through logic, previous empirical analysis or at least the forecaster's subjective judgement, while for other possible outcomes probabilities are lacking. Commonly, events which can be clearly described and quantified with known probabilities are categorised as riskswhereas under ('Knightian') uncertaintythe possible future states of nature and their probabilities are not clearly known. However, risk and uncertainty are often hard to tell apart in practice, and economic agents typically face several risks and various types of uncertainty simultaneously. 

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