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ECB's front-load easing to cushion fiscal tightening

A front-loaded easing cycle by the ECB is needed to cushion a sustained fiscal tightening to cushion a sustained fiscal tightening

Recent expectations for a faster easing path by the European Central Bank (ECB) reflect strengthening growth headwinds that are adding to existing structural issues. Foremost amongst these is a need to take fiscal prudence more seriously. Efforts to rein in government deficits and debt mean front-loaded monetary easing will be needed to maintain growth. For Australian businesses, this will have implications for the AUD/EUR cross.

Europe is starting its fiscal consolidation journey. Countries like France and Italy are proposing plans to cut spending and raise revenue to meet the EU’s government deficit and debt rules. The European Commission has set out that deficits must be under 3% of GDP or a plan must be put in place to achieve that by the end of a 4–7 year adjustment period.

Across the four largest economies, France and Italy are the furthest from this threshold with government deficits of 5.5% and 6.7% of GDP as at December 2023. For these two countries, the arithmetic of returning to 3% implies an annual average fiscal drag of 0.4–0.6ppts of GDP over the next few years for France and 0.5–0.9ppts for Italy.

This feels all too familiar. After the GFC, government debt-to-GDP ratios skyrocketed across much of the EU leading to a series of sovereign debt crises that lasted the best part of a decade. At its worst, sharp rises in long-term yields threatened not only growth prospects but the financial stability of the bloc. The need for rapid fiscal consolidation complicated the situation for the ECB – a 50bp tightening in 2011 proving premature, with the crisis and the combined fiscal and monetary tightening resulting in a recession between 2011 and 2013 that proved to be far more scarring than the original GFC for many European economies. 

With government debt having risen significantly through COVID, fiscal consolidation is again in sight. However, we expect the ECB to act differently this time, providing monetary easing in preparation for the tighter fiscal settings to come.

Fiscal consolidation will still prove tricky. After the debt crisis of the 2010s, Germany was the only economy among the four largest in the EU to dip below the 60% government-debt-to-GDP threshold set by the European Commission. Others struggled, both with reducing debt and achieving growth. 

This time around, front-loaded rate cuts should provide more support for the economy, making it a little easier for countries to pursue fiscal targets. They will provide an important offset to the contractionary impacts of fiscal tightening, helping to maintain growth, and in turn allowing more of the fiscal consolidation to happen via growth rather than what might otherwise need to be more aggressive fiscal policy measures. That comes partly through the denominator of deficit and debt measures but also through the ‘virtuous’ dynamics growth generates, especially in labour markets where the combined effect of employment gains, boosting tax takes and lowering social spending, can provide a powerful uplift to government finances. 

Strong demand for services has already seen employment soar across southern Europe. The unemployment rates in Spain, Italy and Portugal are sitting below or near the levels prevailing just prior to the pandemic. This comes at a time when labour forces have also expanded to be larger than pre-pandemic. Consequently, receipts from income and wealth taxes are now sitting above where they would have been expected to be based on trend growth from 2010 to 2019 for Italy and Spain, and at these levels for France

With at-target inflation in sight, the ECB will increasingly consider the growth outlook in setting monetary policy. We expect the ECB to cut rates at its next meeting and twice more in the first half of 2025 ending at 2.50%. 

For Australian businesses, this will have implications for the AUD/EUR cross. Since 2019, trends in this pair have largely been driven by bilateral movements against the USD as opposed to key events in either Australia or Europe. At the onset of the pandemic, the Aussie weakened against the euro owing to its reputation as a risk-on currency and the euro’s as a reserve. Since then, war in Ukraine and the ensuing energy crisis saw the euro weaken. In contrast, the AUD benefited from the strong gains in commodity prices through 2022.

From here, the RBA’s extended tightening bias compared to the ECB will see the Australian dollar benefit through the next year, with the somewhat more favourable growth outlook for Australia also providing support. Headwinds to European growth as fiscal consolidation takes centre stage alongside weakness in export markets will add pressure to the euro over the next couple of years. As such, we expect the cross to finish at 0.64 by end-2025 from 0.62 at present. This compares to a range of 0.60–0.64 seen through 2019.

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