Eurozone Slides Into Recession as Inflation Hurts Consumption

The eurozone has slipped into recession as Germany, its largest economy, wobbled, suggesting that the impact of Russia’s war in Ukraine may have been deeper than expected earlier this year.

While the U.S. economy has so far brushed aside higher borrowing rates and continues to grow thanks to robust consumption, employment and an extended market rally, Europe is lagging ever further behind, stuck in the economic equivalent of long Covid. While the U.S. economy is now 5.4% larger than it was before the Covid-19 pandemic struck, the eurozone economy is just 2.2% bigger.

Inflation driven by a spike in energy costs and stubbornly high food prices has softened in Europe recently but remains much higher than policy makers would like and is affecting consumption negatively.

The weakness in Germany is a particular concern. In past decades, the country’s economy often managed to recover rapidly from economic shocks thanks to the strength of its highly competitive exporters.

But global trade has suffered under the Covid-19 pandemic and mounting geopolitical tensions, and it may not offer the same degree of support this time. Factory output in the country showed a steep drop in March. And the continuing war in Ukraine, a close neighbour, is another major source of uncertainty for the region.

Because of its size, the German economy on its own can drag the eurozone up or down. The eurozone’s slide into recession at the start of the year came in spite of growth in France, Italy and Spain, its other large economies.

Economists think all this points to a slow and protracted recovery for the continent later this year, where consumers and businesses are also feeling the drag from higher borrowing costs as the European Central Bank continues to raise interest rates to fight inflation. The eurozone’s slide into recession wasn’t so dramatic as to trigger a pause in the ECB’s rate-raising campaign, according to most analysts.

The European Union’s statistics agency said Thursday the combined gross domestic product of the countries that share the euro fell at an annualised 0.4% during the three months through March, having also declined in the final three months of last year.

Eurostat had previously estimated that the currency area’s economy grew slightly in the first quarter, but the sizeable change to the data from Germany and weakness in Ireland and Finland pushed it into contraction. This left the region with two consecutive quarters of shrinking output, matching the official definition of an economic recession.

Economists expect growth to resume in the three months through June as falling energy bills ease the pressure on household budgets, but any rebound is likely to be anaemic. The Organization for Economic Cooperation and Development on Wednesday said it expected the eurozone’s economy to grow 0.9% this year, roughly half as much as the U.S. economy.

The main difference between the eurozone and the U.S. is consumer spending. Americans are spending freely on the activities they skipped during pandemic lockdowns, such as travel, concerts and dining out. Unlike Europeans, they haven’t had to cut their spending on goods to be able to do so. In Europe, household spending fell in both the final quarter of last year, and the first quarter of 2023. Imports also fell sharply in both quarters, a sign that weakness in the eurozone is affecting businesses in other parts of the world.

One reason for the growing trans-Atlantic economic gap is the amount of savings Americans accumulated during the pandemic. Oxford Economics estimates that while excess savings in the U.S. stood at around 8.3% of annual economic output at the end of 2022, in the eurozone the equivalent was just over 5%. Americans have also been more willing to draw on those savings, with surveys showing Europeans are conscious of the uncertainties flowing from the war in Ukraine.

Back in Europe, while energy prices have normalised from their 2022 peaks, food prices have continued to rise at a rapid pace, weakening household spending on other goods and services. U.S. food prices have been rising half as quickly as their European equivalents so far this year.

The European Central Bank’s series of rate increases, which started in July last year, have now worked their way through the currency area’s financial system. The drag on growth from that source is likely to build during coming months, with the ECB signalling that it intends to raise its key interest rate for an eighth straight meeting next week.

“A peak in underlying inflation wouldn’t be sufficient to declare victory: We need to see convincing evidence that inflation returns to our 2% target in a sustained and timely manner,” ECB policy maker Isabel Schnabel said Wednesday. “We aren’t at that point yet.”

The OECD said it expects eurozone inflation to fall to 5.8% this year from 8.4% in 2022, but remain well above the ECB’s target at 3.2% in 2024.

One reason for the eurozone’s slide into recession is that Ireland—long the currency area’s fastest-growing economy—experienced a 44.7% decline in factory output during March, likely driven by U.S. pharmaceutical companies that operate in the country. That led to a 17.3% annualized fall in the country’s GDP during the first quarter.

Ireland’s statistics office hasn’t offered a reason for that drop in production, but figures it released Wednesday showed a rebound of 70.7% in April, suggesting the first-quarter contraction is unlikely to be sustained.

The eurozone’s poor economic performance so far this year partly reflects the costs of Moscow’s invasion of Ukraine last year. The Russian economy contracted 2% last year and the OECD expects it to shrink a further 1.5% this year and 0.4% in 2024. Ukraine’s economy shrank by a third in 2022, and is likely to have suffered further damage following the destruction of a dam and hydroelectric plant in the country’s south this week.

In the U.S., unlike in Europe, a weakening of the jobs market is required before the National Bureau of Economic Research, an academic group, declares a recession. That has yet to happen in the eurozone, with employment increasing 0.6% during the first quarter.