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The Biggest Risk to the Eurozone’s Booming Economy: Inflation

For the first time in a decade, economic forecasters appear to be unambiguously optimistic about the prospects for the eurozone economy. What did forecasters miss in 2017 and what might they be missing this time?


Simon Nixon

For the first time in a decade, economic forecasters appear to be unambiguously optimistic about the prospects for the eurozone economy. Perhaps that isn’t surprising given how badly wrong-footed they were by the strength of the recovery in 2017.

A year ago, the European Central Bank was forecasting growth of 1.7% while the consensus among independent forecasters was 1.3%. Yet the ECB now reckons that the eurozone grew in 2017 by 2.4%. Given that it was the fourth consecutive year of economic growth, ECB board member Benoît Coeuré insists this should no longer be called a recovery but an expansion. Some even call it a boom.

Certainly the latest data points to a very strong start to the New Year. Business and consumer confidence in the eurozone are at their highest levels since 2001, according to the European Commission’s economic sentiment indicator, while the latest surveys of purchasing managers show optimism among manufacturers at record levels and export orders at new highs.

Shoppers in Brussels hit the shops on Wednesday. Photo: Thierry Roge/Belga/Zuma Press

Growth is increasingly self-sustaining, fueled largely by domestic demand and underpinned by the strongest job creation since 2000. Eurozone unemployment is now down to 8.8% from a peak of 12.7% and falling fast. German firms reported a record rise in hiring intentions in December; Spanish unemployment similarly fell by 1 percentage point in the same month. An expanding labor market leads to rising consumer spending and investment—a virtuous circle.

What did forecasters miss in 2017 and what might they be missing this time? Euro-area economists were hardly alone in underestimating growth in 2017 amid what proved to be a global upswing. Their mistake was to assume that 2017 would look much like 2016: Many simply extrapolated the same 1.7% growth into the following year.

That caution may have seemed justified by experience, given the nasty habit in previous years of political risks emerging to hold back promising recoveries. With a crowded political agenda in 2017, it was perhaps reasonable to expect further political tensions to continue to damp economic activity in 2017. In fact, those risks largely melted away, sparking a revival of animal spirits.

Few political concerns are clouding forecasts this year. The biggest risk is the Italian election on March 4. But the antiestablishment 5 Star Movement, which leads in the polls, has toned down its euroskeptic rhetoric and ruled out a referendum on euro membership. Under Italy’s electoral system, it is hard to see any party winning a parliamentary majority, leading most analysts to conclude that the main risk lies in an inconclusive result that brings a period of instability and limits the prospect of reforms.

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Other challenges facing the eurozone include continued tensions in Catalonia, the possible need for fresh elections in Germany, lack of progress on further eurozone overhauls and, of course, a chaotic Brexit. But none of these represent the kind of existential threat with which the eurozone has had to grapple in recent years.

Perhaps the bigger risk for investors is that forecasters are once again underestimating the strength of the economy. Most are again extrapolating what happened in 2017 into their 2018 projections. The ECB, for example, is forecasting growth this year of 2.3% and a gentle rise in inflation over the next two years to 1.8% in 2020, in line with its target of close to but below 2%.

This forecast underpins the ECB’s commitment to continue to buy €30 billion of government bonds a month until at least September 2018 and its guidance that it won’t raise interest rates until “well past” the end of its quantitative easing program. This guidance in turn has ensured that both short and long-term eurozone borrowing costs remain very low, supporting growth.

But what if these forecasts are too cautious, particularly regarding inflation? At present, most investors assume that if there is an inflation problem in the global economy, it lies in the U.S., where unemployment is set to fall below 3.5%.

But Ian Harnett, chief economist of Absolute Strategy Research, reckons that the more immediate risk lies in the eurozone, which has already been growing above its long-term trend rate for five years. “Even with an 8.8% unemployment rate, the eurozone is hitting capacity constraints across a wide range of metrics,” he says. “This is a story that is not just limited to Germany, nor to the manufacturing sector. It is much more broad-based than that.”

Mr. Harnett believes that the eurozone may have already closed its output gap—a measure of spare capacity—which has historically led to wage-induced inflation. Core inflation is already picking up across 80% of eurozone economies.

Of course, inflation has been the dog that hasn’t barked across many developed economies for several years now. As in other economies, it is possible that demand for labor in the eurozone will create its own supply, with plentiful jobs luring potential workers into the employment market. At the same time, wage inflation may be held in check by technology and globalization, as it appears to have been in recent years. But Mr. Harnett suspects that less flexible labor markets in some countries make the eurozone more vulnerable to wage-led inflation.

If so, the market may start to bet on a sudden stop to the ECB’s QE program in September and an earlier rise in interest rates, leading to rising borrowing costs that could damp growth and pose particular challenges for some economies still in an earlier stage of recovery. One to watch in 2018.

Write to Simon Nixon at simon.nixon@wsj.com