Revising up our forecasts for euro area growth and inflation

Euro area GDP (flash estimate) rose by 2.0% q-o-q in Q2, much better than we expected (1.4%). High-frequency data also point to strong activity at the start of Q3 despite the spread of the Delta variant. Indeed, we expect Q3 growth to be even better than Q2. Survey data published so far point to a strong start to Q3 as covid-sensitive services catch up with sectors that have already rebounded. Meanwhile, even if held back by bottlenecks and input shortages, manufacturing activity remains solid.

As a result, we have raised our full-year GDP growth forecast for the euro area to 5.0% in 2021 (from 4.3%), but we have left unchanged our forecast for 2022 at 4.5%. Growth momentum should begin to slow in Q4 but remain firm given supportive monetary and fiscal policies and the gradual unwinding of household savings.

The spread of the Delta variant remains a source of concern. So far, however, relatively few new restrictions have been imposed and recent news from early Delta hotspots have been encouraging. Our baseline assumption is that minor restrictions combined with vaccinations will be enough to flatten the infection curve. There is also some uncertainty regarding the strength of pent-up household demand. Yet momentum may remain strong in areas such as housing, thanks to supportive financing conditions.

Euro area HICP headline inflation rose to 2.2% y-o-y in July from 1.9% in June, the highest increase in almost three years and slightly above our estimate. Prices could continue to accelerate the coming months due to a series of technical and one-off factors.

Following recent upside surprises in inflation data and persistent bottlenecks we have revised our forecast for 2021 to 2.1% for headline inflation (from 1.7%) and 1.2% for core inflation (from 1.0%). Risks to our inflation forecasts are skewed to the upside, mainly because of supply-chain bottlenecks. How long these inflationary pressures persist will depend on how quickly supply comes back in line with demand. But we continue to expect the rise in inflation in H2 2021 to peter out and our 2022 forecast remains unchanged at 1.3% for headline inflation.