Europe's outlook

Our Euro area forecast implies that GDP growth will improve slowly in the coming quarters but nevertheless remain sluggish. On the positive side, we expect some of the factors that held the economy back this year to prove temporary, and we think that some of the deeper headwinds that the Euro area faces will ease at the margin. Set against this, however, those headwinds remain brisk and we expect this to restrain the recovery. Outside of the Euro area, we expect growth to be stronger, but to be curtailed by the weakness of Europe's largest economy.

At a time when Euro area growth has been weak, inflation has fallen to close to zero. While we expect inflation to remain undesirably weak for some time, we nevertheless think the risk of a sustained period of outright deflation across the Euro area is limited, for two reasons.
First, reflecting the structural rigidities in Euro area labor markets and despite high levels of unemployment, domestic cost pressures in the Euro area remain consistent with low but positive inflation.
Second, the cross-country evidence suggests that deflation is rare and difficult to generate among countries that set monetary policy independently.

Given weak growth and weak inflation, we expect the ECB to maintain Euro area overnight rates at close to their current levels until 3Q2017. We also expect the ECB to announce further easing measures in the coming months, extending and deepening the T-LTRO, covered bond and ABS purchase programmes that it has already announced. However, reflecting the high (political) fixed cost of adopting sovereign QE, we continue to ascribe a probability of around 1/3 to the ECB engaging in a large-scale sovereign purchase programme.

A key risk to our forecast - one that would almost certainly prompt the ECB to engage in large-scale sovereign purchases - is the possibility that falling inflation expectations become entrenched in wage- and price-setting behavior, provoking a self-fulfilling dynamic of area-wide price deflation.