A year of stagflation

The war in Ukraine has delivered a shock to Europe just as it was coming out of the pandemic. Higher energy prices will keep inflation elevated, squeeze household incomes and dent business confidence. We think the euro-zone economy will do no more than flat-line during the second and third quarters of this year, despite a rebound in tourism. Headline inflation should fall back later this year but will be much higher than the consensus expects for the year as whole. With underlying price pressures rising, the ECB will soon end net asset purchases and start raising interest rates, lifting the deposit rate into positive territory by the end of the year. We expect interest rates to peak at around 1.5% next year, also well above the consensus forecast. The possibility of the ECB re-starting its asset purchases should mean that the increase in peripheral bond yields is manageable.