Difficult to Predict Due to Pandemic? 2021 Euro Area Outlook

on Dec 22, 2020
Updated: Dec 19, 2022

The Euro area has suffered one of the most severe economic contractions in 2020. The COVID-19 pandemic hit Europe harder than other parts of the world if we judge by the number of lockdowns and their duration. 

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Yet, despite all of it, the common currency, the Euro, ended up as one of the strongest of the FX dashboard. It literally gained against all G10 counterparts, especially against the main rival, the U.S. dollar.

What lies ahead for the Euro area economy? Here are some scenarios.

What Lies Ahead for Europe?

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One of the reasons why the Euro is so strong comes from the joint reaction to the crisis. For the first time in history, Europe issued joint debt – a move that signalled the cohesion of the Euro area and bodes well for the European project.

However, the road to pre-COVID-19 economic growth is full of hurdles. The Euro area economy is projected to recover its pre-COVID-19 level only in the fourth quarter of 2022. Yes, that means two years from now – so severe is the current economic contraction!

Moreover, next year the economy is expected to rebound, mostly on hopes that the new vaccines will be effective in stopping the pandemic. Even so, the vaccination takes time, and the economic recovery will be gradual.

Inflation is expected to remain depressed in the year ahead. The risks are tilted to the downside and, with a bit of luck, the European Central Bank (ECB) may manage to bring inflation close to 1%. However, the risks are that inflation will threaten to move below zero, something that the ECB will not accept.

2021 will be a year with extended fiscal policy support in the Euro area. In fact, the EU fiscal rules are already suspended and thus, countries have more power to act in the fiscal space.

On top of everything lies Brexit. We still do not know how the relationship between the European Union and the United Kingdom will continue as of January next year. However, we do know that the impact on the Euro area economy is negative, making it even more difficult to recover from the most severe recession in our lifetimes.

Last week, Isabel Schnabel, a member of the ECB’s Executive Board, said that the Euro is stronger in 2020 for good reasons. In 2021, the risk is that the strong currency will weigh on inflation – putting pressure on economic growth and threatening the ECB’s credibility.