European stocks and bonds have had a lot to deal with in recent years, not least war, an energy crisis and surging inflation. Now things are looking up. Germany’s DAX index of shares has added 14% since the start of November. Yields on French ten-year government bonds have dropped from 3.5% in October to 2.6%. Even Italian yields have fallen below 4%, from 5% in mid-October. Investors are upbeat in part because inflation is falling faster than expected. Yet their mood also reflects a grimmer reality: the economy is so weak that surely interest-rate cuts are not far away. As Russia’s war in Ukraine takes a rising toll on Europe’s economies, growth is flagging across the continent, while inflation shows little sign of abating.
Europe’s advanced economies will grow by just 0.6 percent next year, while emerging economies (excluding Türkiye and conflict countries Belarus, Russia, Ukraine) will expand by 1.7 percent, according to projections in our latest World Economic Outlook. That’s down by 0.7 percentage point and 1.1 percentage points, respectively, from July’s projections.
This winter, more than half of the countries in the euro area will experience technical recessions, with at least two consecutive quarters of shrinking output; among these countries, output will fall, on an average, by about 1.5 percent from its peak. Croatia, Poland and Romania will experience technical recessions as well, with an average peak-to-trough output decline of more than 3 percent. Next year, Europe’s output and income will be nearly half a trillion euros lower as compared to the IMF’s pre-war forecasts—a stark illustration of the continent’s severe economic losses from the war.
And while inflation is projected to decline next year, it will stay significantly above central bank objectives, at about 6 percent and 12 percent, respectively, in advanced and emerging European economies.
Growth and inflation could both get worse than these already sobering forecasts. European policymakers have swiftly responded to the energy crisis and built adequate gas storage ahead of the heating season, but further disruptions to energy supplies could lead to more economic pain.
Our scenarios show that a complete shutoff of remaining Russian gas flows to Europe, combined with a cold winter, could result in shortages, rationing and gross domestic product losses of up to 3 percent in some central and eastern economies. On top of these, it could also result in yet another bout of inflation across the continent.
Even without any new energy supply disruptions, inflation could remain higher for longer. Most of the inflation surge so far is driven by high commodity prices—primarily energy, but also food, particularly in the Western Balkan countries. While these prices might remain elevated for some time, there is hope that they will stop increasing and thereby contribute to a steady decline in inflation throughout 2023.
Inflation risks
However, our latest Regional Economic Outlook shows that the pandemic and Russia’s war in Ukraine might have fundamentally altered the inflation process, with rising input and labor shortages contributing notably to the recent high-inflation episode. This suggests there may be less economic slack and, accordingly, more underlying inflationary pressures, than commonly thought across Europe.
These results highlight a risk to our forecasts and those by others that inflation will fall steadily next year. Other wild cards include a de-anchoring of medium-term inflation expectations, or a much sharper acceleration in wages that would trigger an adverse feedback loop between prices and wages.
Tightening needed
In advanced economies, including in the euro area, tight monetary policy will likely be needed in 2023 unless activity and employment weaken more than expected, materially bringing down medium-term inflation prospects.
A tighter stance is generally warranted in most emerging European economies, where inflation expectations are not as well anchored, demand pressures are stronger and nominal wage growth is high—often in the double digits.
Finally, steady implementation of reforms that enhance productivity, relieve supply constraints in energy and labor markets, and expand economic capacity remain essential to raise growth and ease price pressures over the medium-term. This includes accelerating the implementation of the 800-billion-euro economic recovery package, the Next Generation EU programs.
Strength, coordination and solidarity pulled Europe out of the COVID-19 crisis. Once again, the task ahead is immense, but if European policymakers muster the spirit of the pandemic response, it can be accomplished.
BY SHANNUL MAWLONG
SOURCES:
https://www.imf.org/en/Blogs/Articles/2022/10/23/europe-must-address-a-toxic-mix-of-high-inflation-and-flagging-growth