Russia’s invasion of Ukraine has prompted the European Commission to downgrade its EU growth outlook and upgrade its inflation forecast. As discussed in this column, the war is compounding already existing headwinds to growth, which were previously expected to ease, through further upward pressure on commodity prices, renewed supply disruptions and increased uncertainty. Nonetheless, the economy is expected to continue expanding and inflation is expected to gradually fall to 2%, albeit to remain above, throughout the forecast period. Should there be further disruption in energy markets, the economy would not escape stagflation.
Russia’s invasion of Ukraine hits EU economy through multiple channels…
The shocks triggered by the Russian invasion of Ukraine resonate deep and far in the EU and around the world (IMF 2022a). They are putting pressure on energy, food and other commodity prices amid heightened uncertainty and falling consumer confidence (European Commission 2022a); entail renewed interruptions in global supply; and contributing to the tightening of financing conditions (see Figure 1). The EU is the first among advanced economies to be affected due to its geographical proximity to Russia and Ukraine, its heavy reliance on imported fossil fuels, especially from Russia, and its high level of integration in global value chains (IMF 2022b).
illustration 1 How Russia’s invasion of Ukraine is affecting the EU’s economic prospects
…but economic expansion in the EU will continue and inflationary pressures will ease…
The current shock has many similarities to that of the 1970s, when oil prices skyrocketed when the Organization of Arab Petroleum Exporting Countries (OAPEC) cut supplies in response to the October 1973 Yom Kippur War. This alone has prompted observers to conjure up the specter of stagflation. However, similarities should not be overemphasized. First, the rate of increase in the price of energy commodities has, at least so far, been less than in the 1970s (Ha et al. 2022). Admittedly, the price of gas is now about six times what it was before the pandemic, an increase even greater than the rise in oil prices between October 1973 and February 1974. But the rise in oil prices – which is still the primary source of energy for the EU – was better contained at around 60% above pre-pandemic levels. Second, in the 1970s, OAPEC controlled almost 60% of the world’s oil supply, while today Russia has a much smaller share of the world’s oil and gas supply (12% and 17%, respectively; British Petroleum 2022). Third, four decades ago, thanks to advances in energy efficiency and a greater share of services, manufacturing in advanced economies was much more energy-intensive than it is today (IMF 2022c). Fourth, other structural features of the economy also differ: as early as the 1970s, widespread wage and price indexation, highly regulated and oligopolistic markets, and trade protectionism were key to the propagation and prolongation of price shocks. Finally, the prevailing demand management policies were slow to respond to the untested supply shock (ECB 2000).
Despite the downward revision of the projections for growth and upwards for inflation, the spring 2022 forecast for the European economy (European Commission 2022b) still projects that the economy will continue to expand over the forecast horizon and that inflation will gradually converge towards the target – but will stay about it. This is not the full blown stagflation scenario of the 1970s.
Real GDP growth in both the EU and the euro area is now expected at 2.7% in 2022 and 2.3% in 2023, after 4.0% and 2.8% respectively (2.7% in Euro area) in the winter 2022 interim forecast ( European Commission 2022c). The downgrade for 2022 must be read against the background of the growth momentum that the economy picked up in the spring and summer of last year, which will add around 2 percentage points to growth this year (“carry-over effect”). Growth within one year was reduced from 2.1% to just 0.8%. Conversely, the projection for inflation has been revised significantly upwards. In the EU, HICP inflation is now expected to reach an all-time high of 6.8% in 2022, before declining to 3.2% in 2023, compared to 3.5% and 1.7% respectively in the winter 2022 interim forecast.
Economic expansion will be supported by remaining tailwinds from the ongoing post-pandemic reopening of contact-intensive services, as well as the resilience of the economy built by decisive policy action at EU and national levels in response to the pandemic crisis. A strong and improving employment situation, high accumulated savings and the full deployment of the Recovery and Resilience Facility (RRF) and accompanying reform agenda should support private consumption and investment. Fiscal measures to offset some of the impact of rising energy prices on vulnerable households and energy-intensive businesses complement this support.
Figure 2a EU GDP Growth Forecast (Spring and Winter)
Figure 2b EU inflation forecast (spring and winter)
Nonetheless, the unprecedented nature and magnitude of the shocks induced by the war add significant uncertainty to the baseline projections of our forecast and skew the balance of risks surrounding them towards unfavorable outcomes. The risks depend heavily on the development of the war and its consequences for the energy markets. The forecast is based on the assumption that geopolitical tensions will not normalize over the forecast period and that energy prices will develop in line with futures market indications. Large-scale supply disruptions to oil and/or gas commodities are not included, reflecting the status as of the forecast cut-off date.
… still severe disruptions in energy markets could plunge the EU into stagflation…
Shocks resulting from energy market developments that deviate from these key assumptions are assessed using model-based scenario analyses. A first negative scenario assumes oil and gas prices to be 25% above the baseline throughout the forecast period. A second, more serious scenario envisages a complete disruption in gas supplies from Russia. Both scenarios are associated with further increases in risk premiums and negative confidence effects. The results of the simulation exercise show that the shocks in the energy markets amplify the forces of stagflation at work, leading to lower growth and higher inflation than in the baseline scenario. Thanks to the strong carryover from 2021, the euro area economy would still post positive annual growth rates over the two forecast years, but without the carryover effect from 2021, the economy would contract in 2022. A sharp drop in gas consumption and supplies from Russia would mean a significant deterioration in the economic outlook: GDP growth rates would be around 2½ and 1pp. below baseline in 2022 and 2023, respectively, while inflation, approximated by the private consumption deflator, would be 3 percentage points higher in 2022 and more than 1 percentage point higher in 2023.
Figure 3a Real GDP growth rates across scenarios, euro area
Figure 3b Inflation rates across scenarios, euro area
… strengthening the need to bring the energy transition forward
Significant macroeconomic risks arising from the EU’s high dependency on oil and gas imports from Russia speak in favor of an accelerated decarbonization of the economy. Policies should target both supply (e.g. investments in renewable energy sources or LNG terminals) and demand (e.g. promoting energy efficiency or charging stations for electric cars). It is vital that the RRF can be counted on to meet this new challenge. The timely implementation of its investment and reform pillars is more important than ever to reduce fossil fuel dependence on Russia and increase the long-term growth potential of the EU economy. As part of the REPowerEU plan (European Commission 2022d), the Commission is ready to scale up its support projects and reforms that accelerate the energy transition. Projects aimed at completing the internal energy market and those with a strong cross-border dimension should be favoured. Unused loans in the RRF can be an additional source of funding.
Policymakers need to recalibrate their policy tools used during the pandemic. Fiscal firepower has been successfully mobilized in recent years to support aggregate demand and stabilize employment, also ensuring price stability in the face of deflationary risks. This response has proven highly effective in protecting EU citizens and preserving the productive capacity of the economy against the backdrop of a temporary shock that is expected to have limited overall transitional impacts. With a potentially lasting shock weighing largely on the supply side of the economy, policy action should no longer aim to avoid excessive dislocation but rather to accompany and accelerate structural change. When dealing with these new challenges, aspects of distribution must be taken into account. While mitigating the impact of rising energy prices on vulnerable households and energy-intensive industries, policymakers need to maintain incentives to reduce energy consumption and ensure that public finances remain on a path of long-term sustainability.
references
British Petroleum (2022), “Country Insight – Russia”.
ECB (2000), “Box: Lessons from the oil price shocks of the 1970s and early 1980s”, ECB Monthly Bulletin, November.
European Commission (2022a), “Results of the business and consumer survey for March 2022”, DG ECFIN, March.
European Commission (2022b), “European Economic Spring 2022 Forecast”, European Economy Institutional Paper 173, May.
European Commission (2022c), “European Economic Winter 2022 Interim Forecast”, European Economy Institutional Paper 169, May.
European Commission (2022d), “RepowerEU: A plan to rapidly reduce dependency on Russian fossil fuels and accelerate the green transition”, press release, May.
Ha, J, MA Kose and F Ohnsorge (2022), “Today’s inflation and the Great Inflation of the 1970s: Similarities and Differences”, VoxEU.org, 30 March.
IMF (2022a), Global Financial Stability Report, April.
IMF (2022b), World Economic Outlook, April.
IMF (2022c), “Lower Oil Reliance Insulates World From 1970s-Style Crude Shock”, IMF Blog, May.
Comments are closed.