European Insights

EU FACES WINTER RECESSION AS WAR, AND INFLATION HIT ECONOMIES HARD

As Russian missiles continue to strike Ukrainian infrastructure plunging millions of citizens into darkness, unprecedented levels of inflation around the continent push consumers into cutting back from non-essential purchases, drastically impacting consumption and denting business confidence.

In addition to the ongoing pain and devastation in Ukraine, the war has had far-reaching economic effects. A global economy that is still dealing with the financial fallout from the pandemic crisis is being hammered hard by the sudden spike in inflation brought on by the strain of rising electricity, fuel, food, and other commodity costs. Due to its proximity to the conflict and considerable - albeit rapidly declining - reliance on fossil fuel imports, the EU is one of the most vulnerable economies.

Despite the challenges, the first half of the year’s real GDP growth exceeded forecasts. As soon as social restrictions were reduced, consumers restarted travelling abroad and enjoying themselves in hotels and restaurants while spending their accumulated savings. Despite the increasing impact of soaring energy bills and across the board rise in the cost of living, even the third quarter saw the EU and eurozone registering an economic expansion, despite this being at a slower rate. Amidst high production costs, ongoing supply constraints, tighter financing conditions, and increased uncertainty, confidence in the business sector also fell.

Despite this availability, energy inflation is predicted to continue rising until the end of the year as the summer spike in wholesale energy prices works its way through the retail markets. High energy prices also represent a major supply shock for firms, especially those that consume significant amounts of energy.

As a result, it is even more likely that the eurozone and most EU countries will head to an economic recession in the last quarter of 2022 and the first quarter of 2023. According to the latest Autumn Economic Forecast published by the European Commission, the momentum from 2021 and strong growth in the first half of the year are set to lift real GDP growth in 2022 to 3.3% in the EU. This rate is significantly above the 2.7% projection of the Summer interim forecast. Accelerating price pressures in the first ten months of the year have increased the yearly inflation rate projection to 9.3% in the EU and 8.5% in the euro area, about one percentage point higher than what was expected in Summer. Late in November, ECB President Christine Lagarde insisted that the inflationary peak had not been reached yet. Despite this reality, economists are not all doom and gloom on upcoming prospects. Concerns of a cold winter have dwindled as gas storage levels in the EU are approaching the winter season at historically high levels, even exceeding the targets originally set by the EU executive. Efforts aimed towards increasing reserves evidently produced another spike in gas prices over the summer amid fresh restrictions to Russian supplies. Despite this, rising prices allowed the EU to draw a larger proportion of LNG supply and create a strong buffer for the upcoming winter. Reduced pressure on wholesale energy prices in recent weeks due to high storage and the benefit of milder late-Autumn temperatures across Europe should however guarantee that Europe manages the next winter without gas supply interruptions. Despite this availability, energy inflation is predicted to continue rising until the end of the year as the summer spike in wholesale energy prices works its way through the retail markets. High energy prices also represent a major supply shock for firms, especially those that consume significant amounts of energy. Many European firms have already curtailed or plan to cut production in sectors such as fertilizers, glass, steel, and aluminum manufacturing, which will likely result in additional price increases across value chains. Inflation in the EU is forecast to increase by 9.3% this year (euro area: 8.5%). It is

On the positive economic side, despite these turbulences, the employment market has remained a strong one, particularly from a job seeker perspective. Employment and participation rates are at historic highs, and unemployment rates are at record lows. Additionally, while beginning to decline, reported job shortages and vacancy rates continue to be quite high. Although with a lag, job demand is projected to respond to the slowdown in economic activity, but before employment decreases, vacancy rates and labour shortages are anticipated to decline considerably. Thus, it is anticipated that the unemployment rate would only slightly rise from a historically low annual average of 6.2% in 2022 to 6.5% in 2023 and then again to 6.4% in 2024. In 2022, wage growth climbed above normal rates according to EU data. Despite additional steps implemented to lessen the effect of rising energy prices on consumers and businesses, strong nominal growth in the first three quarters of the year and the phase-out of pandemic-related support are driving a further reduction of government deficits in 2022.

DEFICITS DECLINING BUT FINANCIAL SUSTAINABILITY IS A CONCERN

The general government deficit in the EU is anticipated to decrease by more than one percentage point in 2022 after decreasing to 4.6% of GDP in 2021. The 2023 aggregate general government deficit for the EU is expected to rise once more, but only by about 0.2 percentage points to 3.6% of GDP, as economic activity weakens, interest spending rises, and governments expand or introduce new discretionary measures to mitigate the impact of high energy prices. The IMF has recently recommended keeping energyrelated support temporary to contain fiscal costs. The Fund has argued that compared with price interventions, a better option is to support low- and middle-income households through lumpsum rebates on their energy bills.

COORDINATION REQUIRED TO ADDRESS CHALLENGES

Europe welcomes 2023 facing a significant conundrum. While established economic and monetary policy provides for the increasing interest rates solution to counter inflation, with the latter being caused by external sources, the traditional solution might not work out appropriately. Some have warned that increasing interest rates will threaten recovery. Private consumption will continue to be negatively impacted by high inflation, and investment expenditure will be constrained by higher borrowing rates. Europe will also be affected by slower growth in the US, where monetary policy is becoming tighter, and in China, where zero-covid policies are still in place.

These challenges, therefore, mean that the European economy will face significant challenges in 2023. As a result, policymakers have pushed for the steady implementation of reforms that enhance productivity, relieve supply constraints in energy and job markets, and expand economic capacity remains essential to raise growth and ease price pressures over the medium term. This includes accelerating the implementation of the Next Generation EU programme, a 700 billion euro economic recovery package.

In its 2023 European Semester cycle of economic policy coordination, the Commission has called for coordinated action to secure adequate and affordable energy supply, safeguard economic and financial stability, and protect vulnerable households and companies while preserving the sustainability of public finances. At the same time, rapid action is needed to boost potential growth and quality job creation and deliver on the green and digital transitions.

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