As Russia’s war of aggression against Ukraine enters its ninth month, there is no sign of a let-up in the fighting, let alone a peaceful resolution of the hostilities. The war continues to cause untold suffering and destruction in Ukraine, but also has economic reverberations that extend far beyond. The sharp rise in inflation under the pressure of energy, food and other commodity prices is hitting a global economy that is still struggling with the economic consequences of the pandemic crisis. The EU is among the most exposed economies, due to its geographical proximity to the war and heavy – albeit much diminishing – reliance on imports of fossil fuels. Although creeping inflation had already dented some of the post-pandemic euphoria ahead of the war, real GDP growth in the first half of the year beat expectations. With the easing of containment measures, consumers resumed international travel and flocked back to restaurants, hotels and other contact-intensive services, unleashing a strong spending spree. The expansion continued in the third quarter, though at a weaker pace. As the terms-of-trade shock makes its way through the economy, the sharp erosion of the purchasing power of households has shifted consumers’ sentiment dramatically. Confidence plunged also in the business sector, amid high production costs, remaining supply bottlenecks, tighter financing conditions and heightened uncertainty.
Notwithstanding a projected contraction of GDP in the fourth quarter, the momentum from 2021 and strong growth in the first half of the year are set to lift real GDP growth in 2022 as a whole to 3.3% in the EU - well above the 2.7% projection of the Summer interim Forecast (SiF). Inflation also continued to surprise on the upside. Accelerating and broadening price pressures in the first ten months of the year have moved the expected inflation peak to the fourth quarter of this year and lifted 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 the SiF.
The contraction of economic activity is set to continue in the first quarter of next year. The EU and euro area, and most Member States, are therefore expected to experience a technical recession this winter. Growth would return in spring, as inflation progressively relaxes its grip on the economy. However, with powerful headwinds still holding back demand, the EU economy is set to manage only lacklustre growth. For 2023 as a whole, this forecast projects real GDP growth in both the EU and euro area at 0.3% - well below the 1.5% and 1.4% expected in the SiF.
Though rapidly declining throughout the year, average inflation is projected to remain high, at 7.0% in the EU and 6.1% in the euro area – again a very large revision with respect to the 4.6% and 4.0% expected respectively for the EU and the euro area only a few months ago. By 2024, the EU is set to have largely adjusted to the shock. As inflation moderates to 3.0% in the EU and 2.6% in the euro area, growth is forecast to progressively regain traction, averaging 1.6% and 1.5% respectively.
The EU is approaching the winter season with gas storages at historically high levels, even above the targets stipulated by the EU.() Amid further cuts of Russian supplies, refilling efforts came at the cost of a sharp increase in gas prices over summer. Rising prices nevertheless allowed the EU to attract a growing share of LNG supplies and build a comfortable buffer for the coming winter. High storages, policy- and price-induced reduction in demand, supported by milder temperatures registered in Europe so far, have reduced pressures on wholesale energy prices in recent weeks and should ensure that Europe manages the upcoming winter without disruptions to gas supply. The near absence of Russian gas supply and infrastructure constraints to further expand LNG imports in the short run will weigh on the EU’s capacity to refill storages next year, heightening risks of disruptions and shortages in the winter of 2023/2024. The forecast rests on the assumption that elevated energy retail prices and other policy incentives will result in a continued reduction of demand, while the diversification of supply achieved this year will carry on over the forecast horizon. Under such hypotheses, which are consistent with the gradual decline in future prices in 2023 and 2024, the EU is assumed to avoid crippling gas shortages also next winter.
As the summer surge in wholesale energy prices makes its way through the retail markets, energy inflation is still expected to increase until year end, before starting to decline next year and turn negative in 2024. The impact of the fiscal measures aimed at shielding households from surging energy prices, nevertheless, adds a degree of uncertainty to the forecast for energy inflation. Pressures stemming from food prices are also set to abate, in line with indications from agricultural commodity markets. Yet, with energy being a key input to much of economic activity, past price increases are now passing through to other inflation components. An uptick in wage growth - though still expected to be moderate – together with the weaker euro would add to external pressures. As a result, core inflation is set to peak only in the first quarter of 2023 and abate very slowly thereafter, thus settling above headline inflation for most of 2024 in both the EU and the euro area.
Faced with persistent inflationary pressures, monetary policy is expected to continue on its tightening path. In line with market expectations, the ECB is assumed to keep hiking its policy rate throughout 2023. With a few exceptions, most EU central banks are also expected to keep tightening throughout 2023. Short-term rates should therefore keep increasing over the forecast horizon. The 10-year Bund yield, averaged over the 10 days preceding the cut-off date of the forecast, stood at 2.3%, some 50 basis points above the yield at the cut-off date of the SiF, though still in negative territory in real terms, based on market expectations of inflation over the same horizon. Long-term real rates of virtually all other Member States are by now well into positive territory. Since July, the spreads of sovereign bonds with respect to the German Bund benchmark have widened somewhat within and especially outside the euro area. The customary technical assumption of fixed spreads over the forecast horizon is complemented in this forecast with the working assumption that the upcoming sharp increase in interest rates will not induce disorderly adjustments in sovereign and financial markets.
Notwithstanding the support from fiscal measures, the large loss in households’ real disposable income is set to continue in the coming quarters. Nor is the hit confined to real income. Recent adjustments in equity and bond valuations have taken a toll on financial wealth of households.
More importantly, the pick-up in inflation is quickly eroding the real value of the additional savings accumulated during the pandemic crisis as well as of the housing wealth following the recent above-trend increases in prices. In most Member States, households are expected to be able to withstand the increase in interest rates, thanks to the prevalence of mortgage loans on fixed term rates. Yet, with saving rates already falling to pre-pandemic levels, households will have no choice but to consume less. Growth in real private consumption is thus projected to decelerate sharply from 3.7% in 2022 to 0.1% in 2023, before picking up to 1.5% in 2024 as real wages, and hence disposable incomes, recoup some of the lost purchasing power.
Higher input and labour costs, coupled with rising borrowing costs, are set to weigh on firms’ financing capacity, while the contraction in demand is likely to soften the pressure on capital utilisation, down from the relatively high rates registered in recent quarters. On the supply front, the ongoing adjustment to supply side disruptions will have to continue, but bottlenecks to production due to shortages in raw material and equipment are still expected to dissipate gradually. These adverse developments are partially mitigated by the continued implementation of the Recovery and Resilience Facility. Overall, total investment in the EU is projected to decelerate markedly from annual growth of 3.0% in 2022 to 0.5% in 2023. Being short-lived and not excessively deep, the economic recession is not expected to result in large capital destruction. An additional assumption for this forecast is that the increase in bankruptcies will remain overall contained and sector-specific, allowing the banking sector to absorb potential increases in non-performing loans without excessively restricting access to credit. This assumption sets the stage for a bounce-back of investment in 2024, by 2.3%.
Despite an unprecedented energy cost shock, EU firms have been able to pass a significant increase in import costs onto export prices, with so far contained losses in market shares. While the income loss of the terms-of-trade shock remains large in historical perspective, it is a fraction of what it would have been, had export prices not largely tracked import prices. This positive outcome was facilitated by the high degree of openness of the EU economy and the important role of the euro as invoicing currency. Going forward, nevertheless, less buoyant trade growth and abating global inflationary pressures may weaken the capacity of EU firms to pass on to foreign customers further increase in costs. Global economic activity already contracted in the second quarter. Although China and the US have in the meantime returned to positive growth and global inflationary pressures appear close to peak, tightening financing conditions are set to also weigh on external demand in most advanced and emerging economies (with the notable exception of China). Overall, weakness in the EU external environment is expected to persist, and net exports are projected to contribute marginally to growth in 2023 and 2024. Price effects are set to dominate over volume effects: the current account surplus is projected to shrink from 3.1% of GDP in 2021 to 2.1% in 2022 and improve only modestly thereafter.
As the recession looms, the EU economy is bolstered by the strongest labour market in decades. Unemployment rates are at record low and participation and employment rates at record high. What is more, vacancy rates and reported labour shortages remain extremely elevated, though they have started declining. Although with a lag, labour demand is set to react to the slowing of economic activity, but vacancy rates and labour shortages are expected to fall significantly before employment contracts. The unemployment rate is thus projected to increase only marginally from a historic low annual average of 6.2% in 2022, to 6.5% in 2023, before falling again to 6.4% in 2024. Wage growth increased to above-average rates in 2022 and is expected to remain strong, but below inflation in 2023.
Strong nominal growth in the first three quarters of the year and the phasing out of pandemic-related support are driving a further reduction of government deficits in 2022, despite new measures adopted to mitigate the impact of surging energy prices on households and firms.
After falling to 4.6% of GDP in 2021, the general government deficit in the EU is projected to decline by more than one percentage point in 2022. As economic activity weakens, interest spending increases and governments extend or introduce new discretionary measures to mitigate the impact of high energy prices, the 2023 aggregate general government deficit for the EU is set to increase again, but only by some 0.2 pps. to 3.6% of GDP. This mild projected increase rests on the customary no-policy-change assumption of the European Commission forecast. In line with governments’ plans, most energy measures are assumed to expire early in 2023, despite the expectation that energy prices will remain at current elevated levels for most of next year.
In 2024, the aggregate deficit in the EU is forecast to fall back to 3.2%, thanks to the projected resumption of economic activity. Over the forecast horizon, a dynamic GDP deflator would support further reduction in the debt-to-GDP ratio, which on the back of the denominator effect is set to drop from 89.4% of GDP in 2021 to 84.1% of GDP in 2024. Yet, over the longer term high inflation (especially if imported) is set to negatively affect public finances as well.
The realisation of the working assumptions underpinning the forecast is subject to high risks. The potential for further disruptions unleashed by Russia’s invasion of Ukraine is alas far from exhausted. A large degree of uncertainty also hangs over the EU’s and global economy’s adjustment to the rapid succession of two extreme shocks. Under these circumstances, this forecast relies again to an exceptional degree on working assumptions. The largest threat comes from adverse developments on the gas market and the risk of crippling shortages, especially in the winter of 2023/2024. Beyond gas, the EU remains directly and indirectly exposed to renewed shocks to commodity markets reverberating from geopolitical tensions. The formation of a wage-price spiral that would entrench high inflation, and potentially disorderly adjustments on financial markets to the new high interest rate environment also remain important risk factors. Both are amplified by potential conflict between fiscal and monetary policy objectives. Pandemic related health risks remain, though they would mostly continue to affect the EU indirectly through demand and supply channels, while the adverse impact of climate change appears to increase threats to the EU and the global economy.