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Economy and Finance

Spring 2022 Economic Forecast: Russian invasion tests EU economic resilience

The outlook for the EU economy before the outbreak of the war was for a prolonged and robust expansion. But Russia’s invasion of Ukraine has posed new challenges, just as the Union had recovered from the economic impacts of the pandemic.

By exerting further upward pressures on commodity prices, causing renewed supply disruptions and increasing uncertainty, the war is exacerbating pre-existing headwinds to growth, which were previously expected to subside. This has led the European Commission to revise the EU’s growth outlook downwards, and the forecast for inflation upwards.

Executive Summary

Almost two years after the start of the pandemic, Russia’s war against Ukraine poses new challenges to the EU economy.

Despite entering the year on a weak note, the outlook for the EU economy before the outbreak of the war was for a prolonged and robust expansionary phase. The pandemic situation was improving, while most of the headwinds posed by logistic and supply bottlenecks and pressures on the price of energy and other commodities were expected to fade in the course of this year. Economic activity would continue to be supported by an improving labour market, large accumulated savings, favourable financing conditions and the deployment of the Recovery and Resilience Facility (RRF). The war has changed the picture, by bringing renewed disruptions in global supply, fuelling further commodity price pressures and heightening uncertainty. The EU is first in line among advanced economies to take a hit, due to its geographical proximity to Russia and Ukraine, heavy reliance on imported fossil fuels, especially from Russia, and high integration in global value chains.  Large inflows of people fleeing the war – as many as 5 million in the first 10 weeks since the start of the war – pose a further organisational and coordination challenge for the EU. 

Against extreme uncertainty around the unfolding of the geopolitical situation, this forecast is underpinned by strong working assumptions.

The ad-hoc assumptions underpinning the forecast are summarised in Box  I.1.1. They concern the duration and intensity of the geopolitical tensions, as well as the size, distribution, labour market integration and budgetary impact of the inflows of people fleeing the war in Ukraine. In particular, it is assumed that geopolitical tensions do not normalise before the end of the forecast horizon. Furthermore, while COVID-19 has significantly relaxed its grip on the EU economy, this is not the case in other parts of the world and risks of a resurgence of serious cases cannot be ruled out. The forecast rests on the assumption that COVID-19 will not pose significant disruptions to economic activity in the EU over the forecast horizon. However, the EU economy remains indirectly exposed to pandemic developments in other regions.

The outlook in the EU is now for lower growth and higher inflation, especially for 2022.

Real GDP growth in both the EU and the euro area is now expected at 2.7% in 2022 and 2.3% in 2023, down from 4.0% and 2.8% (2.7% in the euro area), respectively, in the Winter 2022 interim forecast (WiF). The downgrade for 2022 must be read against the background of the growth momentum gathered by the economy in spring and summer last year, which adds around 2 percentage points to the annual growth rate for this year (see Box  I.2.1.). Output growth within the year has been reduced from 2.1% to just 0.8%. These revised growth projections imply slower convergence to the output level that the economy would have attained in the absence of the pandemic shock – based on an extrapolation of the growth outlook from the last forecast preceding the pandemic. In turn, the projection for inflation has been revised up significantly. In the EU, HICP inflation is now expected to average an all-time high of 6.8% in 2022, before declining to 3.2% in 2023. In the euro area, inflation is projected at 6.1% in 2022 and 2.7% in 2023. This compares with 3.5% and 1.7%, respectively, in the WiF.

The main hit to the global and EU economies comes through higher energy prices.

Energy commodity prices had already increased substantially before Russia’s invasion, from the lows achieved during the pandemic. As supply struggled to keep up with the strong synchronised rebound in global activity, they surged well above pre-pandemic levels. In Europe, in particular, gas and electricity have been trading at record prices since autumn last year. Given the importance of Russia as a major exporter of fossil fuels, uncertainty about supply in the aftermath of the war has brought renewed upward pressures on energy commodity prices, amidst heightened volatility. The forecast uses the indications coming from markets’ futures curves to project energy inflation, and does not factor in large-scale interruptions in the supply of oil and gas commodities, as by its cut-off date, there were no such supply stoppages. The model-based scenario analyses presented in Chapter 4 highlights the importance of developments in energy markets for the euro area. In the severe scenario of an outright cut in gas supply, GDP growth rates would be around 2½ and 1pps. below the forecast baseline in 2022 and 2023, respectively, while inflation would increase 3 pps. in 2022 and more than 1 pps. in 2023 above. The euro area economy would still manage positive annual growth rates in both forecast years, but in 2022 economic output would contract on a quarterly basis.

Pressure on prices is broadening beyond energy…

Rising input costs, notably for energy and fertilisers, had already started to put food commodity prices under pressure late last year. By putting at risk the production and export of grains, oil seeds and other agricultural commodities, for which Ukraine and Russia are key exporters, the war has intensified the pressures. Similar concerns pushed up the price of some industrial metals (e.g. nickel and copper), as well as neon gas (a key input for semiconductors). Furthermore, fresh disruptions in logistics and global supply chains are also adding price pressures across a wide range of industrial goods. Finally, notwithstanding a projected reduction in wholesale energy prices over the forecast horizon, accrued increases are set to keep passing through to a broad range of goods and services. Consequently, core inflation (i.e. inflation netted out of the more volatile energy and food prices) is set to be above 3% in both the euro area and the EU as a whole over the forecast horizon.

… curtailing households’ purchasing power, but a combination of factors support a further recovery in consumption.

Higher energy and food prices reduce households’ purchasing power, especially for lower income families who spend a higher fraction of their income on these items. Consumption growth paused in the first quarter of the year, amidst reinstated pandemic restrictions and inflation surprises. As of the second quarter, reopening dynamics prop up consumption of services, with gradually fading vigour. A strong and still improving labour market, government measures to offset high energy prices and normalisation of households’ saving behaviour push the volume of consumption slightly above its pre-pandemic level by the end of this year, and support a further expansion thereafter. In a context of high inflation and falling purchasing power, households devote a larger fraction of their disposable income to consumption: the savings rate is thus projected to fall in the EU from 17% last year to 13.8% in 2022 and 12.5% in 2023, broadly the same rate recorded in 2019. The large amount of accumulated savings could allow for a faster recovery of consumption, but amid heightened uncertainty and lower confidence, households may be reluctant to dig deeper into their savings. Finally, a further push to consumption would come from people fleeing the war, who are expected to spend part of the social transfers granted to them by the host countries. 

Investment growth is held back by rising costs and heightened uncertainty…

The inability of firms to fully pass on higher production costs to consumers is set to squeeze corporate profit margins. Heightened uncertainty around the unfolding of the geopolitical situation and its impact on the demand outlook are set to weigh on companies’ investment decisions and delay the realisation of investment plans. Moreover, as the strengthening of inflationary pressures has accelerated the pace of monetary policy normalisation, financial conditions are tightening, further increasing the cost of financing for firms. Finally, material shortages continue constraining investment from the supply side.

… but is supported by the RFF and the need for frontloaded energy saving investment.

At the same time, capital utilisation rates remain at record highs, while the full deployment of the RRF and the needed frontloading of energy-saving investment in the context of REPower EU is set to support construction and equipment investment. Overall, the outlook for investment in the EU is subdued, as it is projected to grow by only 3.1% in 2022 – much of which (2 pps.) is being carried over from the rebound in investment in 2021. In 2023, investment is expected to recover momentum and expand by 3.6%.

The outlook for external demand also weakens.

The collapse of import demand in the EU’s Eastern neighbourhood weighs on EU exports, especially for those Member States with deeper trade relations with the region. Also, demand from the rest of the world is negatively affected by war-induced surges in commodity prices, disruptions in global trade and tightening global financing conditions. The growth forecast for the global economy in 2022 has been downgraded by more than 1 percentage point compared to the previous forecast. Strict COVID-19 containment measures applied in parts of China are contributing to the weaker economic outlook for emerging Asia, with impact set to reverberate globally through additional bottlenecks in manufacturing. The deterioration of the global growth outlook is shaving off a significant fraction of the previously expected growth in external demand. Following a very strong rebound recorded in 2021, the volume of global (excl. the EU) imports of goods and services is now forecast to grow by 4.9% and 4.3% in 2022 and 2023, respectively.

The labour market entered the new crisis on a strong footing and is expected to improve slightly further.

Last year, the EU economy created more than 5.2 million jobs and attracted nearly 3.5 million more people into the labour market. With unemployment rates at record-low levels, a rapid increase in unfilled vacancies and a growing share of managers reporting labour shortages as a factor limiting their production, labour markets in the EU have tightened. This strong performance was broad-based across countries, sectors and socio-economic groups, with the exception of the low skilled who are still lagging behind. Still, total hours worked and hours worked per employee in the fourth quarter of last year remained below their pre-pandemic levels in the EU and most Member States.  Job creation is expected to ease markedly this year, amidst signs of attenuating labour shortages. Unemployment rates are forecast to decline further, to 6.7% this year and 6.5% in 2023 in the EU. People fleeing the war in Ukraine to the EU are expected to enter labour markets gradually, with tangible effects only from next year.

Growth of compensation of employees per head is expected to lag behind inflation this year.

In the EU, compensation of employees per head is forecast to increase by 3.9% this year and 3.6% the next. As in 2021, these growth rates are well above those recorded in previous years, but fall short of the surge in inflation. Consequently, this year real wages are expected to decline, before increasing moderately next year. Against the background of soaring production costs and increased economic uncertainty, concerns about job security rather than pay increases are likely to continue to have the upper hand in wage deals. Real household disposable income is set decrease by 2.8% in 2022, despite increased social spending to support people fleeing the war and transfers to offset high energy prices. In 2023 it is set to recover by around 1% in 2023.

General government deficits continue declining in 2022 and 2023, despite energy-related measures and humanitarian assistance.

From 4.7% of GDP in 2021, the general government deficit in the EU is forecast to fall to 3.6% of GDP in 2022, as temporary measures taken in response to COVID-19 continue to be unwound and economic expansion improves the cyclical components of the budget. These deficit-decreasing factors are set to override the additional costs of measures to mitigate the impact of high energy prices (0.6% of GDP for the EU) and to deal with the humanitarian crisis following the invasion of Ukraine by Russia (0.1 % of GDP). The further drop in the deficit to 2.5% in the EU in 2023 is driven by the complete phasing out of temporary COVID-related measures, the expected unwinding of the energy-related measures and a still increasing cyclical component. Overall, these developments imply a supportive stance in 2022, followed by normalisation in 2023. The debt-to-GDP ratio for the EU as a whole is set to decline to 85% of GDP by 2023, remaining above the pre-COVID-19 crisis level.

The balance of risks surrounding the forecast is skewed towards adverse outcomes.

The unprecedented nature and size of the shocks ushered in by the war make the baseline projections presented in this forecast subject to considerable uncertainty. The realisation of the key working assumptions underpinning them – regarding the evolution of the geopolitical situation and its reverberations in e.g. commodity markets and trade – is subject to high risks. Namely, further increases of import prices could strengthen the stagflationary forces unleashed by the war. Greater than expected second round effects could amplify them. In addition, strong inflationary pressures could lead to tighter financial conditions than those underpinning the forecast, with negative impact on domestic demand and strains on public budgets and the banking sector. A stronger-than-expected deceleration of economic activity in the US and China would further dent growth in the EU. Finally, COVID-19 remains a risk factor. At the same time, private consumption could prove more resilient to increasing prices if households were to use more of their savings for consumption. Investments fostered by the RRF could generate a stronger impulse to activity through e.g. stronger cross-sector and cross-country spillovers. Finally, an accelerated reduction of fossil fuel dependency and green transition could reduce the negative impact of high energy prices faster than assumed.

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Documents

European Economic Forecast. Spring 2022
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Spring 2022 Economic Forecast - Statistical annex
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Thematic boxes

Box I.1.1: Key assumptions concerning the forecast
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Box I.2.1: Carry-over effects and the annual growth forecast for 2022
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Box I.2.2: Member States’ vulnerability matrix
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Box I.5.1: Some technical elements behind the forecast
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Thematic Special Topics

Alternative scenarios on the economic outlook
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