## Europe’s Knife-Edge Path Toward Beating Inflation Without a Recession

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**Canonical URL:** [Europe’s Knife-Edge Path Toward Beating Inflation Without a Recession](https://www.imf.org/-/media/files/news/blogs/blog-eur-reo-april2023.pdf)

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### Overview
- Europe exited the pandemic strongly but was hit hard by the economic impact of Russia’s invasion of Ukraine, causing growth to slow, inflation to shoot up, and episodes of financial stress.
- Decisive policy action helped most economies narrowly avoid a recession this winter.
- The challenge ahead is to sustain the recovery, defeat inflation, and safeguard financial stability.

### Growth and inflation outlook
- Growth projections:
  - Advanced economies in Europe: will slow to 0.7 percent this year from 3.6 percent last year.
  - Emerging economies (excluding Türkiye, Belarus, Russia, and Ukraine): will decline to 1.1 percent this year from 4.4 percent last year.
  - Projected rebound next year: advanced economies to 1.4 percent and emerging economies to 3 percent, as real wages catch up and external demand picks up.
- Inflation dynamics:
  - Headline inflation continues to decline, but underlying inflation (excluding energy and food) will remain persistent and uncomfortably above central bank targets even by the end of next year.
  - Recent and projected declines in energy prices will feed into lower underlying inflation, but not enough to bring it down quickly.
- Baseline projection assumptions:
  - Central banks succeed in steadily bringing down inflation.
  - Any renewed bouts of financial stress remain contained.
  - No further escalation of Russia’s war in Ukraine and associated sanctions, keeping energy prices in check.
  - Broader geoeconomic fragmentation is kept at bay.

### Inflation and supply-side risks
- Upside inflation risks:
  - Energy prices could spike again.
  - Wage growth could pick up more than projected as workers obtain greater compensation for recent purchasing power losses in tight labor markets.
  - Faster wage gains would make underlying inflation more persistent, particularly in Emerging European economies where nominal wage growth is in double digits.
- Damage to productive capacity and persistent effects:
  - Persistently higher energy prices will reduce euro area output by more than 1 percent on average in the medium term, with larger losses in more energy-intensive economies such as Germany or Italy.
  - Shifts in worker preferences (away from long hours) and more workdays lost to sickness related to long COVID may durably reduce labor supply and complicate matching of workers with vacancies.
  - Historical revisions: estimates of economic slack in European countries were revised downwards by a full percentage point one year after the fact and by even more later, indicating the risk of underestimating permanent crisis damage.

### Monetary policy stance and rationale
- Central bank guidance:
  - Central banks should maintain tight monetary policy until core inflation is unambiguously on a downward path back to central bank inflation targets.
  - Further increases in policy rates are required in the euro area.
  - Central banks in emerging European economies should stand ready to tighten further where real interest rates are low, labor markets are tight, and underlying inflation is sticky.
- Uncertainty and policy timing:
  - High uncertainty strengthens the case for tight monetary policy: reacting too late risks entrenching high inflation and forcing central banks to tighten later for longer, likely requiring a sharp recession to bring inflation back to target.
  - When economic slack is uncertain, monetary policymakers should place more weight on inflation and labor market dynamics, both of which now favor higher interest rates.
  - Even accounting for elevated uncertainty, policy rates in a number of countries are at the lower end of commonly used benchmarks, suggesting higher rates may be needed to rein in inflation.
- Interaction with financial conditions:
  - If financial conditions tighten due to banking sector problems, central banks would not need as tight a monetary policy to achieve objectives.
  - It would be misguided to pause or reverse tightening prematurely on the legitimate concern that higher interest rates come with higher financial stability risks.

### Financial stability measures
- Key supervisory and regulatory actions:
  - Close supervision and monitoring of both banks and nonbank financial intermediaries.
  - Contingency planning and prompt corrective action.
- EU-specific measures to bolster stability:
  - Extending the reach of bank resolution tools.
  - Clarifying availability of the Single Resolution Fund’s resources.
  - Ratifying the European Stability Mechanism’s amended treaty.
  - Agreeing on a pan-European deposit insurance.

### Fiscal policy recommendations
- Governments should pursue more ambitious fiscal consolidation than embedded in current plans.
- A recommended starting point: phase out most energy relief measures and target any remaining ones more narrowly to vulnerable households.
- Tighter fiscal policy benefits:
  - Helps central banks meet their objectives at lower interest rates.
  - Reduces debt service costs.
  - Bolsters financial stability by reducing euro area economies’ vulnerability to financial fragmentation risks and emerging European economies’ vulnerability to spillovers from ECB monetary policy tightening and higher global interest rates.

### Supply-side and structural reforms
- Supply-side reforms can help sustain growth amid restrictive macroeconomic policies and ease underlying inflation pressures:
  - Reduce labor market tensions by raising female and older workers’ labor force participation and enhancing job matching.
  - In the EU, progressing on implementing the Recovery and Resilience Plans and the Capital Markets Union could unlock investments needed to raise crisis-hit productive capacity, achieve the EU’s climate goals, and enhance energy security.

*Alfred Kammer, Director of the European Department at the International Monetary Fund.*

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_Source: https://www.imf.org/-/media/files/news/blogs/blog-eur-reo-april2023.pdf_