## Executive Summary

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---

### Facing Spillovers from Trade and Manufacturing
- Global trade and manufacturing weakened beginning in early 2018:
  - Global export volumes slowed from about 4½ percent in 2017 to close to zero in the first half of 2019.
  - Industrial production is now expanding at a rate that is less than half of its early 2018 peak.
- Europe closely followed global trends:
  - European exports, both within and outside the region, stalled in the first half of 2019 after decelerating in 2018.
  - The slowdown in EU exports within the region is pronounced in intermediate goods, indicating spillovers into European supply chains.
  - The slowdown in Europe’s exports mainly stemmed from softening exports of machinery and transport equipment, and other manufactured goods.
- Vehicle sector dynamics:
  - Sluggish demand and production of cars significantly affected European activity.
  - Car production remains particularly weak in Germany, while it has held up among car producers in Central Europe (Czech Republic, Hungary, Slovak Republic).
- Current account and domestic demand implications:
  - External surpluses in some advanced European economies have declined slightly but remain high (for example, Germany and the Netherlands).
  - In the NMS and several Southeastern European non-EU countries, strong domestic demand led to a small deterioration in current account balances; market shares generally held up well.
  - Turkey saw a sharp current account improvement mainly on import compression; Russia’s current account weakened on lower oil prices.
- Labor markets and inflation:
  - Services and domestic consumption have been buoyant, linked to still-robust labor market conditions.
  - Inflation has fallen in advanced Europe; in emerging Europe inflation pressures remain relatively contained in most countries.
  - In some NMS (Hungary, Romania) core inflation has risen, partly due to domestic demand pressures.

### Will the Weakness in Trade and Manufacturing Spread?
- Principal forces and expected persistence:
  - Asia’s capital expenditure and consumer durables slowdown will likely continue to weigh on Europe’s exports and growth.
  - Solid demand growth in the United States has mitigated effects but US growth is expected to ease.
  - The vehicle sector may continue to be a drag due to saturation in China, tighter emission standards, and shifts toward electric vehicles.
- Transmission to domestic activity:
  - The industry and trade slowdown, combined with trade- and Brexit-related uncertainty, has started to weigh on fixed investment in several countries.
  - Services PMI still suggests expansion while manufacturing PMI plunged into contractionary territory; services’ value added in European manufacturing value added is estimated at about 30 percent.
  - There are signs firms are becoming more careful about hiring decisions, which could weaken consumer confidence and dampen consumption.
- Macroeconomic policy buffers:
  - Stances of the European Central Bank and the US Federal Reserve have become more accommodative.
  - Some emerging European countries have loosened monetary policy (Russia, Serbia, Turkey, Ukraine).
  - Overall financial conditions have loosened, but credit growth has been modest and most firms do not report credit availability as a key constraint.
  - Many countries are conducting expansionary fiscal policy in 2019, albeit less so in 2020.

### Outlook: A Modest Recovery
- Regional growth projections:
  - Europe’s growth is projected to decline from 2.3 percent in 2018 to 1.4 percent in 2019.
  - Growth is projected to rebound to 1.8 percent in 2020.
- Differences across country groups and revisions:
  - Advanced Europe:
    - Growth has been revised down by 0.1 percentage point to 1.3 percent in 2019.
    - Advanced Europe expected to recover modestly from 1.3 percent in 2019 to 1.5 percent in 2020.
    - Projections were downgraded by 0.1 percentage point both in 2019 and 2020, with larger revisions for economies with greater exposure to manufacturing.
  - Emerging Europe:
    - Growth has been revised up by 0.5 percentage point to 1.8 percent in 2019.
    - Emerging Europe revised up by 0.2 percentage point to 2.5 percent in 2020.
    - Growth in other emerging European economies is forecast at 3.7 percent in 2019 and 3.1 percent in 2020.
  - Turkey and Russia:
    - Turkey’s growth is anticipated to recover from 0.2 percent in 2019 to 3.0 percent in 2020.
    - Russia’s growth is projected to pick up from 1.1 percent in 2019 to 1.9 percent in 2020, assuming planned national projects are implemented effectively.
- Forecast context:
  - The regional projections are broadly unchanged from the April 2019 World Economic Outlook but mask significant cross-country differences and some large revisions.

### Risks and Policy Priorities
- Downside risks:
  - A no-deal Brexit is identified as the key near-term risk and could have a sizeable negative impact on regional economies.
  - Intensification of trade tensions and related uncertainty could dampen investment.
  - The weakness in trade and manufacturing could spread to other sectors—notably services—faster and to a greater extent than currently envisaged.
  - Other risks include abrupt declines in risk appetite, financial vulnerabilities, the re-emergence of deflationary pressures in advanced economies, and geopolitics.
- Monetary policy:
  - Subdued inflationary pressures and slowing activity call for monetary policy to remain accommodative in most European economies.
  - The passthrough from wages to prices is likely to be weaker when inflation and inflation expectations are low, corporate profitability is high, and firms face greater competition.
  - Extending loose monetary policy for longer calls for heightened monitoring of financial sector vulnerabilities—such as rising house prices—and active use of macroprudential measures as needed.
- Fiscal policy and contingency planning:
  - Unemployment rates are projected to remain close to or below levels reached during the pre-crisis boom; fiscal stances should generally remain guided by medium-term objectives.
  - Overall fiscal balances should be allowed to absorb cyclical fluctuations in activity.
  - Countries with ample fiscal space should take measures to boost potential output.
  - Countries with elevated debt and deficit levels should generally proceed with fiscal consolidation; this would also help address external imbalances.
  - Given elevated downside risks, contingency plans should be at the ready for implementation; a synchronized fiscal response, appropriately differentiated across countries, could become suitable.
- Structural reforms:
  - Reinvigorating structural reforms remains vital to raise potential output and address long-term challenges, including adverse demographic trends.
  - Priorities include raising labor force participation, enhancing human capital and infrastructure, and strengthening governance.

*International Monetary Fund | November 2019*

---

### 1. FACING SPILLOVERS FROM TRADE AND MANUFACTURING

### Growth and inflation outlook
- Revisions reflect a better-than-expected outturn in the first half of the year for several countries; growth in Central European countries and Southeastern European EU member states upgraded for 2019–20 due to robust domestic demand.
- Russia saw one of the largest downward revisions for 2019 on the back of a weak outcome in the first half of the year and signs of softening domestic demand and export growth.
- Advanced Europe headline inflation:
  - 2018: 1.8 percent
  - 2019: 1.4 percent
  - 2020: 1.5 percent
  - Note: 0.1 percentage point lower in both 2019 and 2020 relative to prior (Annex Table 1.2).
- Emerging Europe headline inflation:
  - 2018: 6.3 percent
  - 2019: 6.9 percent (temporary pick up)
  - 2020: 5.7 percent (moderation)
  - Downward revisions of 0.3 and 0.5 percentage point for 2019 and 2020 largely driven by Turkey in 2019 and Russia in 2020.
- Turkey:
  - 2019 inflation forecast revised down by 1.8 percentage points due to more favorable market sentiment and lira stability.
  - Outlook remains highly uncertain; central bank needs to strengthen monetary policy credibility and lower inflation expectations.
- Russia:
  - Inflation picked up earlier in 2019 but is expected to be below the target at end-2019 and in 2020 as effects of the January 2019 value-added tax rate hike and other one-off factors dissipate.
- In emerging Europe excluding Russia and Turkey, inflation generally expected to remain restrained despite some upward revisions.

### Risks to the outlook
- Amid high uncertainty, risks are tilted to the downside.
- Brexit:
  - Modalities of Brexit are key. A no-deal Brexit could lower output by about 3½ percent in the United Kingdom and about ½ percent in the European Union in two years relative to the April 2019 forecast.
  - Value added trade exposure of European countries to the United Kingdom is sizable.
- Trade tensions and tighter financing conditions can weigh significantly on European investment and growth.
- Weakness in manufacturing and trade could spread to services and other sectors faster and more extensively than expected.
- Other risks include abrupt declines in risk appetite, build-up of financial vulnerabilities, re-emergence of deflationary pressures in advanced economies, country-specific domestic weaknesses, geopolitical tensions, delayed structural reforms, demographic challenges, climate change, rising inequality, and declining trust in mainstream policies.

### Policy priorities
- Monetary policy:
  - Should remain accommodative in many European countries given muted inflationary pressures.
  - In advanced Europe, monetary policy should support gradual upward adjustment of inflation toward policy objectives.
  - Russia: monetary policy loosening could be considered given contained inflation and easing inflationary pressures.
  - Romania and Turkey: monetary policy should be kept tight to contain inflationary pressures and strengthen policy credibility.
  - Most other emerging European countries can afford to keep monetary policy accommodative for now.
  - Loose monetary policy for longer calls for heightened monitoring of financial sector vulnerabilities and adverse developments, including effects of negative interest rates on traditional financial operations, profitability, and asset prices.
  - Example actions: In Turkey, a comprehensive third-party assessment of bank balance sheets and stress tests with follow-up measures would help strengthen confidence in the sector.
  - Countries should persevere in implementing new financial sector regulations and reducing nonperforming loans.
- Macroprudential policy:
  - Pockets of vulnerabilities should be closely watched and addressed with targeted macroprudential measures as needed.
  - Monitor house prices where they have strengthened and vulnerabilities of nonbank financial institutions.
- Fiscal policy:
  - Given output above or close to full employment in most countries and generally high debt levels, fiscal stance should remain anchored by countries’ medium-term objectives while allowing automatic stabilizers to work freely.
  - Countries with ample fiscal space and human capital or infrastructure needs (Germany, Netherlands) should consider a measured fiscal expansion to boost potential output and help reduce external surpluses.
  - Countries with still-elevated public debt and deficits should proceed with fiscal consolidation, except where private demand is so weak that consolidation would push output far below potential.
  - Consider debt management operations that take advantage of currently low interest rates.
  - If significant negative risks materialize and monetary policy space is limited, fiscal stance should be more expansionary while keeping medium-term debt sustainability objectives in mind; options include a temporarily slower pace of consolidation or a temporary expansion where debt sustainability and market confidence are preserved.
  - Policymakers should prepare contingency plans focused on growth-friendly and inclusive policies to deliver timely support; a synchronized fiscal response, appropriately differentiated across countries, could become suitable.
- Structural reforms:
  - Remain essential to raise potential output, boost resilience, and strengthen inclusive growth.
  - Product market reforms could improve competitiveness and productivity.
  - Policies to increase labor force participation and enhance human capital (including shifting taxes away from labor, enhancing apprenticeship programs, and improving tailoring education to labor market needs) should be urgently implemented.
  - Completing the euro area’s architecture is critical to increase resilience to shocks.
  - The European Union would benefit from deepening the single market for services.
  - In many emerging European countries, continued strengthening of governance and improving public sector efficiency remain imperative to sustain convergence in living standards.

### Vehicle sector: European perspective and spillover risks
- Importance:
  - Vehicle sector is important for domestic economies and exports in many European countries.
  - Germany: vehicles constitute about 20 percent of manufacturing and about 17 percent of exports.
  - Slovak Republic: vehicle sector comprises about one-third of manufacturing and more than a quarter of exports.
- Recent developments:
  - Europe’s vehicle production has fallen and has been one of the main contributors to the industrial production slump in the European Union.
  - Several structural and cyclical factors: tighter EU emission standards, shift in preferences from diesel toward gasoline and other alternative fuel vehicles, weakening global demand (especially from China).
  - After the emissions-related dip in 2018, car registrations have normalized.
- Cross-country heterogeneity:
  - 2018 vehicle production contraction was led by Germany and to a lesser extent the United Kingdom and Spain.
  - Germany’s production remained weak in the first half of 2019, dropping by about 12 percent versus the first half of 2018.
  - Vehicle production held up in Central and Eastern Europe; anecdotal evidence attributes CEE resilience to production of SUVs and utilitarian cars and to CEE suppliers adapting and re-orienting to other models and plants outside Germany.
- Outlook and risks:
  - Near-term outlook for Europe remains conservative due to falling demand for diesel cars, trade tensions, Brexit-related uncertainty, and additional tighter emission standards.
  - Potential reorganizations of supply chains related to the shift to alternative fuel vehicles pose considerable uncertainty for the medium-term outlook.
  - A sustained weakness in the vehicle sector could spill over to the broader economy and across borders via supply chains.

### Key numerical findings and projections (selected exact figures)
- Advanced Europe inflation: 1.8 percent (2018) → 1.4 percent (2019) → 1.5 percent (2020).
- Emerging Europe inflation: 6.3 percent (2018) → 6.9 percent (2019) → 5.7 percent (2020).
- Turkey 2019 inflation forecast revision: down by 1.8 percentage points.
- No-deal Brexit impact (relative to April 2019 WEO, two years):
  - United Kingdom output lower by about 3½ percent.
  - European Union output lower by about ½ percent.
- Germany vehicle production: drop of about 12 percent in first half of 2019 versus first half of 2018.
- Germany: vehicles ≈ 20 percent of manufacturing; ≈ 17 percent of exports.
- Slovak Republic: vehicles ≈ one-third of manufacturing; > a quarter of exports.

*International Monetary Fund | November 2019*

---

### Chapter 2 — Wage, Productivity, and Inflation Dynamics

### Recent wage, productivity, and inflation trends
- Nominal wage growth averaged nearly 8 percent in NMS since the first quarter of 2017, and 2 percent in other European countries (EU15+3).
- Labor costs constitute almost 50 percent of business expenses in NMS and 53 percent in EU15+3 countries.
- Productivity-adjusted wage growth in NMS has exceeded inflation by about 3 percentage points on average since early 2017; in EU15+3 the gap is about 0.4 percentage point.
- In several EU15+3 countries (for example, Germany, Israel, Portugal), annual real wage growth exceeded productivity gains by more than 1 percentage point since the beginning of 2017.
- In NMS, more than 40 percent of firms cited labor shortages as a major factor limiting production in 2019, up from 10 percent in 2013.

### Analytical approach
- Empirical framework: four-variable panel vector autoregression (PVAR) for a sample of 27 European countries since 1995, with variables: import price inflation, nominal wage growth adjusted for trend productivity growth, core consumer price inflation, and unemployment gap.
- Specifications: quarterly data, four lags, Cholesky ordering (import prices most exogenous, unemployment gap most endogenous); wage growth assumed to impact inflation immediately, wages assumed to take at least a quarter to respond to consumer price movements.
- Wages baseline measure: compensation per employee (compensation per hour worked discussed but not used as main series due to data limitations).
- Extensions: interacted-PVAR (IPVAR) to allow the passthrough response to vary with observable state variables (examples: pre- versus post-global financial crisis; inflation expectations anchoring; corporate profitability; labor share; product market regulation).

### Main empirical findings on passthrough
- Wage growth leads to higher core inflation after several quarters; impact peaks after about six quarters then dissipates.
- After three years, the cumulative impact of a 1 percentage point increase in wages is:
  - 1.1 percentage point higher inflation in NMS.
  - 1 percentage point higher inflation in other European countries (EU15+3).
- Passthrough ratio (cumulative change in prices divided by cumulative change in wages) is about a third in the historical sample.
- The passthrough has weakened after the global financial crisis: after 2009 the cumulative impact of wage growth on European core inflation decreased, with the passthrough ratio declining to less than 20 percent.

### Role of inflation, expectations, and the inflationary environment
- Passthrough depends on prevailing inflation: in low-inflation periods (core inflation below country average), a 1 percentage point wage increase raises inflation by a cumulative 0.3 percentage point over three years, with an estimated passthrough ratio of 11 percent.
- In high-inflation periods (inflation above country average), the cumulative impact is about three times higher, with a passthrough ratio of about 30 percent.
- Using an inflation expectations anchoring metric (deviation of long-term professional forecasts from central bank target), the passthrough is muted when inflation expectations are better anchored.
- Empirical example: a 1 percentage point wage increase raises inflation by a cumulative 0.9 percentage point over three years when evaluated at the 75th percentile of the inflation expectations anchoring measure; the text notes this impact increases by about a half under poorer anchoring.

### Factors considered for changes in passthrough
- Inflation and inflation expectations anchoring (better anchoring → lower passthrough).
- Domestic and foreign competition (higher competition → limited ability to pass through costs).
- Corporate profitability and firms’ buffers (higher profit margins → firms can absorb wage increases without immediate price increases).
- Workers’ share of value added (labor share) and product market regulation (differences examined in IPVAR).

---

### Key findings on wage–price passthrough and sectoral heterogeneity

### Aggregate passthrough magnitudes
- The cumulative impact of a 1 percentage point increase in wages is 1.1 percentage point higher inflation in European countries at the end of three years.
- The overall passthrough ratio, which takes into account the response of wages to their own increases, is about a third.
- When inflation expectations are weakly anchored (evaluated at the 25th percentile of the distribution of inflation expectations anchoring), the passthrough is 1.4 percentage point.
- The passthrough ratio is also smaller when expectations are anchored within a low range.
- In the NMS subsample, inflation expectations became significantly better anchored in the 2000s, which may be an important reason why the passthrough has declined over time in the sample countries analyzed.

### Role of competition and sectoral differences
- Import penetration (ratio of final imports to sectoral gross value added) is about 60 percent in the manufacturing sector and less than 5 percent in the services sector.
- Economy-wide wage growth is more likely to lead to higher growth in services prices relative to non-energy industrial goods prices:
  - PVAR regressions suggest that in EU15+3 countries, the extent to which economy-wide wage growth feeds into services inflation is nearly two times stronger than the impact on non-energy industrial goods inflation.
  - In NMS, prices of services are about four times more responsive to wage increases compared to manufacturing prices.
- Panel regressions across 55 sectors in 32 European countries (2000–14) reveal the correlation between sectoral wage growth and growth in sectoral value-added deflators is significantly higher in sectors that have lower import penetration.
- Domestic product market competition mutes passthrough:
  - IPVAR regressions based on OECD’s product market regulation (PMR) indices suggest that more vibrant product market competition and fewer barriers to entry mute the sensitivity of consumer prices to wage increases.
  - The passthrough of wage growth to inflation is marginally higher when evaluated at the 75th percentile of a country’s PMR score (that is, in countries with higher regulatory barriers) than at the 25th percentile of the PMR index.
- Industry-based analysis (NMS, 1995–2016, 70 industries) finds:
  - A 1 percentage point increase in unit labor costs increases producer prices by 0.9 percentage point after three years (sectoral regressions).
  - Country variation: smallest cumulative increase about 0.5 percentage point in Poland and Hungary; largest 1.3 percentage points in Latvia.
  - Cumulative response: 0.7 percentage point in manufacturing and close to 1 percentage point in services.
  - Firms in services with greater domestic market power (Lerner Index) tend to fully pass higher wages onto consumers; firms with lower market power limit price increases to two-thirds of wage hikes.
  - Passthrough appears smaller in sectors more exposed to foreign competition (imports of goods/services for final consumption to sectoral gross output).

### Role of corporate profitability and other costs
- At end-2018, corporate profits amounted to 47 percent of gross value added in NMS and 40 percent in EU15+3 countries.
- Since the beginning of 2017, corporate profits declined each year by about 1 percent of gross value added in NMS economies and 0.3 percent in other European countries.
- IPVAR analysis on profitability and passthrough:
  - A 1 percentage point increase in labor costs leads to a cumulative increase in inflation of only 0.7 percentage point during the three-year period when evaluated at the 75th percentile of the distribution of corporate profitability.
  - When corporate profits are at the 25th percentile of the distribution of corporate profitability, the impact of wage growth on inflation is 2.5 times higher (with a somewhat stronger passthrough).
- Low labor share regimes produce cumulative impacts of wage increases on inflation very similar to the high corporate profit regime.
- Declining relative prices of machinery and equipment since the 1990s are linked to a more muted wage growth–inflation passthrough by enabling firms to pay higher wages without raising prices.

### Aggregate and survey evidence on competition and profitability
- More than two-thirds of firms report increased competitive pressures compared to the precrisis era according to the latest Wage Dynamics Network Survey.
- Despite comfortable aggregate profit margins, firms in many economies appear to use profit buffers to absorb faster wage growth rather than pass costs onto consumers.

### Policy implications and outlook
- Labor markets remain strong in Europe; wage growth has risen above productivity gains, especially in NMS, but underlying consumer price pressures remain limited.
- Several cyclical (for example, inflation, corporate profitability) and structural (for example, degree of competition) factors shape the responsiveness of inflation to wage developments.
- Current conditions pointing to a low wage–inflation passthrough include:
  - Inflation and inflation expectations near historical lows for three quarters of European economies.
  - Corporate profitability still healthy from a historical perspective and significantly above that of EU15+3 (despite recent declines in NMS).
  - High reported levels of product competition among firms.
- These factors suggest it is unlikely that the recent increase in wage growth will meaningfully spur inflation in the near term.
- Policy recommendation: Findings support the need for monetary policy in many European countries to remain accommodative for longer to guard against a downshift in inflation expectations.
- Caveat for policymakers: Prolonged accommodative financial conditions may foster greater risk taking; policymakers need to remain vigilant and guard against further buildup of financial vulnerabilities and other undesirable side effects.

*International Monetary Fund | November 2019*

---

### Box 2.1 — Sectoral Dimension of the Link between Wage Growth and Inflation
- Focus: How the three-year cumulative passthrough from labor cost growth to producer prices varies across Manufacturing and Services and across firm/sector characteristics.
- Market power measured by Lerner Index (price–cost margin); high market power = 1 when Lerner Index exceeds sectoral average.
- Foreign trade exposure measured as share of imports of goods and services used for final consumption relative to total gross output of the industry.
- Subsamples partitioned by median values within sectors in 2000 (special threshold for import of services).
- Empirical patterns show passthrough magnitudes differ by cyclical position (positive vs negative output gap), firms' market power (high vs low), and foreign trade exposure (low vs high).
- Interpretation: Higher market power and lower foreign trade exposure increase the likelihood that labor cost increases are translated into higher producer prices over a three-year horizon.

*International Monetary Fund | November 2019*

### Executive Summary vi

### Executive Summary vi

### Facing Spillovers from Trade and Manufacturing
- Global trade and manufacturing weakened beginning in early 2018:
  - Global export volumes slowed from about 4½ percent in 2017 to close to zero in the first half of 2019.
  - Industrial production is now expanding at a rate that is less than half of its early 2018 peak.
- Europe closely followed global trends:
  - European exports, both within and outside the region, stalled in the first half of 2019 after decelerating in 2018.
  - The slowdown in EU exports within the region is pronounced in intermediate goods, indicating spillovers into European supply chains.
  - The slowdown in Europe’s exports mainly stemmed from softening exports of machinery and transport equipment, and other manufactured goods.
- Vehicle sector dynamics:
  - Sluggish demand and production of cars significantly affected European activity.
  - Car production remains particularly weak in Germany, while it has held up among car producers in Central Europe (Czech Republic, Hungary, Slovak Republic).
- Current account and domestic demand implications:
  - External surpluses in some advanced European economies have declined slightly but remain high (for example, Germany and the Netherlands).
  - In the NMS and several Southeastern European non-EU countries, strong domestic demand led to a small deterioration in current account balances; market shares generally held up well.
  - Turkey saw a sharp current account improvement mainly on import compression; Russia’s current account weakened on lower oil prices.
- Labor markets and inflation:
  - Services and domestic consumption have been buoyant, linked to still-robust labor market conditions.
  - Inflation has fallen in advanced Europe; in emerging Europe inflation pressures remain relatively contained in most countries.
  - In some NMS (Hungary, Romania) core inflation has risen, partly due to domestic demand pressures.

### Will the Weakness in Trade and Manufacturing Spread?
- Principal forces and expected persistence:
  - Asia’s capital expenditure and consumer durables slowdown will likely continue to weigh on Europe’s exports and growth.
  - Solid demand growth in the United States has mitigated effects but US growth is expected to ease.
  - The vehicle sector may continue to be a drag due to saturation in China, tighter emission standards, and shifts toward electric vehicles.
- Transmission to domestic activity:
  - The industry and trade slowdown, combined with trade- and Brexit-related uncertainty, has started to weigh on fixed investment in several countries.
  - Services PMI still suggests expansion while manufacturing PMI plunged into contractionary territory; services’ value added in European manufacturing value added is estimated at about 30 percent.
  - There are signs firms are becoming more careful about hiring decisions, which could weaken consumer confidence and dampen consumption.
- Macroeconomic policy buffers:
  - Stances of the European Central Bank and the US Federal Reserve have become more accommodative.
  - Some emerging European countries have loosened monetary policy (Russia, Serbia, Turkey, Ukraine).
  - Overall financial conditions have loosened, but credit growth has been modest and most firms do not report credit availability as a key constraint.
  - Many countries are conducting expansionary fiscal policy in 2019, albeit less so in 2020.

### Outlook: A Modest Recovery
- Regional growth projections (exact figures preserved):
  - Europe’s growth is projected to decline from 2.3 percent in 2018 to 1.4 percent in 2019.
  - Growth is projected to rebound to 1.8 percent in 2020.
- Differences across country groups and revisions:
  - Advanced Europe:
    - Growth has been revised down by 0.1 percentage point to 1.3 percent in 2019.
    - Advanced Europe expected to recover modestly from 1.3 percent in 2019 to 1.5 percent in 2020.
    - Projections were downgraded by 0.1 percentage point both in 2019 and 2020, with larger revisions for economies with greater exposure to manufacturing.
  - Emerging Europe:
    - Growth has been revised up by 0.5 percentage point to 1.8 percent in 2019.
    - Emerging Europe revised up by 0.2 percentage point to 2.5 percent in 2020.
    - Growth in other emerging European economies is forecast at 3.7 percent in 2019 and 3.1 percent in 2020.
  - Turkey and Russia:
    - Turkey’s growth is anticipated to recover from 0.2 percent in 2019 to 3.0 percent in 2020.
    - Russia’s growth is projected to pick up from 1.1 percent in 2019 to 1.9 percent in 2020, assuming planned national projects are implemented effectively.
- Forecast context:
  - The regional projections are broadly unchanged from the April 2019 World Economic Outlook but mask significant cross-country differences and some large revisions.

### Risks and Policy Priorities
- Downside risks (enumerated):
  - A no-deal Brexit is identified as the key near-term risk and could have a sizeable negative impact on regional economies.
  - Intensification of trade tensions and related uncertainty could dampen investment.
  - The weakness in trade and manufacturing could spread to other sectors—notably services—faster and to a greater extent than currently envisaged.
  - Other risks include abrupt declines in risk appetite, financial vulnerabilities, the re-emergence of deflationary pressures in advanced economies, and geopolitics.
- Monetary policy:
  - Subdued inflationary pressures and slowing activity call for monetary policy to remain accommodative in most European economies.
  - The passthrough from wages to prices is likely to be weaker when inflation and inflation expectations are low, corporate profitability is high, and firms face greater competition.
  - Extending loose monetary policy for longer calls for heightened monitoring of financial sector vulnerabilities—such as rising house prices—and active use of macroprudential measures as needed.
- Fiscal policy and contingency planning:
  - Unemployment rates are projected to remain close to or below levels reached during the pre-crisis boom; fiscal stances should generally remain guided by medium-term objectives.
  - Overall fiscal balances should be allowed to absorb cyclical fluctuations in activity.
  - Countries with ample fiscal space should take measures to boost potential output.
  - Countries with elevated debt and deficit levels should generally proceed with fiscal consolidation; this would also help address external imbalances.
  - Given elevated downside risks, contingency plans should be at the ready for implementation; a synchronized fiscal response, appropriately differentiated across countries, could become suitable.
- Structural reforms:
  - Reinvigorating structural reforms remains vital to raise potential output and address long-term challenges, including adverse demographic trends.
  - Priorities include raising labor force participation, enhancing human capital and infrastructure, and strengthening governance.

*International Monetary Fund | November 2019*

### 1. FACING SpILLOvERS FROM TRAdE ANd MANUFACTURING

### 1. FACING SpILLOvERS FROM TRAdE ANd MANUFACTURING

### Growth and inflation outlook
- Revisions reflect a better-than-expected outturn in the first half of the year for several countries; growth in Central European countries and Southeastern European EU member states upgraded for 2019–20 due to robust domestic demand.
- Russia saw one of the largest downward revisions for 2019 on the back of a weak outcome in the first half of the year and signs of softening domestic demand and export growth.
- Advanced Europe headline inflation:
  - 2018: 1.8 percent
  - 2019: 1.4 percent
  - 2020: 1.5 percent
  - Note: 0.1 percentage point lower in both 2019 and 2020 relative to prior (Annex Table 1.2).
- Emerging Europe headline inflation:
  - 2018: 6.3 percent
  - 2019: 6.9 percent (temporary pick up)
  - 2020: 5.7 percent (moderation)
  - Downward revisions of 0.3 and 0.5 percentage point for 2019 and 2020 largely driven by Turkey in 2019 and Russia in 2020.
- Turkey:
  - 2019 inflation forecast revised down by 1.8 percentage points due to more favorable market sentiment and lira stability.
  - Outlook remains highly uncertain; central bank needs to strengthen monetary policy credibility and lower inflation expectations.
- Russia:
  - Inflation picked up earlier in 2019 but is expected to be below the target at end-2019 and in 2020 as effects of the January 2019 value-added tax rate hike and other one-off factors dissipate.
- In emerging Europe excluding Russia and Turkey, inflation generally expected to remain restrained despite some upward revisions.

### Risks to the outlook
- Amid high uncertainty, risks are tilted to the downside.
- Brexit:
  - Modalities of Brexit are key. A no-deal Brexit could lower output by about 3½ percent in the United Kingdom and about ½ percent in the European Union in two years relative to the April 2019 forecast.
  - Value added trade exposure of European countries to the United Kingdom is sizable.
- Trade tensions and tighter financing conditions can weigh significantly on European investment and growth.
- Weakness in manufacturing and trade could spread to services and other sectors faster and more extensively than expected.
- Other risks include abrupt declines in risk appetite, build-up of financial vulnerabilities, re-emergence of deflationary pressures in advanced economies, country-specific domestic weaknesses, geopolitical tensions, delayed structural reforms, demographic challenges, climate change, rising inequality, and declining trust in mainstream policies.

### Policy priorities
- Monetary policy:
  - Should remain accommodative in many European countries given muted inflationary pressures.
  - In advanced Europe, monetary policy should support gradual upward adjustment of inflation toward policy objectives.
  - Russia: monetary policy loosening could be considered given contained inflation and easing inflationary pressures.
  - Romania and Turkey: monetary policy should be kept tight to contain inflationary pressures and strengthen policy credibility.
  - Most other emerging European countries can afford to keep monetary policy accommodative for now.
  - Loose monetary policy for longer calls for heightened monitoring of financial sector vulnerabilities and adverse developments, including effects of negative interest rates on traditional financial operations, profitability, and asset prices.
  - Example actions: In Turkey, a comprehensive third-party assessment of bank balance sheets and stress tests with follow-up measures would help strengthen confidence in the sector.
  - Countries should persevere in implementing new financial sector regulations and reducing nonperforming loans.
- Macroprudential policy:
  - Pockets of vulnerabilities should be closely watched and addressed with targeted macroprudential measures as needed.
  - Monitor house prices where they have strengthened and vulnerabilities of nonbank financial institutions.
- Fiscal policy:
  - Given output above or close to full employment in most countries and generally high debt levels, fiscal stance should remain anchored by countries’ medium-term objectives while allowing automatic stabilizers to work freely.
  - Countries with ample fiscal space and human capital or infrastructure needs (Germany, Netherlands) should consider a measured fiscal expansion to boost potential output and help reduce external surpluses.
  - Countries with still-elevated public debt and deficits should proceed with fiscal consolidation, except where private demand is so weak that consolidation would push output far below potential.
  - Consider debt management operations that take advantage of currently low interest rates.
  - If significant negative risks materialize and monetary policy space is limited, fiscal stance should be more expansionary while keeping medium-term debt sustainability objectives in mind; options include a temporarily slower pace of consolidation or a temporary expansion where debt sustainability and market confidence are preserved.
  - Policymakers should prepare contingency plans focused on growth-friendly and inclusive policies to deliver timely support; a synchronized fiscal response, appropriately differentiated across countries, could become suitable.
- Structural reforms:
  - Remain essential to raise potential output, boost resilience, and strengthen inclusive growth.
  - Product market reforms could improve competitiveness and productivity.
  - Policies to increase labor force participation and enhance human capital (including shifting taxes away from labor, enhancing apprenticeship programs, and improving tailoring education to labor market needs) should be urgently implemented.
  - Completing the euro area’s architecture is critical to increase resilience to shocks.
  - The European Union would benefit from deepening the single market for services.
  - In many emerging European countries, continued strengthening of governance and improving public sector efficiency remain imperative to sustain convergence in living standards.

### Vehicle sector: European perspective and spillover risks
- Importance:
  - Vehicle sector is important for domestic economies and exports in many European countries.
  - Germany: vehicles constitute about 20 percent of manufacturing and about 17 percent of exports.
  - Slovak Republic: vehicle sector comprises about one-third of manufacturing and more than a quarter of exports.
- Recent developments:
  - Europe’s vehicle production has fallen and has been one of the main contributors to the industrial production slump in the European Union.
  - Several structural and cyclical factors: tighter EU emission standards, shift in preferences from diesel toward gasoline and other alternative fuel vehicles, weakening global demand (especially from China).
  - After the emissions-related dip in 2018, car registrations have normalized.
- Cross-country heterogeneity:
  - 2018 vehicle production contraction was led by Germany and to a lesser extent the United Kingdom and Spain.
  - Germany’s production remained weak in the first half of 2019, dropping by about 12 percent versus the first half of 2018.
  - Vehicle production held up in Central and Eastern Europe; anecdotal evidence attributes CEE resilience to production of SUVs and utilitarian cars and to CEE suppliers adapting and re-orienting to other models and plants outside Germany.
- Outlook and risks:
  - Near-term outlook for Europe remains conservative due to falling demand for diesel cars, trade tensions, Brexit-related uncertainty, and additional tighter emission standards.
  - Potential reorganizations of supply chains related to the shift to alternative fuel vehicles pose considerable uncertainty for the medium-term outlook.
  - A sustained weakness in the vehicle sector could spill over to the broader economy and across borders via supply chains.

### Key numerical findings and projections (selected exact figures from text)
- Advanced Europe inflation: 1.8 percent (2018) → 1.4 percent (2019) → 1.5 percent (2020).
- Emerging Europe inflation: 6.3 percent (2018) → 6.9 percent (2019) → 5.7 percent (2020).
- Turkey 2019 inflation forecast revision: down by 1.8 percentage points.
- No-deal Brexit impact (relative to April 2019 WEO, two years):
  - United Kingdom output lower by about 3½ percent.
  - European Union output lower by about ½ percent.
- Germany vehicle production: drop of about 12 percent in first half of 2019 versus first half of 2018.
- Germany: vehicles ≈ 20 percent of manufacturing; ≈ 17 percent of exports.
- Slovak Republic: vehicles ≈ one-third of manufacturing; > a quarter of exports.

*International Monetary Fund | November 2019*

### Chapter 2 of the May 2018 Regional Economic

### Chapter 2 of the May 2018 Regional Economic

### Recent wage, productivity, and inflation trends
- Nominal wage growth averaged nearly 8 percent in NMS since the first quarter of 2017, and 2 percent in other European countries (EU15+3).
- Labor costs constitute almost 50 percent of business expenses in NMS and 53 percent in EU15+3 countries.
- Productivity-adjusted wage growth in NMS has exceeded inflation by about 3 percentage points on average since early 2017; in EU15+3 the gap is about 0.4 percentage point.
- In several EU15+3 countries (for example, Germany, Israel, Portugal), annual real wage growth exceeded productivity gains by more than 1 percentage point since the beginning of 2017.
- In NMS, more than 40 percent of firms cited labor shortages as a major factor limiting production in 2019, up from 10 percent in 2013.

### Analytical approach
- Empirical framework: four-variable panel vector autoregression (PVAR) for a sample of 27 European countries since 1995, with variables: import price inflation, nominal wage growth adjusted for trend productivity growth, core consumer price inflation, and unemployment gap.
- Specifications: quarterly data, four lags, Cholesky ordering (import prices most exogenous, unemployment gap most endogenous); wage growth assumed to impact inflation immediately, wages assumed to take at least a quarter to respond to consumer price movements.
- Wages baseline measure: compensation per employee (compensation per hour worked discussed but not used as main series due to data limitations).
- Extensions: interacted-PVAR (IPVAR) to allow the passthrough response to vary with observable state variables (examples: pre- versus post-global financial crisis; inflation expectations anchoring; corporate profitability; labor share; product market regulation).

### Main empirical findings on passthrough
- Wage growth leads to higher core inflation after several quarters; impact peaks after about six quarters then dissipates.
- After three years, the cumulative impact of a 1 percentage point increase in wages is:
  - 1.1 percentage point higher inflation in NMS.
  - 1 percentage point higher inflation in other European countries (EU15+3).
- Passthrough ratio (cumulative change in prices divided by cumulative change in wages) is about a third in the historical sample.
- The passthrough has weakened after the global financial crisis: after 2009 the cumulative impact of wage growth on European core inflation decreased, with the passthrough ratio declining to less than 20 percent.

### Role of inflation, expectations, and the inflationary environment
- Passthrough depends on prevailing inflation: in low-inflation periods (core inflation below country average), a 1 percentage point wage increase raises inflation by a cumulative 0.3 percentage point over three years, with an estimated passthrough ratio of 11 percent.
- In high-inflation periods (inflation above country average), the cumulative impact is about three times higher, with a passthrough ratio of about 30 percent.
- Using an inflation expectations anchoring metric (deviation of long-term professional forecasts from central bank target), the passthrough is muted when inflation expectations are better anchored.
- Empirical example: a 1 percentage point wage increase raises inflation by a cumulative 0.9 percentage point over three years when evaluated at the 75th percentile of the inflation expectations anchoring measure; the text notes this impact increases by about a half under poorer anchoring (text truncated here).

### Factors considered for changes in passthrough
- Inflation and inflation expectations anchoring (better anchoring → lower passthrough).
- Domestic and foreign competition (higher competition → limited ability to pass through costs).
- Corporate profitability and firms’ buffers (higher profit margins → firms can absorb wage increases without immediate price increases).
- Workers’ share of value added (labor share) and product market regulation (differences examined in IPVAR; see Figure 2.3 for comparative estimates).

*Regional Economic Outlook: Europe, Chapter 2. International Monetary Fund | November 2019*

### 1.4 percentage point—when inflation expectations

### text - 1.4 percentage point—when inflation expectations

### Key findings on wage–price passthrough
- The cumulative impact of a 1 percentage point increase in wages is 1.1 percentage point higher inflation in European countries at the end of three years.
- The overall passthrough ratio, which takes into account the response of wages to their own increases, is about a third.
- When inflation expectations are weakly anchored (that is, when the cumulative impulse response is evaluated at the 25th percentile of the distribution of inflation expectations anchoring), the passthrough is 1.4 percentage point.
- The passthrough ratio is also smaller when expectations are anchored within a low range.
- In the NMS subsample, inflation expectations became significantly better anchored in the 2000s, which may be an important reason why the passthrough has declined over time in the sample countries analyzed.

### Role of competition
- Import penetration (ratio of final imports to sectoral gross value added) is about 60 percent in the manufacturing sector and less than 5 percent in the services sector.
- Economy-wide wage growth is more likely to lead to higher growth in services prices relative to non-energy industrial goods prices:
  - PVAR regressions suggest that in EU15+3 countries, the extent to which economy-wide wage growth feeds into services inflation is nearly two times stronger than the impact on non-energy industrial goods inflation.
  - In NMS, prices of services are about four times more responsive to wage increases compared to manufacturing prices.
- Panel regressions across 55 sectors in 32 European countries (2000–14) reveal the correlation between sectoral wage growth and growth in sectoral value-added deflators is significantly higher in sectors that have lower import penetration.
- Domestic product market competition mutes passthrough:
  - IPVAR regressions based on OECD’s product market regulation (PMR) indices suggest that more vibrant product market competition and fewer barriers to entry mute the sensitivity of consumer prices to wage increases.
  - The passthrough of wage growth to inflation is marginally higher when evaluated at the 75th percentile of a country’s PMR score (that is, in countries with higher regulatory barriers) than at the 25th percentile of the PMR index.
- Industry-based analysis (NMS, 1995–2016, 70 industries) finds:
  - A 1 percentage point increase in unit labor costs increases producer prices by 0.9 percentage point after three years (sectoral regressions).
  - Country variation: smallest cumulative increase about 0.5 percentage point in Poland and Hungary; largest 1.3 percentage points in Latvia.
  - Cumulative response: 0.7 percentage point in manufacturing and close to 1 percentage point in services.
  - Firms in services with greater domestic market power (Lerner Index) tend to fully pass higher wages onto consumers; firms with lower market power limit price increases to two-thirds of wage hikes.
  - Passthrough appears smaller in sectors more exposed to foreign competition (imports of goods/services for final consumption to sectoral gross output).

### Role of corporate profitability and other costs
- At end-2018, corporate profits amounted to 47 percent of gross value added in NMS and 40 percent in EU15+3 countries.
- Since the beginning of 2017, corporate profits declined each year by about 1 percent of gross value added in NMS economies and 0.3 percent in other European countries.
- IPVAR analysis on profitability and passthrough:
  - A 1 percentage point increase in labor costs leads to a cumulative increase in inflation of only 0.7 percentage point during the three-year period when evaluated at the 75th percentile of the distribution of corporate profitability.
  - When corporate profits are at the 25th percentile of the distribution of corporate profitability, the impact of wage growth on inflation is 2.5 times higher (with a somewhat stronger passthrough).
- Low labor share regimes produce cumulative impacts of wage increases on inflation very similar to the high corporate profit regime.
- Declining relative prices of machinery and equipment since the 1990s are linked to a more muted wage growth–inflation passthrough by enabling firms to pay higher wages without raising prices.

### Aggregate and survey evidence on competition and profitability
- More than two-thirds of firms report increased competitive pressures compared to the precrisis era according to the latest Wage Dynamics Network Survey.
- Despite comfortable aggregate profit margins, firms in many economies appear to use profit buffers to absorb faster wage growth rather than pass costs onto consumers.

### Policy implications and outlook
- Labor markets remain strong in Europe; wage growth has risen above productivity gains, especially in NMS, but underlying consumer price pressures remain limited.
- Several cyclical (for example, inflation, corporate profitability) and structural (for example, degree of competition) factors shape the responsiveness of inflation to wage developments.
- Current conditions pointing to a low wage–inflation passthrough include:
  - Inflation and inflation expectations near historical lows for three quarters of European economies.
  - Corporate profitability still healthy from a historical perspective and significantly above that of EU15+3 (despite recent declines in NMS).
  - High reported levels of product competition among firms.
- These factors suggest it is unlikely that the recent increase in wage growth will meaningfully spur inflation in the near term.
- Policy recommendation: Findings support the need for monetary policy in many European countries to remain accommodative for longer to guard against a downshift in inflation expectations.
- Caveat for policymakers: Prolonged accommodative financial conditions may foster greater risk taking; policymakers need to remain vigilant and guard against further buildup of financial vulnerabilities and other undesirable side effects.

*International Monetary Fund | November 2019*

### Box 2.1. Sectoral Dimension of the Link between Wage Growth and Inflation

### Box 2.1. Sectoral Dimension of the Link between Wage Growth and Inflation

### Key premise and empirical focus
- Examines how the passthrough from labor cost growth to producer prices varies across sectors and across sectoral characteristics.
- Empirical object: Cumulative response of producer prices to changes in labor costs (Three-year cumulative; percent).
- Sectors explicitly compared: Manufacturing and Services.
- Dimensions of heterogeneity analyzed: cyclical position, firms' market power, and firms' exposure to foreign trade.

### Measurement and data
- Firms' market power is measured using the Lerner Index, constructed as the price–cost margin (Roeger 1995).
  - High market power is an indicator that takes the value of 1 when the Lerner Index exceeds the sectoral average.
- Firms' exposure to foreign trade is measured as the share of imports of goods and services used for final consumption relative to total gross output of the industry.
- Subsamples are partitioned into high or low regimes by median values within the two sectors in 2000, except for import of services, where a doubled threshold is chosen since median exposure is low.
- Data sources: IMF, World Economic Outlook; Organisation for Economic Co-operation and Development, Structural Analysis Database; and IMF staff calculations.

### Empirical patterns highlighted (qualitative)
- The Figure (Figure 2.1.1) presents sectoral differences in the three-year cumulative passthrough from labor costs to producer prices for:
  - Manufacturing vs Services
  - Within each sector: comparisons by cyclical position (positive output gap vs negative output gap)
  - By firms' market power (high market power vs low market power)
  - By foreign trade exposure (low exposure vs high exposure)
- The presentation emphasizes that passthrough magnitudes differ across these sectoral and firm-level characteristics (figure shows separate cumulative responses by category), indicating a sectoral dimension to the link between wage growth and inflation.

### Interpretive notes
- High market power, as measured by the Lerner Index above the sectoral average, is used to identify firms more able to translate labor cost increases into higher prices.
- Greater exposure to foreign trade (higher share of imports used for final consumption) is used to gauge how international competition may dampen domestic labor cost passthrough; the special threshold for import of services reflects generally low median exposure in that category.
- Cyclical position (positive vs negative output gap) is treated as a determinant of passthrough dynamics across the three-year horizon.

*International Monetary Fund | November 2019*

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_Source: https://www.imf.org/-/media/files/publications/reo/eur/2019/november/english/text.pdf_