## Executive Summary vii ## Source details **Canonical URL:** [Executive Summary vii](https://www.imf.org/-/media/files/publications/reo/eur/2022/october/english/text.pdf) ## Other formats - [Markdown version](/-/media/files/publications/reo/eur/2022/october/english/text.pdf.md) - [Structured JSON version](/-/media/files/publications/reo/eur/2022/october/english/text.pdf.json) --- ### Outlook and Key Projections - Europe’s outlook has darkened markedly under a confluence of adverse forces, led by Russia’s war in Ukraine, an energy crisis, multi-decade high global inflation, and weaker external demand. - Growth projections (excluding conflict countries and Türkiye): - Output growth in advanced European economies: 3.2 percent in 2022 to 0.6 percent in 2023. - Output growth in emerging European economies: 4.3 percent in 2022 to 1.7 percent in 2023. - These 2023 forecasts are 0.7 and 1.1 percentage points lower than the July 2022 World Economic Outlook Update projections, respectively. - Inflation projections: - Headline inflation in 2023: 6.2 percent in advanced European economies and 11.8 percent in emerging European economies. - Recent activity and prices: - Real GDP growth in Q2 2022: advanced European economies reached 4.1 percent (year over year); emerging European economies (excluding conflict countries and Türkiye) posted 5.2 percent. - Yearly inflation through August: 9.3 percent in advanced European economies; 14.9 percent in emerging European economies (excluding conflict countries and Türkiye). - Energy and food prices explained about 60 percent of cumulated inflation through August in emerging European economies (excluding conflict countries and Türkiye) and 70 percent in the euro area. - Russian pipeline gas exports fell by 80 percent (year over year) through mid-September 2022. - Coal prices more than tripled on a yearly basis through September 2022. ### Major Risks and Transmission Channels - Balance of risks: downside for growth and upside for inflation, especially core inflation. - Key near-term risk: further disruption to energy supplies combined with a cold winter, which could lead to gas shortages, rationing, and deeper economic pain. - Inflation persistence drivers: - Medium-term inflation expectations de-anchoring. - Excessive wage compensation triggering a wage-price feedback loop. - Secondary transmission channels: - Social tensions prompting more expansionary fiscal stances and forcing further monetary tightening. - Tighter financial conditions, weakened private balance sheets, and reduced demand with potential for medium-term output scarring. ### Recent Developments Affecting the Outlook - Russia’s war in Ukraine: - Refugee flows reached 7.5 million (of which 4.2 million are in the EU) as of end-September; about 7 million internally displaced persons remain within Ukraine. - Natural gas imports from Russia to the EU have almost dried up, pushing the continent into an energy crisis. - Climate and bottlenecks: - Extreme summer weather (high temperatures, scant rainfall) led to exceptionally low river levels, raising inland transport costs and impairing hydroelectric generation and some nuclear plant operations. - Labor markets: - Labor markets have remained broadly resilient, but wage growth has lagged inflation in many places. ### Policy Guidance and Trade-Offs - Overarching objective: navigate severe trade-offs between bringing down inflation and protecting vulnerable households and viable firms from the energy shock, while remaining ready to adjust policy if shocks intensify. - Monetary policy: - With real rates generally still accommodative, labor markets broadly resilient, above-target inflation forecasts, and predominant upside risks to core inflation, central banks should continue raising policy rates. - Faster rate hikes are called for in advanced economies. - An even tighter stance is generally warranted in most emerging European economies, where inflation expectations are less well anchored, cyclical positions are more robust, and nominal wage growth is higher. - A tight monetary policy stance will likely be needed in 2023 unless growth and labor market prospects weaken sufficiently below the current baseline to materially reduce medium-term inflation. - Fiscal policy: - The task is to rebuild fiscal space and support monetary policy in fighting inflation while managing the extraordinary energy price shock. - Consolidation should proceed in 2023, with faster consolidation in countries with less fiscal space, greater vulnerability to tighter financial conditions, and/or stronger cyclical positions—including most emerging European economies. - Slowing the pace of consolidation for a few months may be appropriate to allow temporary support to households and viable firms through the energy crisis. - Such support should be temporary and preserve strong price signals to foster energy savings. - Macroprudential and financial supervisory policy: - Macro-prudential settings can be kept broadly unchanged to avoid amplifying the downturn. - Supervisors should closely monitor and stress-test banks’ risk exposures to vulnerable households and firms affected by deteriorating growth prospects, higher energy prices, and tighter financial conditions. - Structural policies: - Steady implementation of reforms to enhance productivity, relieve supply constraints in energy and labor markets, and expand economic capacity is essential. - Priorities include ensuring energy security, accelerating the green transition, countering adverse demographic trends, and accelerating the implementation of Next Generation EU programs. ### Near-Term Outlook Summary - Europe faces weak growth and high inflation that could persist or worsen. - The projected technical recessions (at least two quarters of negative GDP growth) observed in parts of Europe could deepen and spread across the continent if shocks intensify. - Policymakers must be nimble: tighten monetary policy to restore price stability while using temporary, well-targeted fiscal support to shield the most vulnerable and viable firms, and maintain financial stability through careful supervisory action. *International Monetary Fund | October 2022 — Executive Summary (text - Executive Summary vii).* ### Executive Summary vii ### Executive Summary vii ### Outlook and Key Projections - Europe’s outlook has darkened markedly under a confluence of adverse forces, led by Russia’s war in Ukraine, an energy crisis, multi-decade high global inflation, and weaker external demand. - Growth projections (excluding conflict countries and Türkiye): - Output growth in advanced European economies: 3.2 percent in 2022 to 0.6 percent in 2023. - Output growth in emerging European economies: 4.3 percent in 2022 to 1.7 percent in 2023. - These 2023 forecasts are 0.7 and 1.1 percentage points lower than the July 2022 World Economic Outlook Update projections, respectively. - Inflation projections: - Headline inflation in 2023: 6.2 percent in advanced European economies and 11.8 percent in emerging European economies. - Recent activity and prices: - Real GDP growth in Q2 2022: advanced European economies reached 4.1 percent (year over year); emerging European economies (excluding conflict countries and Türkiye) posted 5.2 percent. - Yearly inflation through August: 9.3 percent in advanced European economies; 14.9 percent in emerging European economies (excluding conflict countries and Türkiye). - Energy and food prices explained about 60 percent of cumulated inflation through August in emerging European economies (excluding conflict countries and Türkiye) and 70 percent in the euro area. - Russian pipeline gas exports fell by 80 percent (year over year) through mid-September 2022. - Coal prices more than tripled on a yearly basis through September 2022. ### Major Risks and Transmission Channels - Downside risks to growth and upside risks to inflation, especially core inflation. - Key near-term risk: further disruption to energy supplies combined with a cold winter, which could lead to gas shortages, rationing, and deeper economic pain. - Inflation could remain higher for longer if: - Medium-term inflation expectations de-anchor; or - Excessive wage compensation for recent price increases triggers a wage-price feedback loop. - Social tensions from the cost-of-living crisis could prompt more expansionary fiscal stances, which could force central banks to tighten monetary policy further. - The multilayered shocks have tightened financial conditions and are weakening private balance sheets and demand, with potential for medium-term output scarring. ### Recent Developments Affecting the Outlook - Russia’s war in Ukraine: - Refugee flows reached 7.5 million (of which 4.2 million are in the EU) as of end-September; about 7 million internally displaced persons remain within Ukraine. - Natural gas imports from Russia to the EU have almost dried up, pushing the continent into an energy crisis. - Climate and bottlenecks: - Extreme summer weather (high temperatures, scant rainfall) led to exceptionally low river levels, raising inland transport costs and impairing hydroelectric generation and some nuclear plant operations. - Labor markets: - Labor markets have remained broadly resilient, but wage growth has lagged inflation in many places. ### Policy Guidance and Trade-Offs - Overarching objective: navigate severe trade-offs between bringing down inflation and protecting vulnerable households and viable firms from the energy shock, while remaining ready to adjust policy if shocks intensify. - Monetary policy: - With real rates generally still accommodative, labor markets broadly resilient, above-target inflation forecasts, and predominant upside risks to core inflation, central banks should continue raising policy rates. - Faster rate hikes are called for in advanced economies. - An even tighter stance is generally warranted in most emerging European economies, where inflation expectations are less well anchored, cyclical positions are more robust, and nominal wage growth is higher. - A tight monetary policy stance will likely be needed in 2023 unless growth and labor market prospects weaken sufficiently below the current baseline to materially reduce medium-term inflation. - Fiscal policy: - The task is to rebuild fiscal space and support monetary policy in fighting inflation while managing the extraordinary energy price shock. - Consolidation should proceed in 2023, with faster consolidation in countries with less fiscal space, greater vulnerability to tighter financial conditions, and/or stronger cyclical positions—including most emerging European economies. - Slowing the pace of consolidation for a few months may be appropriate to allow temporary support to households and viable firms through the energy crisis. - Such support should be temporary and preserve strong price signals to foster energy savings. - Macroprudential and financial supervisory policy: - Macro-prudential settings can be kept broadly unchanged to avoid amplifying the downturn. - Supervisors should closely monitor and stress-test banks’ risk exposures to vulnerable households and firms affected by deteriorating growth prospects, higher energy prices, and tighter financial conditions. - Structural policies: - Steady implementation of reforms to enhance productivity, relieve supply constraints in energy and labor markets, and expand economic capacity is essential. - Priorities include ensuring energy security, accelerating the green transition, countering adverse demographic trends, and accelerating the implementation of Next Generation EU programs. ### Near-Term Outlook Summary - Europe faces weak growth and high inflation that could persist or worsen. - The projected technical recessions (at least two quarters of negative GDP growth) observed in parts of Europe could deepen and spread across the continent if shocks intensify. - Policymakers must be nimble: tighten monetary policy to restore price stability while using temporary, well-targeted fiscal support to shield the most vulnerable and viable firms, and maintain financial stability through careful supervisory action. *International Monetary Fund | October 2022 — Executive Summary (text - Executive Summary vii).* ### 1. Europe: Inflation Decomposition, 2022:M1–M8 ### 1. Europe: Inflation Decomposition, 2022:M1–M8 ### Baseline assumptions underpinning the outlook - (1) Sanctions remain in place and natural gas flows from Russia remain very low in 2022–23, averaging 15 percent of normal levels; therefore, energy and other commodity prices stay elevated and volatile in the months ahead. - (2) The war in Ukraine continues. - (3) Disruptions to the supply of critical inputs gradually ease as demand softens, with possible additional COVID-19-related lockdowns in China representing a downside risk; in Europe, weather-related bottlenecks also gradually ease. - (4) The pandemic’s health and economic impact on Europe fades. - (5) Monetary policy normalization proceeds steadily in advanced European economies, with the policy rate in the euro area, for example, reaching a neutral stance by early 2023; in emerging European economies, the pace of rate hikes eases after significant rate increases throughout 2021–22. - (6) Fiscal policy consolidates in 2023 in advanced and emerging European economies, but less than envisioned in the July 2022 World Economic Outlook Update, because of recent measures to ease the impact of energy and food price increases. ### Growth and inflation projections (key statistics) - Advanced European economies: output growth forecast of 3.2 percent in 2022 and 0.6 percent in 2023 (the 2023 figure is a downward revision of 0.7 percentage point with respect to July projections). - Emerging European economies (excluding conflict countries and Türkiye): growth projected to decelerate from 4.3 percent in 2022 to 1.7 percent in 2023 (about a 1 percentage point downward revision for 2023 with respect to July). - Output scarring by end-2023: projected at 3.5 percent in both advanced and emerging European economies (excluding conflict countries and Türkiye). - Headline inflation in advanced European economies: projected at 8.3 percent in 2022 and 6.2 percent in 2023. - Headline inflation in emerging European economies (excluding conflict countries and Türkiye): projected at 13.3 percent in 2022 and 11.8 percent in 2023. - Inflation path back to targets: projected to return to about 2 percent by 2025 in advanced European economies and to below 3 percent by 2026 in emerging European economies (excluding conflict countries and Türkiye). ### Labor markets, wages, and consumption - Labor markets: tightness indicators (vacancy-to-unemployment ratios, job vacancy ratios) show labor markets significantly tighter by summer 2022 than before the pandemic, including in the euro area and the United Kingdom. - Despite tighter labor markets, real wages have declined in the euro area; negotiated wage growth has remained relatively contained. Nominal wage growth has been closer to inflation in countries with stronger cyclical positions (for example, the Czech Republic, Hungary, Lithuania, Poland, and Romania). - Household cost of living due to higher energy prices: increase of 7 percent in 2022 and 9 percent in 2023, both with respect to 2021. - Private consumption: contracted sequentially in Q1 2022 in France, Italy, and Spain; expected to remain subdued in H2 2022 and in 2023. Survey evidence indicates more households in the EU-27 plan fewer major purchases in the next 12 months. ### Fiscal and policy responses - Fiscal impact in emerging European economies (excluding conflict countries and Türkiye): higher energy subsidies and refugee support are expected to add 0.8 percentage point of GDP to the 2022 fiscal deficits compared to projections before the start of the war in Ukraine. - In some countries (for example, the Czech Republic, Estonia, or Poland), fiscal cost of support to refugees is sizable at about 1 percent of GDP in 2022. - Policy responses to energy price shock have often featured price-suppressing measures with significant fiscal cost in some cases (for example, Greece and Romania). - The United Kingdom experienced an adverse market reaction to a late-September fiscal package that included energy bill caps and tax cuts. ### Financial conditions and risks to stability - Financial conditions: monetary policy normalization, lower credit availability, and a higher price of risk have tightened financial conditions; conditions are more restrictive than before the pandemic in the euro area and emerging European economies. - Market deterioration in some emerging European economies: nonresidents have been net sellers of securities, sovereign bond spreads over German bunds have risen broadly, and credit default swaps increased (notably in Romania and Serbia). Several national currencies depreciated vis-à-vis the euro (for example, Hungary, Poland); others held up but at the cost of international reserve losses (for example, Montenegro, North Macedonia, and Serbia). - Banks’ capital positions: median Tier 1 ratios are 19 percent across advanced European economies and 21 percent across emerging European economies. - Debt-servicing costs: tighter financial conditions have increased household and firm debt-servicing costs; simulations indicate further intensification given expected persistently high inflation and further monetary policy tightening. ### Sectoral and firm-level impacts - High energy prices: large negative shock for households and energy-intensive firms; many firms have curtailed or plan to cut production in fertilizers, glass, steel, and aluminum manufacturing, likely producing additional price increases across value chains. - Firms’ interest coverage ratios: decreasing because of deteriorated earnings and tightening credit, weighing on corporate investment. ### Downside risks and scenario specifics - Balance of risks: to the downside for growth and to the upside for inflation. Risks are exceptionally high in winter 2022–23. - Full Russian gas shutoff scenario: a complete shutoff of remaining Russian gas flows combined with a cold winter could create further economic pain. Simulations indicate a possible physical shortfall of about 6 percent of typical winter consumption. The most exposed countries (notably landlocked central and eastern European countries) could see GDP losses of some 3 percent with respect to the baseline projection; other countries (such as Italy) could also face sizable output losses. - Compound downside scenario: simultaneous materialization of softer growth in China, a full Russian gas shutoff, increases in oil prices, and more persistent inflation with tighter financial conditions could lead to a decline in the EU’s GDP level of about 1.4 percent in 2023 with respect to the baseline. - Upside possibilities: faster-than-expected unwinding of supply bottlenecks and greater resilience of private consumption could improve the growth outlook. *Italic: Source — text - 1. Europe: Inflation Decomposition, 2022:M1–M8 (IMF Regional Economic Outlook: Europe, October 2022).* ### 1. ThE FOG OF WAR CLOUds ThE EUROPEAN OUTLOOK ### 1. ThE FOG OF WAR CLOUds ThE EUROPEAN OUTLOOK ### Overview: Current Shock and Policy Imperatives - Europe faces a massive, yet largely temporary, energy price shock that could worsen if Russia shuts the gas off completely, possibly causing irreversible economic damage and threatening social cohesion. - Policy mix called for: - Monetary policy rate increases. - Fiscal consolidation, with consolidation temporarily slowed while governments roll out measures to weather the energy crisis. - A tighter macroeconomic policy stance particularly required in most emerging European economies. - Policy recalibration conditional on downside risks: - Policy normalization could be slowed amid a stronger demand slowdown. - Further supply-side shocks would create far more acute policy trade-offs. ### Monetary Policy: Keep Raising Policy Rates, Remain Nimble - Recent central bank actions: - Many emerging European economies (including Hungary, Poland, and Romania) and advanced European economies (the Czech Republic, Iceland, the United Kingdom) increased the frequency and magnitude of rate hikes in the last 6–12 months. - A few central banks have begun to reduce the size of their balance sheets. - Inflation has contributed to reducing the real value of central banks’ financial assets. - ECB actions and guidance: - In September, the European Central Bank (ECB) front-loaded a large portion of the needed policy normalization. - Announcement of the Transmission Protection Instrument last July to address fragmentation risks and ensure monetary policy transmission across euro area economies. - Quantitative tightening: the ECB may consider discontinuing some or all of Asset Purchase Program (APP) reinvestments, with flexible Pandemic Emergency Purchase Program (PEPP) reinvestments serving as the first line of defense to address fragmentation risks. - Forward guidance and risks: - Given a still broadly accommodative policy stance, central banks should continue to raise policy rates under most scenarios in the next few months. - Monetary policy should respond to keep inflation expectations well-anchored and to the more persistent component of the energy price shock, which will reduce potential output. - The key immediate recession risk is a full Russian gas shutoff, which would push inflation even higher and likely trigger further fiscal policy support. - Core inflation risks are predominantly on the upside; their materialization would warrant higher policy rates than assumed under the baseline. - Cross-country differentiation: - Additional increases in policy rates are required in both advanced European economies (including the euro area and the United Kingdom) and in some emerging European economies. - Policy rate increases should be faster in advanced economies, which started normalization cycles more recently. - Comparatively, tighter monetary policy is needed in most emerging European economies where inflation is higher, expectations are not strongly anchored, cyclical positions are more robust, and nominal wage growth is higher. - Maintaining full central bank independence and transparency in these economies is key to avoiding unmoored inflation expectations and wage-price feedback loops. - Timing and conditionality: - In the euro area, monetary policy normalization should continue with a view to reaching a neutral stance by early 2023. - Exceptional uncertainty calls for a flexible risk management approach: baseline paths should remain data-dependent and respond to emerging risks in both directions. - If a further global demand slowdown threatened to move Europe into recession, policy normalization should generally be slowed as long as wage increases are contained and inflation expectations are anchored. - If additional supply shocks occur, central banks should avoid wage-price spirals and be ready to slow or pause normalization if demand and the medium-term inflation outlook weaken substantially. ### Fiscal Policy: Managing the Extraordinary Energy Price Shock while Rebuilding Fiscal Space - Consolidation and timing: - Fiscal consolidation should proceed during 2023, with its pace temporarily slowed in the coming months to allow governments to support vulnerable households and viable firms through the energy crisis. - Fiscal consolidation will support monetary policy normalization, helping central banks achieve objectives with smaller policy rate increases—which will also help reduce public debt. - Fiscal deficits should decrease faster in high-debt countries, in those with limited fiscal space, and in those more vulnerable to tighter financial conditions, including many emerging European economies. - On current trends, debt ratios would decline mainly in low-debt advanced European economies in the medium term, while in several high-debt economies they would remain stable or even increase further. - In the EU, a reformed fiscal framework should ideally be in place before the expiration of the general escape clause at the end of 2023. - Targeting support and preserving incentives: - Spending should be reprioritized toward assisting vulnerable households and viable firms affected by the surge of energy prices. - Domestic prices should reflect as much as possible the signals provided by energy markets; targeted and temporary fiscal transfers to low-income households should be given priority. - The extraordinary magnitude and partly temporary nature of electricity and natural gas price increases caution against a full immediate pass-through to all end users. - Temporary energy subsidies might be considered; their size should depend on the gap of current to medium-term energy prices and available fiscal space. - Such subsidies should be limited in size to maintain fiscal consolidation, and price signals should be preserved to encourage adjustment by households and firms. - Increasing the progressivity of tariffs for upper consumption levels and for peak demand hours would encourage better-off households to reduce demand. - EU-level and national measures: - The European Commission proposal to tax all revenues above a certain electricity price level (the so-called cap) will bring new fiscal revenues to tackle the energy crisis; the cap should be temporary and well-calibrated to avoid affecting electricity supply. - Given uneven generation by inframarginal producers and operational difficulties to share revenues, the impact of this measure will likely differ across countries. National policies need to be coordinated to avoid unwarranted asymmetries and international competitiveness effects. - Refugee inflows and social spending: - Managing unprecedented refugee inflows requires increased budgetary allocations for social services, education, and health, estimated at about 0.2 percent of the EU’s GDP for 2022. - Countries hosting large numbers of refugees will need to reallocate investment for social infrastructure in schools, hospitals, and housing. - Contingency options: - If additional shocks materialize, countries with available fiscal space would need to reconsider fiscal consolidation plans. - If a sharper-than-forecast demand slowdown weakens employment and creates slack, countries with fiscal space could ease fiscal policy temporarily. - Countries with limited fiscal space could let automatic stabilizers work but offset any additional support to the vulnerable with tax increases or other spending cuts, avoiding harmful reductions in health, education spending, and public investment. - If the gas supply is insufficient, nonfiscal policy tools like well-designed rationing programs could contain output losses. - Preparing for a full gas cut-off requires implementing regional gas-sharing agreements to distribute gas shortfalls more evenly. ### Financial Policies: Preserving the Flow of Credit while Containing Vulnerabilities - Credit outlook and banking sector: - In a context of weaker growth, tighter financial conditions, and higher energy prices, households’ and firms’ debt-service capacity are expected to deteriorate, pushing banks to tighten credit standards. - Such tightening has already begun, although healthy bank balance sheets will help contain it under most scenarios. - Supervisory actions and macroprudential settings: - Policymakers need to monitor and contain pockets of vulnerabilities to keep credit flowing and mitigate liquidity risks. - Supervisors should ensure bank asset classifications and loan loss provisions swiftly and accurately reflect credit risk and losses. - Macroprudential policy settings can be kept broadly unchanged under the baseline, with supervisors ensuring cyclical buffers have been rebuilt. - Supervisors should closely monitor banks’ risk exposures to vulnerable households and firms, including stress-testing bank balance sheets for the impact of higher interest rates. - Housing market developments deserve particular attention, including stress tests to estimate the impact of a sharp fall in house prices on households’ balance sheets and banks—particularly important in countries where adjustable-rate mortgages are predominant (such as Poland). - Supervisors should have access to timely and reliable data and ensure banks have sound risk management systems. - Macroprudential policies should avoid turning procyclical; if downside risks materialize, some macroprudential tools may have to be eased to dampen asset price declines (including housing) and support lending. ### Structural Policies: Addressing Immediate Needs and Long-standing Priorities - Energy security and the green transition: - Ensuring energy security remains a top priority. - Near-term actions taken: securing alternative supply sources; substituting gas with other fuels where possible (though at the cost of increased greenhouse gas emissions); updating contingency plans; building storage ahead of the heating season as planned. - Several countries (for example, Germany and Italy) and the EU launched campaigns to encourage energy savings during the 2022–23 winter. - While short-term trade-offs exist between investing in the green transition versus energy security, clear synergies exist in the medium term. - In line with REPowerEU’s strategy, overcoming infrastructure bottlenecks while reducing greenhouse gas emissions requires accelerating the rollout of renewables, reducing fossil fuel consumption in industry and transport, and ramping up smart investment, including in gas connectivity. - REPowerEU’s objective: make Europe independent from Russian fossil fuels before 2030. - Reconstructing Ukraine: - Reconstructing Ukraine’s economy after the war will require massive financing flows, primarily in the form of grants, and policies to promote the return of refugees. - The IMF established a new administered account to facilitate channeling of bilateral contributions (loans or grants). *International Monetary Fund | October 2022* ### 1. Europe: Banks’ Capital Adequacy Ratio ### 1. Europe: Banks’ Capital Adequacy Ratio ### Europe: financial conditions and projected macroeconomic impact - Financial conditions in Europe tightened significantly in 2022 after pandemic-era loosening, with notable tightening in the euro area and select emerging European economies beginning in early 2022. - A new Financial Conditions Index (FCI) characterizes credit availability and financing ease in relation to both prices and quantities; the FCI tightening is approaching levels seen in the global financial crisis and the European debt crisis. - Drivers of FCI tightening: - Credit availability tightened in Q1 and Q2 2022 due to higher corporate bond spreads and sovereign bond yields, feeding into higher mortgage and consumer lending rates. - The price of risk increased, reflecting substantial volatility in European bond and equity markets. - Funding constraints—banks’ ability to lend—matter more in bank-based financing countries; recent bank surveys point to further tightening ahead because of higher risk perceptions. - The policy stance is expected to tighten in 2022 in response to increased inflation, contributing to additional FCI tightening. - Projected macroeconomic effects of the FCI tightening: - The current FCI tightening could lower output by up to 2.5 percent over the next three years. - The current FCI tightening could raise the unemployment rate by up to 0.8 percentage point over the next three years. - The FCI tightening is occurring broadly across countries and sectors within the euro area, with similar tightening across government, household, and nonfinancial corporate FCIs. ### Refugee shock from Russia’s war in Ukraine: scale, labor-market implications, and fiscal costs - Scale and composition: - Number of Ukrainian refugees in Europe reached 7.5 million (4.2 million in the European Union) as of end-September 2022. - About 7 million internally displaced persons remain within Ukraine. - Refugee demographic profile: about 30 percent of all Ukrainian children, 17 percent of adult Ukrainian women, and about 6 percent of adult Ukrainian men have fled the country so far in 2022. - As of late September, 4.2 million people registered under the EU’s Temporary Protection Directive (EU-TPD) or similar non-EU programs. - Labor-market and growth implications: - Ukrainian refugees represent about 0.5 percent of Europe’s labor force—about twice the size of the 2015–17 refugee wave. - Country-level refugee labor-force shares: Czech Republic 2.2 percent, Poland 2.1 percent, Estonia 1.9 percent. - The medium-term impact on growth depends on the speed and quality of labor-market integration, potential skill downgrading, and complementarity/substitutability with native workers. - Fiscal cost estimates: - IMF staff estimates short-term fiscal cost in the EU of €30–€37 billion in 2022 (about 0.2 percent of EU GDP). - EUROMOD estimates of fiscal cost: €26–€34 billion (microsimulations covering education, health, housing, and social protection costs). - EU and non-EU countries with the largest population shares of refugees could incur fiscal costs of about 1 percent of GDP (examples include the Czech Republic, Estonia, Moldova, and Poland). ### Households, mortgages, and firm vulnerabilities - Households: - Median household debt-to-GDP ratio in advanced European economies peaked at 60 percent of GDP in 2021. - Median financial net worth in 2021: 147 percent of GDP in advanced European economies; 96 percent of GDP in emerging European economies. - Median financial net worth in 2007: 107 percent of GDP in advanced European economies; 66 percent in emerging European economies. - The average share of households overburdened by financing costs (mortgage debt-service-to-income ratios above 40 percent) fell from the 7.5 percent peak in 2011 to under 3 percent in 2020. - Mortgages at risk are concentrated among low-income households: in Bulgaria, Croatia, Italy, and Lithuania more than 40 percent of mortgage owners in the bottom quintile of the income distribution are overburdened. - Rising food and energy prices will further constrain low-income households’ debt-servicing capacity. - Nonfinancial corporations: - Aggregate nonfinancial corporations’ liquidity and solvency positions have remained resilient since the start of the pandemic. - Firms’ liquidity (current-assets-to-current-liabilities) ratios improved on average in both advanced and emerging European economies since 2019. - Nonfinancial corporations’ leverage (debt-to-equity) ratios decreased, especially in advanced economies. - Small firms and service sectors remain particularly vulnerable to tighter financial conditions, higher input costs, and slower growth. ### Banking sector resilience and vulnerabilities - Banks’ profitability and capital positions could be negatively affected by rising defaults stemming from tighter financial conditions, but recent capital strength should contain further fallout. - (Visual/indicator panels in the chapter include regulatory Tier 1 capital to risk-weighted assets, percent, and distributions of vulnerable mortgage owners and nonfinancial firms with interest coverage ratios lower than one; the text emphasizes overall resilience but concentration of risks among low-income households and small firms.) ### Policy recommendations and priorities - Refugee integration and fiscal policy: - Prioritize rebuilding Ukraine while recognizing that a fraction of refugees will remain in host countries and require integration. - Emphasize targeted active labor market policies, such as temporary wage subsidies, job search services, job training, and language courses. - Remove regulatory barriers preventing effective labor-market integration, for example by improving skill recognition. - Consider temporary exceptions from minimum wage laws or temporary wage subsidies if integration proves too slow, particularly where minimum-to-median wage ratios are high. - Central governments should fund subgovernments adequately and reward successful integration, given responsibilities in education, health care, social welfare, housing, and active labor market policies. - Facilitate refugees keeping ties to Ukraine to ease their return and reintegration once the war ends. - Consider transnational mechanisms beyond EU transfers and free transportation to help distribute the burden of hosting refugees more fairly. - Structural and macroeconomic policies: - Continue long-standing structural reform priorities to boost productivity, accelerate the digital transition, relieve supply constraints, and ease factor reallocation through more flexible labor and product markets. - Timely and efficient implementation of recovery and resilience plans (including Next Generation EU programs) is crucial to reap full benefits. - Financial-sector and macroprudential policy: - Monitor tightening financial conditions closely given their potential to lower output by up to 2.5 percent and raise unemployment by up to 0.8 percentage point over three years. - Prepare contingency measures to support vulnerable households and small firms, where mortgage and debt-servicing stress is concentrated. - Ensure bank capital and provisioning frameworks remain adequate to absorb potential losses from rising defaults. *Source: https://www.imf.org/-/media/files/publications/reo/eur/2022/october/english/text.pdf* ### Box 1.3. How Vulnerable Is Europe’s Private Sector to the Weakening Macroeconomic Outlook? ### Box 1.3. How Vulnerable Is Europe’s Private Sector to the Weakening Macroeconomic Outlook? ### Aggregate assessment - Corporations’ debt-servicing capacity (measured by the interest coverage ratio [ICR]) remained stronger than it did during the global financial or European debt crises. - Aggregate debt-servicing strength masks significant heterogeneity across sectors, firm sizes, and countries. - The debt-servicing capacity of households and corporates appears to be relatively strong, but pockets of stress would build up if the economic outlook deteriorated or interest costs rose more than expected or both. - Shocks in simulations are cumulative over 2022–23. ### Scenario design and data - Adverse scenario assumptions: - a 200 basis point interest rate shock relative to the baseline assumptions; and - a 10 percent negative shock to household income or corporate earnings relative to the baseline forecast. - Household simulations also account for the projected rise in the cost of food and utilities given the surge in commodity prices. - A household is considered overburdened (and its debt at risk) if debt servicing and essential consumption (food and utilities) exceed 70 percent of gross income. - Data sources and samples: - Households: 2017 Household Finance and Consumption Survey microdata as proxy for the debt-service-to-income distribution at the end of 2021. - Firms: firm-level data from Orbis; financial positions in 2020 are used as the starting point. - Country coverage (firms analysis) includes Austria, Belgium, Bulgaria, the Czech Republic, Finland, France, Germany, Hungary, Italy, Luxembourg, The Netherlands, Norway, Poland, Portugal, Romania, Russia, the Slovak Republic, Slovenia, Spain, Sweden, Switzerland, and the United Kingdom. Each country sample includes at least 1,000 observations after data cleaning. - Firm-level household/corporate sample for simulations includes Austria, Belgium, Bulgaria, the Czech Republic, Germany, Finland, France, Hungary, Italy, Norway, Poland, Portugal, Romania, the Slovak Republic, Slovenia, Spain, and Sweden (limited to at least 100 observations per country in 2020). - Only adjustable-rate mortgages and short-term corporate debt are assumed to be subject to the interest rate shock. ### Households — simulated outcomes - Under the baseline projections: - the share of overburdened mortgage holders could rise from 14 to 19 percent; - these overburdened households would account for more than 20 percent of mortgage debt held by households. - Under the illustrative downside scenario combining adverse shocks to both interest rates and nominal incomes: - the share of overburdened mortgage holders would rise to 26 percent; - about 30 percent of mortgage debt would then be considered at risk, up from 16 percent in the original survey. - Country heterogeneity: increases in overburdened households in both baseline and downside scenarios tend to be significantly more pronounced in countries with higher household indebtedness before the shock and a larger share of variable-rate mortgages (example cited: Croatia). ### Corporates — simulated outcomes - In the illustrative combined adverse scenario: - the analysis shows a 5 percentage points average increase in the share of firms with ICRs less than one; - the range across countries is from 1 percentage point in Sweden to 9 percentage points in Italy and Spain. - Sector and firm-size heterogeneity: - contact-intensive sectors (for example, hospitality) have a significantly higher share of firms with low ICRs compared with less affected sectors such as information and communications technology; - the deterioration of debt-servicing capacity would be largest in manufacturing and wholesale and retail trade sectors, reflecting their generally higher shares of short-term liabilities; - the share of distressed SMEs would continue to exceed that of large firms; the share of SMEs with ICR lower than one is about 50 percent higher on average than that of large firms and even higher in some countries (for example, Poland and the Slovak Republic); - large firms would be more affected by the combined shocks in some cases, possibly reflecting the high maturity of pandemic-related support that benefited primarily contact-intensive sectors and SMEs. ### Banking sector buffers and implications - Banks are well capitalized to absorb losses: - median ratio of regulatory Tier 1 capital to risk-weighted assets at the end of 2021 is 19 percent in advanced economies (ranging from 13–16 percent in Greece, Portugal, and Spain, to 23 percent in the Baltics and Ireland); - median ratio is 21 percent in emerging market economies (ranging from 16 percent in Hungary and Poland, to 25 percent in Croatia). - Capital adequacy improved between 2019 and 2021 and is higher than in mid-2009 and ahead of Europe’s sovereign debt crisis (with few exceptions such as Greece). - Higher interest rates, particularly when accompanied by steeper yield curves, could support banks’ earnings, helping offset losses from credit deterioration; however, interest rate risk from maturity transformation could weigh on profitability in the event of large upward interest rate shocks. ### Additional observations - Bank earnings will be reduced by rising defaults, but capital buffers are judged sufficient to absorb losses under the scenarios analyzed. - On the corporate side, bankruptcies in 2020 were lower than in any year since 2007, but the median expected default frequency for European firms started to rise in 2022. *Source: Box 1.3, Regional Economic Outlook: Europe, International Monetary Fund, October 2022.* ### 1. ThE FOG OF WAR CLOUds ThE EUROPEAN OUTLOOK ### 1. ThE FOG OF WAR CLOUds ThE EUROPEAN OUTLOOK ### Overview - Inflation in Europe has surged to multidecade highs, driven substantially by soaring commodity prices and amplified by pandemic- and war-related supply shocks. - Much of the rise in inflation can be traced to energy and food prices and, to a lesser extent, supply bottlenecks; on average, commodity prices contributed about two-thirds of the rise in headline inflation. - The chapter provides empirical analysis of inflation drivers, assesses prospects and risks under October 2022 WEO projections, and draws implications for monetary and fiscal policy. ### Key findings and metrics - Inflation exceeded 5 percent in almost all European economies by late summer 2022. - Headline inflation reached between 20–25 percent in the Baltic countries. - Commodity prices accounted for about two-thirds of the rise in headline inflation. - The standard Phillips-curve model can at most account for 60 percent of the recent surge in inflation. - The number of items with price increases exceeding central banks’ inflation targets accounted for 70–90 percent of the core consumer price index basket across broad country groups by late summer 2022. - Labor market indicators: - Unemployment rates below prepandemic lows in two-thirds of economies. - Job vacancies per unemployed exceeding prepandemic highs in three-quarters of economies. - Hours worked almost back to pre-COVID-19 levels by mid-2022. - Output gap projections (October 2022 WEO): two-thirds of advanced and four-fifths of emerging European economies are projected to have positive output gaps in 2022. ### Inflation drivers and empirical evidence - Conventional drivers in the Phillips-curve framework (lower slack, lagged and expected inflation, foreign price developments, global energy and food prices) explain a substantial share of inflation but leave a sizable unexplained component. - Empirical approach: - Phillips curves estimated for 24 advanced and 7 emerging European economies (2000:Q1–22:Q2). - Model includes unemployment gap, lagged inflation, three-year-ahead inflation expectations of professional forecasters, external price pressures (foreign producer prices and exchange rates), and global energy and food prices interacted with CPI shares. - Key empirical insights: - In emerging European economies, inflation increases more sharply when labor markets tighten and is more responsive to foreign price developments (especially global food prices) than in advanced Europe. - Some unexplained inflation correlates with indicators of tightness triggered by the pandemic and intensified by the war, such as rising shortages in input markets—suggesting less slack than traditional measures imply. ### Recent developments and cross-country heterogeneity - Durable goods inflation rose significantly due to pandemic-era demand shifts toward consumer durables and persistent supply disruptions. - Domestic services inflation has increased, contributing to broader-based inflation beyond commodities and durables. - Cross-country heterogeneity reflects: - Differences in food and fuels’ weights in CPI baskets. - Exposure to global fuel prices via energy mix, price regulation, and policy measures. - Exchange rate developments (example: depreciation of the lira in Türkiye amplified inflationary impact). - Regulatory and policy measures (price caps/freezes, energy tax measures) limited inflation in some countries but at sizable fiscal cost. Examples noted include France, Malta, and Spain. ### Prospects and risks - Under October 2022 WEO projections for commodity prices and economic growth, inflation is expected to fall steadily, but the decline could be slower than previously expected and highly uncertain. - Inflation risks are very high and primarily on the upside. - If upside risks materialize, model simulations suggest central banks may need to tighten substantially more than currently projected. ### Policy implications and recommendations - Monetary policy: - Central banks should keep raising policy rates in most European countries while remaining nimble and data-dependent. - Authorities must weigh the risk that failing to restore price stability could unmoor expectations and require even larger tightening later, versus the risk that over-tightening could trigger a severe downturn—especially if inflation is driven by negative supply shocks. - Fiscal policy: - Fiscal policies should focus on weathering the energy price shock without adding to inflation pressures. - Targeted measures can limit pass-through to domestic inflation but may incur sizable fiscal costs. - Overall: continued policy tightening is reinforced by the evidence, with central banks standing ready to respond to emerging risks in both directions. *International Monetary Fund | October 2022* ### 2021. However, the model cannot explain 40 to ### text - 2021. However, the model cannot explain 40 to ### Unexplained inflation in 2022 - The Phillips-curve model cannot explain "40 to 50 percent of the rise in inflation in advanced and emerging European economies," reflected in sizable positive residuals in 2022:Q2. - Residuals (inflation exceeding model-predicted values) were consistently positive in the last few quarters and larger when Phillips curves are estimated on pre-COVID-19 data, "suggestive of changes in the relationship between inflation and some of its drivers during the post-COVID-19 period." - The analysis finds core inflation has become more backward-looking and that pass-through of global commodity prices to domestic inflation has increased postpandemic. ### Domestic and foreign drivers (Phillips curve evidence) - Figure 2.4 lists estimated Phillips curve coefficients for core inflation including: - Unemployment gap - Lagged external price pressure - Food price (and lags L2–L4 food price) - Energy price - Lag inflation - Inflation expectations - Panel coefficient estimates statistically significant at the 10 percent level are shown; AE = advanced Europe; EE = emerging Europe. - Commonly used indicators may fail to capture drivers properly: unemployment gaps may be poor proxies for slack given short-term work programs, structural labor market changes, demographic headwinds, and high vacancy-to-unemployment ratios. ### Role of input and labor shortages - Regressing Phillips-curve residuals on variables outside the model uncovers strong correlations with: 1. Alternative measures of labor market tightness (vacancy-to-unemployment ratio; share of firms reporting labor shortages limiting production). 2. Supply bottlenecks (share of firms reporting shortages of intermediate inputs limiting production). - Input shortages appear to account for a sizable portion of unexplained inflation in 2022: - Illustrative decomposition suggests input and, to a smaller extent, labor shortages "might have raised core inflation by about 1.5 percent on average in Europe, or about three-fourths of the 2 percent estimated residual." - Panels and binned scatter plots (Figure 2.6) show correlations between core inflation residuals and: - Labor shortages - Vacancy-to-unemployment ratio - Input shortages - Data limitations prevented including these variables directly in the Phillips-curve regressions due to "lack of comprehensive cross-country time series coverage." ### Future path and risks: forecasts and uncertainty - Under October 2022 World Economic Outlook assumptions for global commodity prices, growth, and unemployment, and assuming stable inflation expectations, the empirical model predicts average inflation to decline gradually to: - 3–6 percent (headline) and 3–7 percent (core) in both advanced and emerging European economies by the end of 2023. - Emerging Europe: despite higher starting levels and greater persistence, inflation would fall more rapidly than in advanced economies because commodity price stabilization would yield larger disinflation gains; gains would be muted where measures dampening commodity pass-through are phased out. - A more conservative approach assumes slower reduction in recent forecast errors: "the conservative approach assumes that the average of the estimated 2022 residuals declines gradually using a first-order autoregressive process with autocorrelation coefficient of 0.6." - Overall, risks around WEO inflation forecasts are "tilted to the upside." - Key sources of uncertainty: - Persistence of supply shocks and bottlenecks if they ease more slowly than projected. - Commodity price trajectories (could fall if global economy slows). - Domestic slack mismeasurement: tight labor markets may mean slack was overestimated; alternatively, integration of Ukrainian refugees could increase slack in some economies. - Continued inflation surprises could de-anchor expectations and prompt wage demands, triggering wage-price feedback loops and making inflation more backward-looking. ### Illustrative scenarios (Table 2.1 and simulations) - Table 2.1 scenarios (summarized): - 0 Baseline: October WEO assumptions (energy inflation 79.6 percent in 2022, 2.9 percent in 2023; food inflation 14.2 percent in 2022, −5.8 percent in 2023). - 1 Negative supply shocks: 20 percent rise in energy and food prices. - 2 Positive supply shocks: 20 percent fall in energy and food prices. - 3 Less slack than estimated: 2 percentage points lower unemployment gap (DSGE: 2 percentage points lower output gap than assumed by central bank). - 4 More slack than estimated: 2 percentage points higher unemployment gap (DSGE: 2 percentage points higher output gap than assumed by central bank). - 5 De-anchoring: 1 percentage point higher expected inflation (sudden rise in expectations increases inflation in the first period by 1 percentage point). - 6 More backward-looking price formation: rise in coefficient on lagged inflation to 0.8 (about its pre-1990s value). - Simulations indicate upside predominance of risks: - Renewed commodity price shocks and smaller-than-estimated slack can delay return to target, more so in emerging Europe due to higher commodity spending, greater pass-through, and steeper Phillips curves. - De-anchoring of expectations would raise inflation. - The most challenging scenario is "more backward-looking price formation," which could be triggered by a wage-price spiral; simulations show this would be especially difficult for advanced economies. ### Wage-price spiral risk and monetary credibility - Two empirical exercises: 1. Response of wages to inflation triggered by oil price shocks (local projection method, instrumenting consumer price changes with global oil price changes, sample Q1 2000–Q4 2019): - Two factors increase pass-through from price shocks to wages: high prevailing inflation and weak central bank independence (linked to weak monetary policy credibility). - When prevailing inflation is high, an oil-induced price increase leads to larger and more long-lasting wage increases. 2. Response of prices to wages (interacted panel VAR, sample Q1 1995–Q1 2019): - Pass-through from wages to prices is larger when prevailing inflation is high—"it is three times larger in a high-inflation environment than in a low-inflation one." - Pass-through is stronger when inflation expectations are not well anchored. - Conclusion: Risks of a wage-price spiral are more pronounced when inflation is already high and monetary policy credibility is weak; such a spiral could lead to monetary tightening and higher unemployment if wages accelerate sharply beyond sustainable levels. *International Monetary Fund | October 2022* ### 2. INFLATION IN EUROPE: AssEssMENT, RIsKs, ANd POLICy IMPLICATIONs ### 2. INFLATION IN EUROPE: AssEssMENT, RIsKs, ANd POLICy IMPLICATIONs ### Assessment of recent inflation dynamics - Multidecade high levels of inflation recorded in much of Europe in the past 18 months increase the risk of inflation becoming entrenched. - There are tentative signs that inflation has become more backward-looking in the post-COVID-19 period. - Prevalence of formal wage indexation to past inflation has fallen across Europe in recent decades, lowering risks of wage-price spirals. - Wage growth has been relatively contained in most advanced European economies so far, with limited evidence of acceleration in negotiated wages until late summer. - More than half of private sector employees in the euro area do not take inflation into account when setting wages; where inflation plays a formal role in wage negotiations, forward-looking inflation measures are used predominantly. - About one-fifth of the euro area public wage bill has full or partial price indexation. - In the Western Balkans: - Inflation was in double digits in the summer of 2022 in all Western Balkan countries except for Albania, where it was at a two-decade high. - Food makes about 40 percent of the average consumption basket in the Western Balkans—twice the EU average. - Domestic food prices have increased more in the Western Balkans than in the European Union because of a high pass-through from global food prices. - Energy price inflation in the Western Balkans has been below the EU average in part due to domestic electricity generation in some countries and policies that dampened energy price increases at the consumer level. - Recent developments show inflation becoming more broad-based, with a rapid rise in core inflation, a build-up of wage pressures, and growing inflation expectations in some countries. - About 70 percent of emerging European economies used measures for food (tax cuts for food items or subsidies to farmers) compared with 12 percent of advanced economies. ### Risks and illustrative scenarios (model findings) - A small dynamic stochastic general equilibrium model calibrated to an average advanced and an average emerging European economy was used to simulate baseline and risk scenarios (baseline replicates dynamics observed in the first half of 2022 using a “cost-push shock” related to commodity price inflation). - Key simulated outcomes: - If some upside inflation risks materialized, monetary policies could need to be tightened by more than 200 basis points more than under the baseline. - Such tightening could reduce GDP growth in the year ahead by up to 2 percentage points in some cases. - A further commodity-driven cost shock would lead to another round of higher inflation, tighter monetary policy, and lower output everywhere but particularly in emerging Europe because of: - Larger share of food and energy in consumption baskets. - Larger role of past inflation in inflation expectation formation. - A de-anchoring of inflation expectations would have even larger and more persistent effects, especially in emerging Europe, producing a larger and more persistent increase in inflation than in advanced economies. - Misestimation of economic slack by central banks (over- or underestimating the output gap for six quarters by 2 percentage points in the scenario) would make policy undesirably expansionary or contractionary until corrected, causing considerably more or less inflation than desirable. - An increase in the extent to which price formation is backward-looking (for example, from a wage-price spiral) would drive up inflation similar to a cost shock but much more strongly and in a more long-lasting manner; advanced economies may be at greater risk of deterioration in forward-lookingness because they currently have more forward-looking inflation expectations to lose. - A contraction in aggregate demand would exacerbate the decline in output but ease inflation pressures; emerging Europe would see inflation drop by more than advanced economies because of steeper Phillips curves. ### Policy implications and recommendations - Monetary policy: - Central banks should keep raising policy rates under most scenarios while remaining nimble and ready to respond to emerging risks in both directions. - Greater chances exist that policy rate paths may ultimately need to be steeper instead of flatter than expected. - Maintaining central bank independence, effective communication, and transparency is key to preserving credibility and preventing unmooring of inflation expectations. - The desirable strength and persistence of monetary policy reaction depend on the risk and vary across economies; emerging European economies would need to react more strongly to a de-anchoring of inflation expectations. - Fiscal policy and energy/price relief: - Fiscal consolidation should proceed under the baseline IMF projections—even if its pace may be temporarily slowed—to avoid boosting aggregate demand and making it harder for monetary policy to tame inflation. - More temporary and targeted relief measures for energy (and food) price shocks are preferable because the more temporary and targeted the relief, the less they will conflict with the monetary policy stance. - Europe’s policy responses to the commodity crisis have included subsidies, tax cuts, and price controls; the fiscal cost of these measures is sizable: - Estimated to reach about 0.6 and 0.5 percent of GDP on average in advanced and emerging European economies, respectively, by mid-2022. - Exceeding 1.5 percent of GDP in countries such as Greece and Malta. - Support measures should remain as temporary and targeted as possible, be designed to preserve price signals, and encourage energy savings. - Labor and structural policies: - Where collective bargaining agreements have a wage indexation clause, authorities could intervene to moderate negotiated wages in the medium term in exchange for one-time wage bonuses rather than outright wage increases. - Structural reforms that enhance productivity and investments that expand economic capacity and relieve supply constraints, notably in energy and labor markets, could support monetary policy in the fight against inflation. - Country-specific considerations: - Policy responses and required monetary tightening will differ across individual countries depending on cyclical and structural specifics not captured in average-country simulations (for example, starting level of inflation, persistence, responsiveness to slack, and degree of anchoring of inflation expectations). *International Monetary Fund | October 2022* --- _Source: https://www.imf.org/-/media/files/publications/reo/eur/2022/october/english/text.pdf_