Getting fiscal policy right will be harder than dealing with inflation.
Europe has met the COVID-19 pandemic with audacity and imagination and is enjoying a strong but bumpy economic recovery. It now faces two policy challenges: controlling inflation and dialing back fiscal support. While there is considerable uncertainty about inflation, central bankers have plenty of experience dealing with it and can deploy their tools quickly and flexibly. By contrast, unwinding the emergency spending measures governments undertook to support their economies is a major, complex endeavor. If policymakers get it wrong, they risk a repeat of the tepid growth that followed the global financial crisis of 2008.
Erring on the side of withdrawing too little fiscal support rather than too much seems the better course of action...
We project that fiscal deficits of key advanced European economies will decline by around 4 percentage points of GDP in 2022, a far larger pivot than the one that followed the global financial crisis. This pivot mainly represents an unwinding of pandemic-related support, with only a part of the resources reallocated toward stimulating hiring and investment. Its impact on growth in 2022 would only be countered to a limited extent by that of disbursements of Next Generation EU funds in support of EU countries’ post-COVID recovery and resiliency plans. The assumption is that private demand has strengthened sufficiently to offset the reduction in government stimulus, driving the European economy along a smooth recovery rather than off a fiscal cliff.
Bringing back jobs
Yet risks abound. To be clear, the concern here is not that governments would sit tight if there were new virus waves or other major shocks. Rather, it is that growth in advanced economies settles at a paltry 1 percent or less toward the end of 2022 rather than the 2–3 percent rates that we are currently projecting. Fiscal policy is not able turn on a dime. And central banks would not be well placed to help, given that policy rates are already about as low as they can go. Every quarter of delay in achieving full employment will then add to the challenge of bringing people back into jobs. The issue is much less of a concern for emerging European economies, mainly because they deployed less stimulus and enjoy higher potential growth rates. Nevertheless, they would suffer from reduced demand for their exports from their advanced European counterparts.
Higher inflation, on the other hand, has been largely driven by forces that can be expected to fade over time. As during the 2010–11 recovery from the global financial crisis, energy has been the biggest driver, largely reflecting the strong rebound of economic activity, which has returned oil prices to the range that prevailed during pre-COVID years.
The recent surge in natural gas prices also reflects short-term factors—including dwindling inventories following a harsh winter and hot summer in 2021, shortages in renewables output in some places, and less supply. Adjusting for the energy-price “down and up” annual inflation rates computed over a 24-month horizon are close to pre-COVID ranges, as shown in the chart. This is the case even though supply-chain disruptions and associated bottlenecks are putting pressure on durable-goods prices, particularly as demand has bounced back quickly.
These supply-demand mismatches are expected to subside in the course of 2022 as consumption patterns normalize, inventories are restocked, and trade bottlenecks, in particular the supply of shipping containers, are resolved. Moreover, inflation in the euro area has also been driven by one-off factors, such as the expiration in Germany of a cut to the Value Added Tax enacted in January 2021.
None of the factors now driving inflation would respond to changes in monetary policy. Rather, monetary policy would need to ensure that they don’t trigger a wage-price spiral. Fortunately, the risk of such second-round effects is limited in many advanced European economies, where labor-market slack remains significant. For example, we estimate that hours worked are still some 3 percent below pre-COVID levels. And at pre-crisis employment, central banks struggled with inflation that was too low, not too high. All of this is not to deny that there is considerable uncertainty surrounding the duration of shocks to prices and the precise amount of slack in advanced economies. But, all in all, our as well as analysts’ forecasts and market-based measures of inflation expectations suggest that the European Central Bank will again find it hard to achieve its medium-term objective of inflation around 2 percent.
In several emerging European economies, where output and employment are already close to pre-COVID levels, the ground for second-round effects is more fertile. Also, inflation expectations have begun to move up, and wages are likely to react more strongly as slack in the labor market continues to diminish. These economies have, rightly, started raising their policy rates toward levels preceding the pandemic. While watching carefully how wages evolve, even there central banks do not need to rush this process given the temporary element in inflation.
In short, policymakers could easily find themselves in a situation that looks eerily similar to that of the early stages of the recovery from the global financial crisis more than a decade ago. There is a strong case for cutting very high fiscal deficits. But this will also require strong revenue growth and therefore strong activity, which could usefully be supported with additional transfers targeted at households in need, more spending on hiring incentives, and investment tax credits. Getting the pace of withdrawal of fiscal support exactly right will be tricky . Erring on the side of withdrawing too little fiscal support rather than too much seems the better course of action, especially in those economies with ample fiscal space, so as to guard against the risk of undercutting the momentum of the recovery.