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

IMF Blog, April 28, 2023

Source details

Canonical URL: Europe’s Knife-Edge Path Toward Beating Inflation Without a Recession

Central banks should maintain tight monetary policy until core inflation is unambiguously on a downward path back to central bank inflation targets.
Further increases in policy rates are required in the euro area.
Central banks in emerging European economies should stand ready to tighten further where real interest rates are low, labor markets are tight, and underlying inflation is sticky.
High uncertainty strengthens the case for tight monetary policy: underestimating persistence could entrench high inflation and force central banks to tighten later for longer, likely requiring a sharp recession to bring inflation back to target.
When the extent of economic slack is uncertain, policymakers should place more weight on inflation and labor market dynamics, both of which currently favor higher interest rates.
Even accounting for elevated uncertainty, policy rates in a number of countries are at the lower end of commonly used benchmarks, suggesting that higher rates may be needed to rein in inflation.

Following a strong exit from the pandemic, Europe was hit hard by Russia’s invasion of Ukraine; growth slowed drastically, inflation shot up, and episodes of financial stress materialized.
Most economies narrowly avoided a recession this winter due to decisive policy action.
Growth projections:
- Growth in Europe’s advanced economies will slow to 0.7 percent this year from 3.6 percent last year.
- Emerging economies (excluding Türkiye, Belarus, Russia, and Ukraine) will see a sharp decline to 1.1 percent from 4.4 percent.
- There will be a mild rebound in growth to 1.4 and 3 percent, respectively, in these two country income groups next year as real wages catch up and external demand picks up.
The projection assumes: central banks will succeed in steadily bringing down inflation; any renewed bouts of financial stress will remain contained; no further escalation of Russia’s war in Ukraine and associated sanctions; and broader geoeconomic fragmentation will be kept at bay.

Headline inflation continues to decline, but underlying inflation (excluding energy and food) will remain persistent and uncomfortably above central bank targets even by the end of next year.
Recent and projected declines in energy prices will feed into lower underlying inflation, but not enough to bring it down quickly.
Inflation upside risks:
- Energy prices could spike again.
- Wage growth could pick up more than projected as workers seek compensation for purchasing power losses in tight labor markets; faster wage gains would make underlying inflation more persistent.
- This is a material risk across much of Emerging European economies, where nominal wage growth is in double digits.
Persistent higher energy prices will reduce euro area output by more than 1 percent on average in the medium term, with larger losses in more energy-intensive economies such as Germany or Italy.
Shifts in worker preferences (away from long hours) and more workdays lost to sickness related to long COVID may durably reduce labor supply and complicate matching of workers with vacancies.
Historical note: estimates of economic slack in European countries were revised downwards by a full percentage point one year after the fact and by even more later.

If financial conditions tighten due to forces such as banking sector problems, central banks would not need as tight a monetary policy to achieve their objectives—but it would be misguided to pause or reverse tightening prematurely because higher interest rates come with higher financial stability risks.
Monetary policy cannot succeed alone; macroeconomic, financial, and structural policies need to work in concert.
Maintaining financial stability will require:
- Close supervision and monitoring of both banks and nonbank financial intermediaries.
- Contingency planning and prompt corrective action.
In the European Union, stability could be bolstered by:
- Extending the reach of bank resolution tools.
- Clarifying availability of the Single Resolution Fund’s resources.
- Ratifying the European Stability Mechanism’s amended treaty.
- Agreeing on a pan-European deposit insurance.

Defeating inflation calls for European governments to pursue more ambitious fiscal consolidation than embedded in their current plans.
A good starting point would be to phase out most energy relief measures and target any remaining ones more narrowly to vulnerable households.
Tighter fiscal policy would help central banks meet their objectives at lower interest rates, reduce debt service costs, and bolster financial stability by reducing:
- Euro area economies’ vulnerability to financial fragmentation risks.
- Emerging European economies’ vulnerability to spillovers from ECB monetary policy tightening and higher global interest rates more broadly.

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

Alfred Kammer, April 28, 2023 — IMF Blog

Blog Eur Reo April2023
- Blog Eur Reo April2023 (Markdown version)
- Blog Eur Reo April2023 (PDF)
Full Report
- Full Report (Markdown version)
- Full Report (PDF)