The European Outlook and Policymaking: Seeing Off Inflation and Pivoting to Longer-Term Reforms
IMF News, October 18, 2023
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- Authors: Laura Papi
- Published: October 18, 2023
Overview and key takeaways
- Progress has been made in taming inflation and the likelihood of a soft landing has increased, both globally and in Europe.
- Downside risks remain significant: risk of persistent and more volatile inflation, greater shock propensity, slowdown in productivity growth, geoeconomic fragmentation, and challenges of the green transition.
- Hungary faces a difficult macroeconomic environment, with still-high inflation and the longest recession since the mid-1990s.
Outlook and near-term challenges
- IMF baseline forecast:
- Europe as a whole: 2023 growth will be 1.3 % (2,7 in 2022), picking up to 1.5% next year.
- Advanced economies: from 0.7 % to 1.2%.
- Emerging European Economies: recovery from about 1 to about 3 %.
- Recent drivers moderating inflation: easing commodity prices and supply constraints; monetary tightening has cooled headline inflation and supported real wages.
- Divergences across countries: energy-intensive and manufacturing-oriented economies (e.g., Germany and Hungary) are performing less well.
- Inflation dynamics and labor markets:
- Headline inflation is falling but not expected to return to target until 2025 in many countries, for some even 2026.
- Core inflation has been persistently high in many European economies, especially in services.
- Nominal wages are growing rapidly; in some economies wage growth outpaces inflation, especially in Eastern Europe.
- Vacancy to unemployment ratios stand at record highs and unemployment rates at record lows in most of Europe.
- Risk of wage-price spiral: unlikely in advanced European economies, but non-negligible in Eastern Europe.
- Historical price shock:
- As the pandemic and Russia’s war in Ukraine hit European economies, in only 2 years prices increased by 25 percent, as much as over the 5 years following the global financial crisis.
- Hungary: inflation reached 25 percent at end- 2022, and prices have increased by 41 percent cumulatively from end-2020 to August 2023.
- Firm-level margins: firms passed on more than input cost increases to consumers in many countries; profits rose in CESEE and have started to fall—creating potential to absorb some wage increases but with no guarantee.
- Structural inflation risk from geoeconomic fragmentation:
- Greater fragmentation can cause commodity price spikes, more trade restrictions, supply-chain disruptions and persistent negative supply shocks that are inflationary.
- Pre-pandemic assumptions that central banks could ignore supply shocks have been challenged.
Medium-term challenges
- Declining medium-term growth prospects: per capita growth has fallen since the 2008 global financial crisis; output scarring from the pandemic and the energy crisis.
- Major structural shifts: fragmentation, climate and technological change, demographic pressures.
- Economic costs of fragmentation (estimates cited):
- Greater international trade restrictions could reduce global economic output by up to 7 percent over the long term, or some $7 trillion in today’s dollars.
- Adding technological decoupling could lead some countries to see losses of up to 12 percent of GDP.
- Segmentation in commodities trade could erase 2 percent from global GDP and up to 3.5 percent from that of emerging Europe.
- Reshoring/near-shoring may present opportunities only if cost competitiveness—especially wages—is preserved.
- Climate transition challenges:
- Rapid temperature rises and more frequent natural disasters increase urgency for a greener, climate-resilient economy.
- Short-term adjustment costs and uneven benefits across countries, firms, and people; effects on prices and growth uncertain depending on the orderliness of adjustment.
- Auto sector example: transition to electric vehicles is already negatively affecting employment in regions focused on internal combustion engine vehicle production; the auto industry employs 7 percent of the European workforce.
- Labor supply and capital constraints: demographic trends constrain labor supply; capital stocks in emerging Europe remain low.
Policy recommendations and priorities
- Monetary policy
- Critical not to loosen policies prematurely in response to temporary declines in inflation; evidence from 100 inflation shocks shows premature easing often led to reaccelerating inflation.
- Monetary policy should remain restrictive until:
- there is clear evidence of a substantial improvement in the core inflation forecast;
- there is a reduction of upward inflation risks (hinging mainly on labor market developments);
- and there is absence of upward movements in inflation expectations.
- Calibration should be country-specific; some central banks may keep rates at current levels while others may need to raise them further.
- Note: Hungary has now one of the highest real policy rate in Europe.
- Fighting inflation now reduces future sacrifice in growth and employment; in emerging markets bringing down sticky inflation can be very costly and creates competitiveness problems.
- Fiscal policy
- Strong recommendation: all countries should step up efforts to rebuild fiscal buffers while protecting the vulnerable—consolidation should start now, especially in high-debt and high-deficit countries.
- Fiscal consolidation complements monetary policy and rebuilds space for future shocks and productivity-enhancing investments, including green infrastructure.
- Revenue mobilization and expenditure efficiency:
- IMF research: potential for revenue mobilization by increasing tax efficiency in emerging European economies is as high as 2 percent of GDP, on average.
- Opportunities to eliminate tax leakages, exemptions, inefficiencies.
- Many countries maintain costly and counter-productive energy subsidies that should be eliminated and replaced with targeted support at a fraction of current cost.
- With high global yields, governments should rigorously prioritize public spending.
- Structural policies
- Supply-side reforms to stimulate business dynamism, encourage investment and R&D, and remove barriers to economic innovation.
- Improve worker training, skills, and active labor market policies to ease transitions and prevent employment losses during the green and digital transitions.
- Boost labor participation to counter demographic trends and relieve labor market tightness and inflation pressures.
- In emerging Europe, priorities include strengthening public governance, enhancing skills and infrastructure, and investing in human capital to reduce emigration and attract inward investment.
- Industrial policy and fragmentation
- Industrial policies can address market failures and externalities (critical infrastructure, basic research) but must be narrow and careful.
- Avoid costly subsidy races, distortionary tariffs; coordinate policies multilaterally to avoid beggar-thy-neighbor outcomes.
- For the EU: complete the single market (single services market, banking union, capital markets union) and ensure green subsidies maintain the integrity of the EU’s Single Market and follow a common EU approach.
- Implement Recovery and Resilience Plans to boost EU productivity and competitiveness.
- Energy importers should diversify suppliers to avoid overdependence.
- Climate policy
- International collaboration on climate change, including a global carbon price floor, will reduce emissions and complement domestic policies.
- IMF Fiscal Monitor proposes a mix of feasible policies: feebates, green subsidies, regulation standards, combined with transfers to vulnerable workers.
Conclusion
- Tackling inflation now will strengthen resilience and competitiveness in the long term.
- Bringing inflation under control and rebuilding fiscal space will allow European policymakers to seize opportunities from big transitions rather than be casualties of structural shifts.
- Structural policies that boost supply—especially at the EU level—are the only sustainable way to raise growth and alleviate structural inflation pressures, supporting convergence for emerging economies like Hungary.
- The IMF remains committed to supporting the region to foster macroeconomic stability and higher living standards.
Laura Papi, Deputy Director, European Department, IMF — Remarks at the Budapest Economic Forum, October 18, 2023
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- European Economic Outlook and Policymaking: Seeing Off Inflation and Pivoting to Longer-Term Reforms