Europe’s Post-Pandemic Economic Challenges

IMF Blog, October 20, 2021

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Europe is enjoying a "strong but bumpy economic recovery" following the COVID-19 pandemic.
Two primary policy challenges identified: controlling inflation and dialing back fiscal support.
Central banks can deploy tools quickly and flexibly to deal with inflation; unwinding emergency fiscal measures is a "major, complex endeavor."
Risk highlighted: repeating the "tepid growth that followed the global financial crisis of 2008."

We project that fiscal deficits of key advanced European economies will decline by around 4 percentage points of GDP in 2022.
The projected 2022 fiscal pivot "mainly represents an unwinding of pandemic-related support," with only part of the resources reallocated toward stimulating hiring and investment.
Disbursements of Next Generation EU funds will counter the fiscal withdrawal "to a limited extent."
Policy assumption: private demand has strengthened sufficiently to offset the reduction in government stimulus, driving a "smooth recovery" rather than a fiscal cliff.
Risk scenario: growth in advanced economies could settle at "1 percent or less toward the end of 2022" instead of the projected "2–3 percent rates."
Fiscal policy is "not able turn on a dime," and central banks are constrained because "policy rates are already about as low as they can go."
Every quarter of delay in achieving full employment will add to the challenge of "bringing people back into jobs."
Emerging European economies: less concern because they "deployed less stimulus and enjoy higher potential growth rates," but they would suffer from reduced demand for their exports.

Higher inflation has been largely driven by forces expected to fade over time.
Energy has been the biggest driver, reflecting the rebound of economic activity and oil prices returning "to the range that prevailed during pre-COVID years."
Recent surge in natural gas prices reflects short-term factors: "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."
Supply-chain disruptions and associated bottlenecks are putting pressure on durable-goods prices as demand 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.
Euro area inflation has also been driven by one-off factors, e.g., the expiration in Germany of a cut to the Value Added Tax enacted in January 2021.

Factors now driving inflation "would not respond to changes in monetary policy"; monetary policy must prevent a wage-price spiral.
Risk of second-round effects is limited in many advanced European economies because "labor-market slack remains significant."
Example estimate: "hours worked are still some 3 percent below pre-COVID levels."
At pre-crisis employment, central banks struggled with inflation that was "too low, not too high."
There remains "considerable uncertainty" about the duration of price shocks and the precise amount of slack.
Forecasts and market-based measures of inflation expectations suggest 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, output and employment are "already close to pre-COVID levels," making second-round effects more likely.
In those economies, "inflation expectations have begun to move up," and wages are likely to react more strongly as slack diminishes.
These emerging economies have "started raising their policy rates toward levels preceding the pandemic," but central banks there "do not need to rush this process given the temporary element in inflation," while watching wage developments carefully.

There is a "strong case for cutting very high fiscal deficits," but this requires "strong revenue growth and therefore strong activity."
Suggested supportive fiscal measures to sustain activity while withdrawing broad support:
- Additional transfers targeted at households in need.
- More spending on hiring incentives.
- Investment tax credits.
Guidance on withdrawal pacing: "Erring on the side of withdrawing too little fiscal support rather than too much seems the better course of action," especially in economies with "ample fiscal space," to avoid undercutting recovery momentum.

Source: Europe’s Post-Pandemic Economic Challenges (October 20, 2021) by Alfred Kammer