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

_IMF Blog, April 28, 2023_

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## Bibliographic details
- Authors: Alfred Kammer
- Published: April 28, 2023

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### Tight monetary policy for longer
- 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.

### Growth and near-term outlook
- 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.

### Inflation persistence and risks
- 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.

### Financial stability and policy coordination
- 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.

### Fiscal policy recommendations
- 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
- 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*

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- **Blog Eur Reo April2023**
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## References

- [Regional Economic Outlook](https://www.imf.org/en/Publications/REO/EU/Issues/2023/04/09/regional-economic-outlook-for-europe-april-2023?cid=bl-com-REOEUREA2023001)
- [geoeconomic fragmentation](https://www.imf.org/en/Blogs/Articles/2023/01/16/Confronting-fragmentation-where-it-matters-most-trade-debt-and-climate-action)
- [nonbank financial intermediaries](https://www.imf.org/en/Blogs/Articles/2023/04/04/nonbank-financial-sector-vulnerabilities-surface-as-financial-conditions-tighten)

_Source: https://www.imf.org/en/blogs/articles/2023/04/28/europes-knifeedge-path-toward-beating-inflation-without-a-recession_