Speech

Good morning, good afternoon and welcome to today’s press conference on the economic outlook for Europe.

Coming into 2022, thanks to the strength, coordination and solidarity displayed in policy responses to COVID19, Europe was on its way to exit the pandemic. Meanwhile, rising inflation was expected to gradually subside as commodity prices and supply bottlenecks would ease.

But Russia’s invasion of Ukraine changed this picture completely, and it is now taking a growing toll on Europe’s economies. Gas flows from Russia to Europe have dropped by over 80 percent relative to 2021. As a result, energy prices have spiked, and they are unlikely to return to their pre-war levels soon. This terms-of-trade shock has raised firms’ costs and led to a cost-of-living crisis. In response to higher and more persistent inflation, central banks have acted forcefully, and financial conditions have tightened.

Under these forces, the European outlook has darkened, with growth set to drop and inflation to remain elevated:

• GDP growth in advanced Europe is forecast to fall from 3.2 percent in 2022 to 0.6 percent in 2023—implying a downward revision for 2023 of 0.7 percentage point from our July World Economic Outlook Update projections. In emerging European economies, growth is also projected to decline sharply, from 4.3 percent in 2022 to 1.7 percent in 2023—a downward revision of 1 percentage point. In the conflict countries, output losses will be very large; Ukraine will see its GDP contract by over a third in 2022, while in Russia GDP is projected to be about 10 percent lower by 2023 than pre-war forecasts.
• Inflation should decline steadily next year, but it will stay significantly above central bank objectives. We project headline inflation at about 6 percent in advanced European economies and 12 percent in emerging economies in 2023.

Risks to growth are on the downside, and risks to inflation are on the upside, as shown in our new Regional Economic Outlook, which we will release on Monday October 24. For example, a complete shutoff of remaining Russian gas flows to Europe, combined with a cold winter, could result in gas shortages and rationing, giving rise to GDP losses of up to 3 percent in some Central and Eastern European economies, and yet another bout of inflation across the continent.

In the current environment, European policymakers face severe trade-offs and tough policy choices. They need to bring down inflation while helping vulnerable households and viable firms cope with the energy crisis. Policymakers also need to stay nimble and stand ready to adjust policies, depending on incoming news.

Central banks should continue raising policy rates for now, including in the euro area. And a tighter monetary policy stance might be needed in 2023, unless the deterioration in economic activity materially reduces medium-term inflation prospects. As financial conditions tighten, financial stability risks are resurfacing; regulators should closely monitor vulnerabilities, such as, for example, by stress-testing banks’ exposures to weakening household and firm balance sheets.

On fiscal policy, we have two main messages. First, fiscal tightening should proceed in 2023. Why? Because it needs to work with monetary policy in the fight against inflation and governments need to rebuild the fiscal space that has been depleted by the COVID crisis. Second, fiscal policy also needs to continue to address the cost-of-living crisis, but it needs to do so more efficiently.

In many European countries, governments have taken measures to dampen the passthrough of higher energy prices to households and firms to limit their economic and social costs. However, such measures should be temporary and will have to become more targeted to make sure their fiscal costs remain manageable and—this is crucial—to make sure that energy prices encourage lower energy consumption.

A helpful example of a well-targeted measure is to support low and middle-income households through lump-sum rebates on their energy bills. A less efficient alternative is to implement higher tariffs for higher levels of energy consumption, as some countries have done. While such an approach is not fully targeted to the vulnerable, it is still a better option than broad price caps.

Let me give you some numbers to make clear how important a well-targeted approach is: for 2022, on average across Europe, the cost of living for households has gone up by over 7 percent due to higher energy prices. IMF analysis suggests that compensating fully the bottom 20 percent of households would cost 0.4 percent of GDP, compensating the lower 40 percent would cost close to 1 percent of GDP. However, the fiscal costs of some of the existing packages, including new measures being announced, are vastly larger than these numbers. So, clearly, there is room to provide support for vulnerable people at lower cost.

Europe’s governments can also be much more efficient in their support of corporates. Energy security is a European problem; it is best addressed jointly, with an eye on ensuring a level playing field across the ‘single market.’

Finally, it remains essential for European policymakers to implement reforms that do not only relieve energy supply constraints, but also ease tensions in labor markets, enhance productivity, and expand economic capacity—including by accelerating implementation of Next Generation EU programs. Down the road, these measures will raise growth and ease inflation pressures. In other words, they will help address the two pressing economic challenges Europe is facing.

The task ahead is immense. But if European policymakers show once again the strength, coordination and solidarity they were able to muster during the pandemic, it can be done.