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The European Outlook and Policymaking: Seeing Off Inflation and Pivoting to Longer-Term Reforms
October 18, 2023
Budapest Economic Forum
Good morning to all of you. Thank you for the introduction. It is a pleasure to be here today and for the first time at the Budapest Economic Forum. I am honored to have been invited to speak.
Today, I will discuss the outlook for Europe and how we see the risks. Inflation, implications of the geoeconomic fragmentation, and the green transition will be particular areas of focus. I will discuss key policies for securing low inflation and forging a path of higher long-term growth.
Progress has been made in taming inflation and the likelihood of a soft landing has increased, both globally and in Europe.
But downside risks are significant. Policymakers face the risk of persistent and more volatile inflation. We now live in a more shock prone world. And the longstanding slowdown in productivity growth, the geoeconomic fragmentation and the challenges of the green transition cast doubt on whether European economies can return to the pre-pandemic growth trajectory.
These competing challenges and a highly uncertain outlook will test policymakers in Europe.
These themes are pertinent to Hungary, which is facing a difficult macroeconomic environment, with still-high inflation and the longest recession since the mid-1990s.
Let me start with the European Outlook.
At first glance, the European economy seems to be approaching a relatively benign moment.
The IMF’s baseline forecast anticipates a continued moderation of inflation in Europe and—contrary to initial expectations of recession—modest growth in 2023 and a slight recovery in 2024. We expect that for Europe as a whole 2023 growth will be 1.3 % (2,7 in 2022), picking up to 1.5% next year. Advanced economies are expected to go from 0.7 % to 1.2%, while Emerging European Economies are expected to have a sharper recovery from about 1 to about 3 %.
Aided by easing commodity prices and supply constraints, monetary tightening has cooled headline inflation, providing support to real wages. In most EU countries, the tightening cycle has peaked, with the prospect of an approaching soft landing as growth this year slows but remains in positive territory.
However, there are divergencies across European countries: energy-intensive and manufacturing-oriented economies, such as Germany and Hungary, are performing less well.
And downside risks continue to prevail everywhere.
Headline inflation is falling, but is 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, outpacing inflation in some economies, especially in Eastern Europe.
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. In Hungary, inflation reached 25 percent at end- 2022, and prices have increased by 41 percent cumulatively from end-2020 to August 2023. This rapid and massive price shock eroded workers’ purchasing power and left a large real wage gap.
Hence, some wage catch up is reasonable and to be expected. However, we have some concerns.
We have decomposed wage growth into inflation expectations and wage catch up in green, the unemployment gap in red, productivity growth in yellow, and in gray other, that is wage growth in excess of what is to be expected from the factors I just mentioned, which as you can see is growing especially in Central, Eastern, and South-Eastern Europe, CESEE.
The risk is that wage pressures could translate into additional inflation pressures, especially where wage setting is backward-looking, as is the case in many European emerging markets, and hence harm competitiveness.
New IMF research, in our recent World Economic Outlook, also shows that near-term inflation may play a greater role in setting long-term inflation expectations than previously thought. Near-term expectations, in turn, are influenced to a large extent by backward-looking agents, particularly in emerging market economies where such agents are more prevalent. There is also evidence that the pass-through from inflation expectations to inflation tends to be higher when inflation is high.
The strength of the labor market is fundamentally good news.
Vacancy to unemployment ratios stand at record highs and unemployment rates at record lows in most of Europe.
But all of this means additional upward nominal wage pressures are likely and the possibility of a wage-price spiral exists.
Let me be clear: we don’t see wage-price spirals likely in advanced European economies, but the risk in Eastern Europe is not negligible.
Another driver of high inflation has been firms’ profits.
In many countries, in the last couple of years, firms have passed on more than the increase in input prices to consumers. In CESEE too we saw an increase in profits, which have started to fall. Going forward, this is positive in the sense that firms could absorb some wage increases by lower profits. But there is no guarantee that this will continue. In sum, all of these forces put together suggest that we may be experiencing a period of especially sticky price and wage pressures.
Besides the more cyclical factors that I have just discussed, there are some additional risk factors for inflation, which are more structural in nature.
Take geoeconomic fragmentation. We have already experienced big shocks from fragmentation, especially Russia’s war in Ukraine. We could see additional commodity price spikes that feed through to core inflation. More generally greater fragmentation brings more trade restrictions and disruptions of supply chains, continuing to generate negative supply shocks, which will be inflationary.
The pre-pandemic view was that central banks could generally ignore supply shocks as these were believed to be mostly transient. But, the pandemic and war in Ukraine have highlighted how supply shocks can have broad and persistent inflation effects.
Let me turn to the medium- and long-term challenges.
Europe’s medium-term growth prospects have been declining for some time.
Since the 2008 global financial crisis, per capita growth has fallen and we expect growth to remain weak over the medium term.
The pandemic and the energy crisis have resulted in significant scarring to the level of output. And this comes at a time when countries also grapple with the structural shifts from fragmentation, climate and technological change, and demographic pressures.
Fragmentation is a particularly potent economic challenge. The increasing trade restrictions and reconfiguration of supply chains, besides raising production costs, can further dampen Europe’s weak productivity growth.
The economic costs of fragmentation are likely to be substantial. While estimates vary, 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—equivalent to the combined size of the French and German economies. If technological decoupling is added to the mix, some countries could see losses of up to 12 percent of GDP. And looking just at commodities trade, the IMF estimates that segmentation in the trade of these critical inputs could erase 2 percent from global GDP and up to 3.5 percent from that of emerging Europe.
While reshoring or near-shoring some aspects of production may also present some opportunities to some countries, these are only available if cost competitiveness is preserved, especially on wages.
But let me be clear: economic fragmentation is a negative sum game for the world as a whole.
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Climate change is another major challenge. European countries, like other parts of the globe, are experiencing rapid temperature rises and greater frequency of natural disasters, underscoring the urgency of transitioning to a greener and more climate resilient economy. The green transition holds the promise of being an engine of growth accompanied by greater sustainability and resilience and is one of the key imperatives of our times.
In the short term, though, this may entail significant adjustment costs and benefits spread unevenly across countries, firms, and people. The effects on prices and growth could be uncertain in the short to medium term, depending on how well managed and orderly the adjustment.
Take the auto sector, so important for several countries in Europe including Hungary. IMF research shows that the transition to electric vehicles is already negatively affecting employment in sectors and regions focused on internal combustion engine vehicle production. We are likely to see disruptions in the extensive regional value chains that have been built around supplying the auto industry, which employs 7 percent of the European workforce. This highlights the need to facilitate the relocation of factors of production across sectors. This transition will have implications for employment, investment, and public policy as countries have to reorient worker training and investment, including in new infrastructure.
Finally, Europe confronts labor supply constraints due to demographics, and capital stocks in emerging Europe are still low.
I realize that I have laid out a sobering list of near- and long-term challenges. So, what to do about all this?
First, it is critical not to loosen policies prematurely in response to what may be temporary declines in inflation.
In a recent IMF paper, we have looked at 100 inflation shocks and we have seen that in many cases, policies were eased too soon, and inflation reaccelerated: here are some examples of premature celebrations, but there are many more.
Fund research also shows that countries that resolved inflation episodes experienced lower growth in the short term, but not over the medium term.
Naturally, the level and duration of tightness in the monetary policy stance should be calibrated to country specific conditions. This may mean that some central banks keep rates at current levels for some time while others may have to raise them further. While many emerging economies started raising policy rates already in 2021 and by substantial amounts, real rates have remained below the neutral level in some countries. Hungary has now one of the highest real policy rate in Europe.
Given the high cost of erring on the side of monetary policy being too loose, the empirical case for a less contractionary stance should be compelling. Monetary policy should remain restrictive until there is clear evidence of a substantial improvement in the core inflation forecast; a reduction of upward inflation risks which hinges mainly on labor market developments; and the absence of upward movements in inflation expectations. These conditions have not been met in most countries.
The key message is that fighting inflation is difficult in the short-term but pays off later, while delaying the day of reckoning ultimately requires a higher sacrifice in future growth and employment.
In emerging markets, in particular, bringing down inflation once it gets sticky can be very costly and high inflation creates competitiveness problems that EMs can ill afford. Short-term pain for long-term gain.
Second and turning to fiscal policy, our strong recommendation is that all countries step up their efforts to rebuild fiscal buffers while protecting the vulnerable. This means consolidation, starting now and especially in high-debt and high deficit countries. By reducing deficits, fiscal consolidation will complement monetary policy in the fight against inflation. Importantly, it will re-build fiscal space for future shocks and for productivity-enhancing investments, including in green infrastructure, and to face the critical transitions that we are experiencing.
In many emerging economies, there is significant room to mobilize resources and to achieve greater expenditure efficiency through better targeting and better spending prioritization. In many countries, there are opportunities to eliminate tax leakages, exemptions, and inefficiencies. IMF research shows that the potential for revenue mobilization by increasing tax efficiency in emerging European economies is as high as 2 percent of GDP, on average. Many countries still have costly and counter-productive energy subsidies, which run counter to the green transition and reduce energy security, which need to be eliminated. Support can be given in a targeted way at a fraction of the current cost. And with high yields globally, governments should be even more rigorous in their prioritization of public spending and not leave money on the table on the tax front.
Third, structural policies remain crucial for achieving strong, sustainable, and more evenly distributed growth. With greater prevalence of supply shocks, constrained policy space, and big transitions under way requiring large reallocation of factors of production, policies that can stimulate the supply side and facilitate the necessary adjustments have to take center stage.
Country needs vary and reforms need to be tailored to the specific institutions and initial conditions, but there are some common priorities.
In emerging European economies, the need to get structural policies right is particularly important given the urgency of reaccelerating income convergence. To attract inward investment countries should ensure business-friendly environments by strengthening public governance, enhancing skills and infrastructure. In addition, investing in human capital to align education, health, and social protection outcomes with those of advanced economies can help stem the excess flow of emigration.
To address geoeconomic fragmentation, some countries have introduced industrial policies to encourage the establishment of critical industries or to produce key inputs at home citing national security or just reshoring. Industrial policies have a role to play in addressing market failures and externalities, such as in the provision of critical infrastructure or in supporting basic research, an under-provisioned public good by the private sector. But they need to be deployed only narrowly and with care. Costly subsidy races and the use of distortionary tariffs must be avoided, and policies should be coordinated at the multilateral level to avoid beggar-thy-neighbor outcomes.
For the EU, focusing on completing the single market—completing the single services market, the banking union, and the capital markets union—is absolutely vital. Green subsidies should maintain the integrity of the EU’s Single Market and follow a common EU approach. Together with the implementation of the Recovery and Resilience Plans, there reforms are critical to boost the EU’s productivity and competitiveness.
Energy importers should continue to seek to diversify suppliers to avoid the consequences of overdependence on a single source.
International collaboration on climate change, including a global carbon price floor, will reduce emissions and complement domestic policies. The recently published IMF fiscal monitor proposes a practical mix of policies that are feasible and would achieve the climate goals, including also feebates, green subsidies, and regulation standards, combined with transfers to vulnerable workers.
I realize that these challenges, and the proposed solutions, seem daunting. But every journey starts with a single step.
The policies that governments put in place today have important implications for the trajectory of inflation, competitiveness, and growth in the future.
The good news is that tackling inflation now will strengthen resilience and help to buttress competitiveness in the long term.
As inflation is brought under control and fiscal space is rebuilt, European policymakers will be able to seize the opportunities posed by big transitions rather than being a casualty of these structural shifts.
Structural policies that help boost supply, including those at the EU level, ultimately will be the only way of boosting growth and will also alleviate some of the structural inflation pressures.
And all this in turn will play an important role in raising regional growth and in helping emerging economies like Hungary to converge with Europe’s advanced economies.
The IMF remains deeply committed to the region and will continue to support our member countries to foster macroeconomic stability and higher living standards.
Thank you.
