The International Monetary Fund’s(IMF) European Department recently cautioned European economies on the toxic mix of slow growth and high inflation which has been causing headache to European policymakers who face severe trade-offs and tough policy choices as they address the situation to prevent it from worsening.
The IMF in its end of October magazine projected that for the winter season, more than half of the countries in theEurozone are headed for a recession.
With at least two consecutive quarters of decreasingeconomic output among these countries, the IMF European office revealed that output will fall on average by about 1.5% from its peak.
The European countries are facing a toxic mix of inflation, slow growth, energy crisis, and pressure to support Ukraine in its war with Russia.
“Under these forces, the European outlook has darkened, with growth set to drop and inflation to remain elevated,” argues Alfred Kammer, director of the IMF’s European department, while blaming Russia’s invasion of Ukraine.
Europe’s 2023economic output and income will be nearly half a trillion euros lower as compared to the IMF’s pre-war forecasts—a stark illustration of the continent’s severe economic losses due to the war.
The IMF scenarios show that a complete shutoff of remaining Russian gas flows to Europe, combined with a cold winter, could result in shortages and rationing, giving rise toGDP losses of up to 3 percent in some Central and EasternEuropean economies, and yet another bout of inflation across the continent.
The IMF analysis shows that even without any new energy supply disruptions, inflation could remain higher for longer.
“Most of the inflation surge so far is driven by high commodity prices—primarily energy, but also food, particularly in the Western Balkan countries,” the IMF said.
While these prices might remain elevated for some time, there is hope that they will stop increasing and thereby contribute to a steady decline in inflation throughout 2023, the IMF estimates.
As a solution, the IMF advised that the European economies tighten macroeconomic policies to bring down inflation while helping vulnerable households and viable firms cope with the energy crisis.
In advanced economies, including in the Euro area, tight monetary policy will likely be needed in 2023 unless activity and employment weaken more than expected, materially bringing down medium-term inflation prospects.
The international lender has also indicated that a tighter stance is generally justified in most emerging European economies, where inflation expectations are not as well anchored, while demand pressures are stronger and nominal wage growth is high—often in the double digits.
As for the cost of money, the IMF expects policy rates to continue to rise as an insurance policy against risks, including a de-anchoring of inflation expectations or a feedback loop between prices and wages, that would require even stronger and more painful central bank responses down the road.
FISCAL POLICY DILEMMA
The IMF stated that a fiscal policy must balance competing objectives facing the European area. One is the need to rebuild fiscal space and help monetary policy in its fight against inflation.
According to the IMF, this calls for fiscal consolidation to proceed in 2023 at a faster pace in countries with less fiscal space, greater vulnerability to tighter financial conditions, or stronger cyclical positions.
This includes most emerging European economies.
Despite the power of fiscal policy, the IMF stressed that the policy also needs to help mitigate the brutal impact of higher energy prices on people and viable firms.
“This suggests that the pace of consolidation may have to be slowed for a few months,”the IMF wrote.
This is because higher energy prices have increased European households’ cost of living by some 7% on average this year despite the widespread measures taken to ease this burden.
Going forward, the IMF has advised the European economies that it will be important to keep energy-related support temporary to contain fiscal costs and to maintain the price signals that will foster energy savings.
Compared with price interventions, a better option is to support low- and middle-income households through lump-sum rebates on their energy bills.
A close alternative is to combine general lump-sum discounts with additional support for the poor through the welfare system, financed by higher taxes for high-income households.
Yet another alternative according to the Fund, which is a less efficient alternative is to implement higher tariffs for higher levels of energy consumption; while such an approach is not fully targeted to the vulnerable, it is still a better option than broad price caps. Email: firstname.lastname@example.org