Russia’s aggression in Ukraine has led the European Commission to revise its EU growth outlook and its inflation forecast. As this column discusses, putting more upward pressure on commodity prices, disrupting new supplies and increasing uncertainty, the war is pushing pre-existing headwinds toward growth, which was previously expected to decline. However, the economy is expected to continue to expand, and inflation will continue to decline, although it will remain above 2% across the forecast horizon. If further disruptions occur in the energy market, the economy will not be able to avoid stagnation.
Russia’s attack on Ukraine has hit the EU economy through multiple channels.
The impact of Russia’s aggression on Ukraine is being deeply and widely echoed in the EU and around the world (IMF 2022a). Amid growing uncertainty and declining consumer confidence (in the European Commission 2022), they are putting pressure on prices of energy, food and other commodities; Disrupting global supply; And contributes to the tightening of financial conditions (see Figure 1). The EU is at the forefront of advanced economies due to the geographical proximity of Russia and Ukraine, especially its reliance on fossil fuels imported from Russia and high integration in the global price chain (IMF 2022b).
Figure 1 How Russia’s invasion of Ukraine is affecting the EU’s economic outlook
… But economic expansion in the EU will continue and inflationary pressures will decrease …
The Organization of the Arab Petroleum Exporting Countries (OPEC) cut off supplies in response to the Yom Kippur War in October 1973, with oil prices skyrocketing and the current shock. This alone has intimidated observers. The stalemate, however, should not be underestimated. First, at least until now, the rate of inflation of fuel products has been lower than in the 1970s (Ha et al. 2022). Admittedly, gas prices are now about six times higher than the pre-epidemic benchmark, which is even higher than the rise in oil prices between October 1973 and February 1974. Nevertheless, rising oil prices – which are still the primary source of energy for the EU – have been held even higher above the pre-epidemic level of about 60%. Second, in the 1970s, OAPEC controlled about 60% of the world’s oil supply, whereas today Russia has a much smaller share of both global oil and gas supplies (12% and 17%, respectively; British Petroleum 2022). Third, four decades ago, production in developed economies was much more energy-intensive than it is today, thanks to advances in energy efficiency and a large portion of services (IMF 2022c). Fourth, other structural features of the economy are also different: in the 1970s, broad wage and price indices, highly regulated and oligopolistic markets and trade protectionism were key to propagating and prolonging the price push. Finally, existing demand management policies were slow to respond to the tested supply shock (ECB 2000).
Despite the downtrend and revision of the forecasts for inflation, the European Economic Spring 2022 forecast (European Commission 2022b) still projected the economy to expand on the forecast horizon and inflation will gradually move towards the target – but above it. This is not the full-blown stagflashing scene of the 1970s.
Actual GDP growth in both the EU and the euro is now expected to be 2.7% in 2022 and 2.3% in 2023, down from 4.0% and 2.8% (2.7% in the euro area), respectively, in the winter 2022 interim forecast (European Commission 2022c). The downgrade for 2022 must fall on the background of the growth momentum collected by the economy in the spring and summer of last year, which added about 2 percentage points to this year’s growth (‘carry-over effect’). The year-over-year growth has slowed to just 0.8% from 2.1%. Instead, estimates for inflation have been significantly revised. In the EU, HICP inflation is now expected to reach an all-time high of 6.8% in 2022, before declining to 3.2% in 2023. In the euro area, inflation is projected at 6.1% in 2022 and 2.7% in 2023. The winter 2022 interim forecast compares with 3.5% and 1.7%, respectively.
Economic expansion supports the remaining tailwinds from the reopening of post-epidemic communication-intensive services, as well as the resilience of economies built through strong policy measures at the European Union and national level in response to the epidemic crisis. A strong and still improving employment situation, high savings and the complete deployment of the Recovery and Resilience Facility (RRF) and supportive reform agenda are set to support personal spending and investment. Financial systems are adding this support to offset part of the impact of rising energy prices on vulnerable households and energy-intensive companies.
Figure 2a EU GDP growth forecast (spring and winter)
Figure 2b EU Inflation Forecast (Spring and Winter)
Yet, the unprecedented nature and sheer size of the war makes our initial predictions a matter of considerable uncertainty, and the balance of risks surrounding them tends to be counterproductive. The risks depend heavily on the evolution of the war and its consequences for the energy market. The forecast is based on the assumption that geopolitical tensions are not normal on the forecast horizon and that energy prices are evolving at the behest of futures markets. It does not cause major disruptions in the supply of oil and / or gas products, which reflects the situation on the forecast cut-off date.
… still serious disruptions to the energy market could push the EU into recession …
Echoes from the evolution of the energy market that deviate from these key assumptions are assessed through model-based scenario analysis. An initial adverse situation estimates oil and gas prices above 25% of the baseline across the forecast horizon. A second, more serious situation is the complete reduction of gas supplies from Russia. Both situations are associated with a further increase in the risk premium and the impact of negative confidence. The results of the simulation exercises show that the strength in the energy market strengthens the stagnant forces during play and results in lower growth and higher inflation than in the baseline. Thanks to the strong carry-over from 2021, the eurozone economy will still handle positive annual growth rates in the two forecast years, but the net of carry-over effect from 2021, the economy will shrink in 2022. A sharp decline in gas supplies from Russia would signal a significant deterioration in the economic outlook: GDP growth would be around 2½ and 1pps. Below the baseline in 2022 and 2023, respectively, while inflation projected by personal spending defaulters will be 3 percentage points higher in 2022 and 1 percentage point higher in 2023.
Figure 3a Real GDP growth rate situation, across the euro area
Figure 3b The situation, the rate of inflation across the euro area
Strengthen the need for frontload energy transitions
Significant macroeconomic risks arising from the EU’s high reliance on oil and gas imports from Russia reinforce the case for an accelerated decarbonization of the economy. Policy measures should target supply (such as investment in renewable sources or LNG terminals) and demand (such as energy efficiency or simplification of electric vehicle charging stations). It is very important that RRF can be relied upon to meet this new challenge. The timely implementation of its investment and reform pillars to reduce the dependence on fossil fuels from Russia and increase the potential for long-term growth of the EU economy is as relevant as ever. Within the framework of the REPowerEU plan (European Commission 2022d), the Commission is ready to scale up its assistance projects and reforms that accelerate the transfer of energy. Special benefits should be given to projects with internal energy markets and strong cross-border dimensions. Unused loans in RRF can be an additional source of funds.
Policymakers need to recalibrate their policy tools deployed during epidemics. Over the past few years, revenue firepower has been successfully integrated to support overall demand and stabilize employment, thereby maintaining price stability in the face of inflationary risks. This response has proven to be extremely effective in protecting the citizens of the European Union and preserving the productive capacity of the economy in the face of temporary shocks, which is expected to have an overall limited transformational outcome. Facing a potential permanent setback that is primarily balanced towards the supply of the economy, the goal of policy action should no longer be to avoid excessive displacement but to be accelerated with structural change. To address this new challenge, attention needs to be paid to the distributional aspects. While softening the impact of rising energy prices on vulnerable households and energy-intensive industries, policymakers need to conserve incentives to reduce energy use and ensure public financing that is on track for long-term sustainability.
British Petroleum (2022), “Insights of the country – Russia”.
ECB (2000), “Box: Lessons to be Learned from Oil Prices of 1970 and Early 1980”, ECB Monthly Bulletin, November.
European Commission (2022a), “Business and Consumer Survey Results for March 2022”, DG ECFIN, March.
European Commission (2022b), “European Economic Spring 2022 Forecast”, European Economy Institutional Paper 173, May.
European Commission (2022c), “European Economic Winter 2022 Interim Forecast”, European Economy Institutional Paper 169, May.
European Commission (2022d), “RepowerEU: Plan to rapidly reduce reliance on Russian fossil fuels and accelerate green transformation”, press release, May.
Ha, J, MA Kose and F Ohnsorge (2022), “Today’s Inflation and the Great Inflation of the 1970s: Similarities and Differences”, VoxEU.org, March 30.
IMF (2022a), Global Financial Stability Report, April.
IMF (2022b), World Economic OutlookApril.
IMF (2022c), “Lower Oil Reliance Protects World from 1970-Style Crude Shock”, IMF Blog, May.