Economic Forecast: Negative impact of Russia’s war 

Let me begin with the four key messages emerging from this forecast:

First, many of the risks identified in spring have materialised.

The Spring Forecast, which I presented on 16 May, identified a number of downside risks such as: “shocks reverberating from an unpredictable evolution of energy markets”, “tighter financial conditions”, a “much sharper deceleration in the US” and pandemic-related lockdowns “[…] resulting in lower-than-expected economic activity in China”. All these risks have materialised to various degrees.

Second, and linked to the first point, our growth forecast has been revised significantly down for 2023.You may be struck by the fact that our growth forecast for this year is unchanged, at 2.7% in the EU. But it is important to understand why this is so. Growth this year is propped up by the strong momentum gathered from last year and a better than expected first quarter. Economic activity in the remainder of the year is no longer expected to add to the annual growth figure. One could say the European economy is moving from a phase of slowing growth to one of putting on the brakes.Growth next year is now projected at 1.5%, 0.8 pps lower compared to the Spring Forecast.

Third, inflation is revised upwards. Despite a weakening economy, inflationary pressures remain strong. Inflation in the euro area is projected to peak at a new record high of 8.4% in the third quarter of 2022. Thereafter, inflation is expected to decline steadily, driven by subsiding pressures from energy prices. Overall, annual inflation in 2022 is projected at 7.6% in the euro area and 8.3% in the EU. In 2023, it should decelerate to 4.0% in the euro area and 4.6% in the EU. These figures are more than one percentage point higher than in the Spring Forecast.

Fourth, the balance of risks is tilted to the downside. The risks are linked to the evolution of the war and are largely – but not exclusively – linked to developments in commodity markets.The EU economy posted a positive growth surprise in the first quarter, with real GDP growth at 0.7%, up from 0.3% projected in the Spring. Economic momentum is expected to have weakened in the second quarter, but should regain some traction during summer, thanks to a promising tourism season.

For 2022 as a whole, growth is expected at 2.7%, unchanged compared to the Spring. As I explained, this unchanged forecast has to be seen in the light of the momentum gathered with the recovery of last year and a somewhat stronger first quarter than previously estimated.

In 2023, economic growth is expected to gather some momentum, on the back of a resilient labour market, moderating inflation, support from the Recovery and Resilience Facility and a still large amount of savings. However, at 1.5%, this growth will be 0.8pps lower than in the Spring Forecast.Commodity prices have been showing signs of easing lately in the face of global weakness. However, gas is an exception. Disruptions in Russian gas supply and concerns over further cuts pushed the European benchmark gas price up again.

By end June, it was trading at above 140 EUR per megawatt hour – more than six times the price one year earlier. Gas prices continued to rise after our cut-off date, reaching 173 euros per Megawatt-hour on 12 July. Gas and electricity futures point to substantial upward pressures compared to the Spring Forecast – particularly leading up to next winter.

In contrast, the Brent crude oil price hit a peak in mid-June, but retrenched thereafter amidst growing evidence of slowing global demand. The oil futures curve that underpins this forecast points to only slightly higher prices over the forecast horizon compared to spring.

Apart from energy commodities, metal prices fell from the high levels seen in March, reflecting the slowdown in global demand. Food prices also moderated in recent weeks, but are still up by some 30% compared to the same period in 2021, with cereal prices (e.g. wheat) affected the most by the war in Ukraine.

Global financing conditions have tightened further since the Spring Forecast. In response to rising inflation, monetary policy is normalising at a faster pace than earlier expected. Markets have lifted their expectations of short-term US rates for this year and next, contributing to a strong appreciation of the US dollar since spring. This has led in particular to the tightening of financing conditions in many emerging market economies and low-income countries.The ECB is set on a path of monetary policy normalisation with a first interest rate increase in July followed by further hikes thereafter. Monetary conditions continued to tighten more forcefully in a number of non-euro area Member States, especially in Central and Eastern Europe.Bond yields have increased across the board and spreads widened considerably a few weeks ago. Over the last few weeks, both short-term rates and long-term yields have declined, as markets adjusted to a worse economic outlook, requiring a less forceful tightening by central banks. In parallel, spreads have come down markedly in recent weeks.

• Global economic growth slowed down in the first quarter to 0.7%, after a strong 1.7% in the previous quarter. Notably, activity contracted in the US, Japan and parts of Asia. Growth in China was held back by lockdowns, but, with ample fiscal and monetary support, China still managed a decent rate of expansion.
• The growth momentum weakened further in the second quarter amid geopolitical tensions, rising prices and tightening financial conditions. The slowing growth momentum was driven by an important slowdown in China.
• Overall, real global GDP (excluding the EU) is now expected to grow by 3.0% in 2022 and 3.3% in 2023. This is respectively 0.3 pps. and 0.4 pps. less than two months ago.

Economic sentiment took a hit, of course, following Russia’s invasion over the second quarter. According to the Commission’s business surveys, confidence in industry has declined significantly but remains above its long-term average.

For the services sector, our survey points to a stable assessment of the past business situation and an improved assessment of past demand during the second quarter, when the sector benefitted from the reopening momentum in contact-intensive services. In contrast, consumer confidence in June fell close to the historic low observed at the onset of the pandemic. The decline is due to a more pessimistic assessment of households’ past and future financial situation as well as of the general economic situation. In addition, a strong rise in perceived inflation went hand in hand with a significant downward revision of consumers’ intentions to make major purchases amidst record high levels of consumer uncertainty.

Labour markets have continued to show strength. In the first quarter of this year, the number of employed persons in the EU increased by 1.1 million or 0.5% compared with the previous quarter. The relaxation of containment measures allowing many workers to exit job retention schemes. Meanwhile unemployment continued to decline to 6.1% in May. Other indicators, such as the continued increase in the job vacancy rate, which is at a record high, and a decline in labour market slack, are indicative of further tightening labour markets.

Looking ahead, labour markets are expected to remain resilient, but employment growth is set to soften. The Commission’s Employment Expectations Indicator for the EU underscores the slowing momentum since March, but remains considerably above its long-term average. Demand for labour is envisaged to soften in industry, construction and retail, while in services it is likely to remain strong in the near term.

In our Spring Forecast, we projected rising wages in 2022, yet well below the current inflation rates. Available data for the first quarter points to some pick-up in wages, but we still expect real wages to decline this year and households’ purchasing power to fall. For 2023 though, real wages are still expected to recoup some of the losses.

Turning to the growth map:

• In Germany, real GDP is expected to increase by 1.4% in 2022 and 1.3% in 2023. This is much lower than projected in spring, particularly for next year. Households’ purchasing power is being dented by inflation while supply bottlenecks and ever-increasing input costs are holding back manufacturing.
• In France, annual real GDP is expected to increase by 2.4% in 2022 and by 1.4% in 2023. Both figures have been revised lower since the spring. After the negative surprise of a decline in the first quarter of this year, growth is set to turn positive but to remain moderate on the back of subdued internal demand. While receiving support from the RRF, investment is expected to suffer from the gradual tightening of financial conditions and persistent supply disruptions.
•  In Italy, growth is expected to reach 2.9% in 2022 and to decelerate to 0.9% in 2023. The forecast for 2022 is higher than in spring thanks to the substantial carry-over effect from 2021 and an upward revision of growth in Q1 2022. Investment increased strongly in the first quarter and will continue to be supported by the implementation of the Recovery and Resilience Plan. The outlook for 2023 has deteriorated, due to the loss in households’ real purchasing power, waning business and consumer sentiment, persistent supply bottlenecks and rising funding costs.
• In Spain, real GDP is expected to expand by 4.0% in 2022, unchanged since Spring, and by 2.1% in 2023. Economic activity this year is set to be supported by the return of tourism to pre-pandemic levels and a faster implementation of investments under the Recovery and Resilience Plan. Towards the end of the year and in 2023, economic activity is projected to slow down as households are expected to adjust their consumption decisions to higher prices and economic uncertainty.
• Finally, in Poland, real GDP is expected to increase by 5.2% in 2022 and 1.5% in 2023. The projections for this year have been revised higher compared with Spring, thanks to a strong start of the year. Investment growth has been particularly strong. Going forward, economic growth is set to decelerate throughout the remainder of 2022 and in 2023. Growth next year has been revised lower, to incorporate the impact of the war, monetary policy tightening, deteriorating economic sentiment and a weaker external environment.

Inflation continued to rise in the second quarter. In the euro area, headline inflation rose to 8.6% year-on-year in June, according to the flash estimate. This is the highest rate in the history of our monetary union.

This pick-up in inflation has been again driven by energy and food prices. That said, inflation increased across the board, including in the case of “core” components like services and non-energy industrial goods.

Inflation is expected to peak at 8.4% in the euro area in the third quarter of this year, and decline thereafter. This profile reflects the commodity price assumptions, which are derived from market futures, and a certain persistence of core inflation.

On an annual basis, inflation in the euro area is projected to reach 7.6% in 2022, before falling to 4% in 2023. This represents an upward revision of 1.5 pps. and 1.3pps. in 2022 and 2023 compared to the Spring Forecast

At the same, market-based inflation expectations over the medium term recently moved back towards 2%. This means that despite the near-term acceleration in inflation, markets expect it to go down towards the target over the medium term. This of course would be good news.

Recent inflation readings and the inflation outlook for the next two years differ widely across Member States.

In 2022 inflation is expected to range from 5.6% in Malta to 17% in Estonia and Lithuania. Next year the range is expected to narrow considerably. Inflation expected in Central and Eastern Europe is visibly higher than the rest of the EU.

The balance of risks to the outlook is tilted towards adverse outcomes, particularly for growth. The risks are essentially linked to the duration of the war and to its consequences for energy supply.

Further reductions in gas supply to the EU would send its prices higher and amplify stagflationary forces. In our Spring Forecast publication, we presented a model-based simulation of a full cut of gas imports from Russia, with limited substitution possibilities in the short run. This scenario, that we called a “severe scenario” at the time, would bring the EU economy into recession over the second half of this year and further depress economic activity next year. In light of recent events, this risk has become more than just a hypothetical scenario, for which we need to prepare. So, a storm is possible, but we are not there at the moment.

Stronger inflationary pressures could trigger a faster tightening in financing conditions that would not only weigh on growth, but also on financial stability.

Covid-19 remains a significant risk. The possibility that the resurgence of the pandemic in the EU would bring renewed disruptions to the economy cannot be excluded – despite the fact that at this time we don’t have measures going in this direction.

Source – EU Commission