Russia’s war in Ukraine is taking a growing toll on Europe’s economies. The worsening energy crisis has depressed households’ purchasing power and raised firms’ costs, only partly offset by new government support. Central banks have acted more forcefully to bring high and persistent inflation down to targets, and financial conditions have tightened. Abroad, growth has softened in China and the United States, and multidecade-high inflation has led to broad-based global monetary policy tightening. Against this backdrop, the European outlook has darkened considerably, with growth set to slow sharply and inflation to remain elevated. Output growth in advanced and emerging European economies (excluding conflict countries and Türkiye) is forecast to fall from 3.2 and 4.3 percent in 2022, respectively, to 0.6 and 1.7 percent in 2023—0.7 and 1.1 percentage points lower than the July 2022 World Economic Outlook Update projections. Output losses will be very large in the conflict countries. While projected to decline in 2023, headline inflation will stay significantly above central bank objectives, at 6.2 and 11.8 percent in advanced and emerging European economies, respectively. Risks to growth are on the downside, while those to inflation—especially core inflation—are on the upside. The technical recessions—at least two quarters of negative GDP growth—projected in parts of Europe could turn into even deeper recessions across the continent. A key near-term risk is further disruption to energy supplies, which, combined with a cold winter, could lead to gas shortages, rationing, and deeper economic pain. Inflation, which exceeds predictions from conventional empirical tools, could stay higher for longer, particularly if medium-term inflation expectations begin to de-anchor or too-high wage compensation for recent price increases were to trigger a wage-price feedback loop. Importantly, social tensions may intensify in response to the cost-of-living crisis, resulting in a more expansionary fiscal stance that could force central banks to further tighten monetary policy. Having to deal with a combination of weak growth and high inflation that could get worse, European policymakers are facing severe trade-offs and tough policy choices. A tightening macroeconomic policy stance is needed to bring down inflation, while helping vulnerable households and viable firms weather the energy crisis. But policies also need to stay nimble and agile and be able to adjust should additional shocks materialize. On the monetary policy front, with real rates still generally accommodative, broadly resilient labor markets, above-target inflation forecasts, and predominant upside risks to (core) inflation, central banks should continue raising policy rates. Faster hikes are called for in advanced economies, and a tight monetary policy stance will likely be needed in 2023 unless growth and labor market prospects weaken sufficiently below their current baseline to materially reduce medium-term inflation. An even tighter stance is generally warranted in most emerging European economies, where inflation expectations are not as strongly anchored, cyclical positions are more robust, and nominal wage growth is higher. The difficult task of fiscal policy is to rebuild fiscal space and help monetary policy in its fight against inflation while managing the extraordinary energy price shock. Consolidation should proceed in 2023, at a faster pace in countries with less fiscal space, greater vulnerability to tighter financial conditions, and/or stronger cyclical positions—including most emerging European economies. Slowing the pace of consolidation for a few months may be appropriate to allow governments to support households and viable firms through the energy crisis. Such support should be temporary and preserve strong price signals that foster energy savings. Macro-prudential policy settings can be kept broadly unchanged to avoid amplifying the downturn, but supervisors should closely monitor and stress-test banks’ risk exposures to vulnerable households and firms hit by deteriorating growth prospects, higher energy prices, and tighter financial conditions. Finally, steady implementation of reforms that enhance productivity, relieve supply constraints in energy and labor markets, and expand economic capacity—including by accelerating the implementation of Next Generation EU programs—remain essential to raising growth and easing price pressures over the medium term, while also ensuring energy security, accelerating the green transition, and countering adverse demographic trends.
