OECD Economic Outlook, Volume 2022 Issue 2

Euro area

After a strong first half of the year, real GDP growth is projected at 3.3% in 2022 and only 0.5% in 2023 owing to Russia’s war of aggression against Ukraine, monetary policy tightening and the global slowdown. Growth is projected to rebound to 1.4% in 2024 as consumption and investment pick up. Inflation is set to decline only gradually, remaining above target in 2024, fuelled by elevated energy prices and tight labour markets. Risks remain tilted to the downside as cold winters and further disruptions in energy supply would hit growth while pushing inflation higher.

High uncertainty, declining real incomes and increasingly widespread inflationary pressures require careful and coordinated policy actions. Fiscal measures to shield households and companies from surging energy and food prices need to avoid providing fiscal stimulus at a time of high inflation. They should be well targeted on the most vulnerable and avoid distorting price signals. Monetary policy should act decisively to bring inflation down, while using all margins of flexibility when reinvesting the proceeds of maturing bonds on the ECB balance sheet to limit financial fragmentation.

Disruption of energy supplies and high inflation are weighing on the outlook

Growth slowed in the third quarter of 2022, after the strong consumption growth during summer. Moreover, forward-looking indicators of sentiment suggest that growth may decline further and even turn negative in the fourth quarter. The output PMIs have been pointing to declining output for several months. Euro area consumer and, to a lesser extent, business confidence have deteriorated sharply. Meanwhile, inflation has continued to strengthen, to 10.6% in October, becoming more broad-based geographically and across categories of goods and services. Inflation expectations have increased and for many market participants and households are now well above the ECB inflation target. Declining real incomes have been partly cushioned by fiscal measures compensating households for the effect of higher energy prices. Although negotiated wage growth has remained contained so far, wage demands are picking up in some countries, including Belgium and Germany. Unemployment has continued to decline; in September 2022, the euro area seasonally‑adjusted unemployment rate was at its historical low of 6.6%, down from 8.6% at its recent peak in September 2020, and well below the average rate of about 9% observed in the last decade.

Euro area 1

1. OECD standardised, amplitude adjusted.

2. Business confidence refers to the manufacturing sector.

Source: OECD Main Economic Indicators database; Eurostat Harmonised index of consumer prices (HICP) database; and OECD calculations.

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Euro area: Demand, output and prices

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Euro area 2

1. Underlying government primary balance as percentage of potential GDP defined as cyclically-adjusted government net lending excluding net interest paid and net one-off operations.

2. Maastricht definition.

Source: OECD Economic Outlook 112 database; and OECD calculations.

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Direct trade with Russia is low and will likely shrink further as the ban on Russian crude and oil imports and other sanctions come into effect. Although 40% of gas and a fifth of oil and petroleum imports came from Russia before the war, the dependency on Russian energy imports has been reduced by about a half in the second quarter of 2022, mainly through supply diversification. Nonetheless, the war in Ukraine continues to have substantial effects on the euro area economy through higher energy prices, persistent supply chain disruptions and rising input costs. Spending to protect vulnerable households and businesses is adding to pressures on public finances already strained by the debt accumulated during the pandemic and long‑term spending needs. The war is also affecting trade in agricultural and other commodities as well as increasing their global prices. In addition, EU countries are sheltering about 4.3 million Ukrainian refugees. To help Member States meet related costs, the EU has made available EUR 27 billion from its cohesion funds and pandemic recovery funds.

Fiscal policy needs to avoid providing stimulus in a time of high inflation

While starkly different across the euro area, the fiscal stance is projected to be restrictive for the euro area as a whole in 2023 and even more so in 2024. Many countries have introduced additional support to shield households and companies from surging energy and food prices in 2022. However, in the absence of common European guidelines and co-ordination, the measures are not equally well designed and targeted across the euro area, which may reduce their effectiveness, distort competition, and possibly work against needed macroeconomic policy tightening. In addition, the war in Ukraine has triggered a rise in military spending in many countries as well as investments to secure energy supply.

The ECB has started monetary policy tightening, but further policy rate increases are needed to ensure that forward-looking measures of real interest rates become positive, the de-anchoring of inflation expectations is reversed, and inflation pressures are durably reduced. This will likely involve a period of below-trend growth to help lower resource pressures. The main refinancing rate is projected to rise to 4.25% in the second quarter of 2023 and to remain unchanged through the rest of the projection period.

Growth will slow sharply in 2023, gradually resuming afterwards

Quarterly growth is projected to turn negative in the final quarter of 2022, although strong carryover effects from 2021 and strong performance in the first half of the year mean that annual GDP growth of 3.3% is projected. High energy and food prices, weak confidence, continuing supply bottlenecks, and the initial impact of tighter monetary policy will lead to a sharp slowdown in 2023. Despite robust wage growth, consumer price inflation of 8.3% in 2022 and 6.8% in 2023 will lead to a contraction of real disposable income in 2022 and 2023, and a slowdown of private consumption growth. Investment will be held back by slowing demand, although additional funding of about 0.5% of GDP a year under the pandemic recovery funds will moderate the slowdown. Inflation is projected to moderate perceptibly only in 2024, with subdued domestic growth helping to contain price and cost pressures. Even so, core inflation is projected to still be above the ECB inflation target at the end of the projection horizon.

The risks to the projections are to the downside. The ongoing energy price shock and disruptions to supply chains could worsen, for example through difficulties in replacing diesel products previously imported from Russia, an enforced reduction in gas usage in industry due to further disruptions to energy supplies or a colder-than-usual winter during the projection period. In addition, the risk of a sustained downturn in China would be associated with slower global growth and lower external demand in the euro area. Inflation may well remain high for longer, especially in case of further disruptions in gas supply and the uncertain evolution of food prices due to extreme weather events and fertiliser shortages. A much tighter monetary policy could also heighten the risk of a recession. On the other hand, deceleration of hostilities during the winter months or a durable ceasefire represent upside risks.

Supporting long-term resilience and the green transition

The Russian invasion of Ukraine has heightened awareness of the link between the goals of energy security and climate change mitigation. Continuing a rapid and effective disbursement of the Next Generation EU funds will help accelerate both the diversification of energy supplies and the green transition. Coordination at the EU level and careful design would help to maximise the effectiveness of such policies and ensure a level playing field. Fiscal policy action to help cushion the impact of higher energy prices should be temporary and well targeted on the most vulnerable, while preserving incentives to reduce energy consumption, for example by using targeted income support rather than price freezes and tax cuts.

In addition to national fiscal policies, the need to kick‑start energy resilience and the green transition may also warrant some common spending and borrowing, for example to invest in critical common energy infrastructure. As investment in clean energy and energy infrastructure will need to increase substantially by 2030, a clear policy framework for combining price signals with regulatory and fiscal tools is needed at the European level. Finally, continued monetary policy tightening needs to be complemented by using all margins of flexibility when reinvesting the proceeds of maturing bonds, and if needed other policy tools, such as the Transmission Protection Instrument, to limit financial fragmentation in the euro area.