Euro area faces risk of stagflation
The conflict between Russia and Ukraine represents a significant shock for Europe. Its full impact is difficult to gauge and will depend on how long the conflict lasts, the nature of sanctions and the risk that violence spreads to other countries.
There are several channels through which the conflict could impact the economy. Commodities are the most important (due to the EU’s high dependence on Russian gas and oil), followed by business and consumer sentiment, finance and trade.
Higher energy prices will act as a drag on consumer spending, but we expect this to be compensated for to a certain extent by government policy measures and the mobilisation of part of the excess savings that were accumulated during the pandemic. Nonetheless, we have cut our 2022 GDP growth forecast for the euro area from 4.5% to 4.1% with risks tilted to the downside. Much will depend on the severity of supply disruptions. A full shutdown of Russian gas supplies would have a significant effect on the economy and would likely push the euro area into recession.
Given higher energy prices, we have revised our euro area inflation forecasts upwards. We now expect headline consumer inflation to average 4.9% in 2022 (previously we expected 4.5%) and core inflation to average 2.6% (up from 2.3%). We believe it is likelier to be above these levels than below them.
The European Central Bank (ECB) is faced with a dilemma. Additional pressure on prices will reinforce concerns about high inflation and possible second-round effects on wages. At the same time, risks to economic activity and the potential implications of falling momentum for the fiscal outlook suggest the ECB will have to be more patient than it planned with respect to policy normalisation.
Beyond the direct economic implications, the conflict will have significant long-term consequences for EU policy. Spending on security will probably increase, as will spending on achieving a more sustainable energy mix. The EU will probably run a more expansionary fiscal policy than it has over the past decade.