Europe’s post-pandemic economic challenges – IMF blog

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By Alfred Kammer

Spanish, English, Portuguese

It will be more difficult to have good fiscal policy than to cope with inflation.

Europe has faced the COVID-19 pandemic with boldness and imagination and is experiencing a strong but bumpy economic recovery. It now faces two political challenges: controlling inflation and reducing budget support. Although there is considerable uncertainty about inflation, central bankers have a lot of experience in the matter and can deploy their tools quickly and flexibly. In contrast, resolving emergency spending measures taken by governments to support their economies is a major and complex undertaking. If policymakers are wrong, they risk a repeat of the lukewarm growth that followed the 2008 global financial crisis.

Favoring the withdrawal of too little budget support rather than too much seems to be the best course of action …

We expect the budget deficits of major advanced European economies to decline by around 4 percentage points of GDP in 2022, a much larger pivot than that following the global financial crisis. This pivot mainly represents an outcome of the support linked to the pandemic, only a part of the resources being reallocated to the stimulation of hiring and investment. Its impact on growth in 2022 would only be thwarted to a limited extent by that of next-generation EU disbursements of funds in support of post-COVID recovery and resilience plans of EU countries. The assumption is that private demand has strengthened enough to offset the reduction in government stimulus measures, sending the European economy on a smooth recovery rather than a fiscal cliff.

Resumption of jobs

Yet the risks abound. To be clear, the concern here is not that governments will sit still if there are new waves of viruses or other major shocks. Rather, it is that growth in advanced economies is set to a paltry 1% or less by the end of 2022 rather than the rates of 2-3% that we are currently forecasting. Fiscal policy cannot run on a dime. And central banks would not be in a good position to help, given that key rates are already about as low as they can get. Each quarter of delay in achieving full employment will then add to the challenge of getting people back to work. The issue is much less of a concern for emerging European economies, mainly because they have deployed less stimulus and benefit from higher potential growth rates. Nevertheless, they would suffer from reduced demand for their exports from their advanced European counterparts.

Rising inflation, on the other hand, is largely due to forces that are expected to subside over time. As with the 2010-11 recovery from the global financial crisis, energy was the main driver, largely reflecting the strong rebound in economic activity, which brought oil prices back to the range that prevailed during the pre-COVID years.

The recent surge in natural gas prices also reflects short-term factors, including lower inventories after a harsh winter and hot summer in 2021, renewable energy production shortages in some locations and reduced supply. Adjusted for annual “down and up” energy price inflation rates calculated over a 24-month horizon, they are close to pre-COVID ranges, as shown in the graph. This is the case even as supply chain disruptions and associated bottlenecks put pressure on durable goods prices, especially as demand rebounded quickly.

These supply-demand mismatches are expected to ease over 2022 as consumption patterns normalize, stocks are replenished, and trade bottlenecks, particularly the supply of shipping containers, are resolved. . In addition, inflation in the euro area has also been driven by one-off factors, such as the expiration in Germany of a value-added tax cut adopted in January 2021.

Second round effects

None of the factors driving inflation would react to changes in monetary policy. On the contrary, monetary policy should ensure that they do not trigger a wage-price spiral. Fortunately, the risk of such second round effects is limited in many advanced European economies, where the labor market slowdown remains significant. For example, we estimate that hours worked are still around 3% lower than pre-COVID levels. And in terms of employment before the crisis, central banks were grappling with inflation that was too low, not too high. All this does not deny that there is considerable uncertainty about the duration of price shocks and the precise amount of slack in advanced economies. But, overall, our forecasts as well as those of analysts and market-based measures of inflation expectations suggest that the European Central Bank will again struggle to meet its medium-term target of around inflation. 2%.

In several emerging European economies, where output and employment are already close to pre-COVID levels, the ground for second-round effects is more fertile. In addition, inflation expectations have started to rise and wages are expected to react more strongly as the labor market slowdown continues to abate. These economies have rightly started to raise their policy rates to pre-pandemic levels. While carefully watching wage developments even there, central banks do not need to rush this process given the temporary element of inflation.

Maintain momentum

In short, policymakers could easily find themselves in a situation that looks eerily like the early stages of recovery from the global financial crisis more than a decade ago. There is a strong case for reducing very high budget deficits. But it will also require strong income growth and therefore strong activity, which could usefully be supported by additional transfers targeted to households in need, greater spending on hiring incentives and tax credits for employees. the investment. It will be difficult to determine exactly the pace of withdrawal of budget support . Prioritizing the withdrawal of too little fiscal support rather than too much seems to be the best course of action, especially in economies with ample fiscal space, in order to guard against the risk of undermining recovery momentum. .


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