Europe Must Succeed in Restoring Price Stability

IMF Blog, October 13, 2023

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Policy interest rates have been raised resolutely, and central banks have signaled commitment to keeping them high for as long as necessary.
Headline inflation is down sharply from the double-digit highs of last year, but underlying inflation (excluding energy, food, and other volatile items) remains more stubborn.
Inflation is projected to return to target sometime in 2025.
Entrenched high inflation is distortionary and would imply prolonged high real interest rates that hurt private and public investment and future growth.

A recent paper looking at 100 inflation episodes worldwide shows history is littered with examples of premature celebrations of victory in disinflationary fights—each time with inflation making a comeback.
As tighter monetary policies begin to be felt, central banks must not blink; fiscal policymakers should help by lowering still-high deficits to rebuild or preserve fiscal buffers, which will help bring inflation down faster.
Nominal wage growth is expected to pick up before inflation returns to target, recouping some of labor’s lost real income.
With tight policies softening domestic demand, firms’ profit margins should compress and help mitigate the impact of faster wage growth on inflation.

Upside risks:
- Wage growth might outpace assumptions, driving up labor costs.
- Profit margins might stay high.
- Commodity price shocks (for example, spikes in oil prices) remain a concern.
Downside risks:
- If interest-rate increases transmit faster or more strongly to demand and to inflation expectations, inflation could decline more rapidly.
Policy stance:
- Monetary policy should remain data dependent and, under the baseline, stay the course and remain restrictive in most countries.
- If inflation comes in much lower or higher, rates would have to adjust.
- During a disinflation effort, it is better to err on the side of doing a little bit more than of doing less in response to an upside surprise.
- A time for interest rate cuts will eventually come, but that time is not now.

Europe’s jobs markets are strong and have remained remarkably resilient through the pandemic, the energy shock, and sharp monetary tightening.
Tighter monetary policy is feeding into sharply tighter credit conditions; industry is still adjusting to higher energy costs relative to a few years ago.
Some softening of activity is inevitable, partially buffered by steady private consumption supported by recovering real wages.

Advanced Europe growth forecasts:
- 2023: 0.7 percent for 2023 as a whole in advanced Europe (down from 3.6 percent in 2022).
- 2024: 1.2 percent.
European emerging market economies (excluding Belarus, Russia, Türkiye, and Ukraine):
- 2023: slowdown expected to bottom out this year at 1.1 percent.
- 2024: 2.9 percent.
Country performance:
- Service-oriented economies (Croatia, Greece, Spain, and Portugal) have benefitted from stronger demand and are expected to grow by more than 2 percent this year; their growth next year is expected to remain stronger than in countries with a greater manufacturing base.
- Energy-intensive manufacturing economies will take longer to recover; Germany is projected to see output contracting by 0.5 percent this year before moderate growth resumes in 2024.

Longstanding factors weighing on Europe’s growth potential include slowing improvements in productivity (which began well before COVID), population aging, and labor-supply constraints.
For many European emerging market economies, weak productivity combined with a loss of business competitiveness from relatively faster wage growth could stall convergence with advanced economies.
Global shifts adding to challenges: pandemic-related supply disruptions, persistent energy supply issues, geopolitical fragmentation, climate change, and adjustment to new technologies (for example in the car industry).
Fiscal and investment imperatives:
- Major investment needs loom, including to keep the planet livable.
- Europe’s high-debt countries in particular need to step up efforts to replenish fiscal buffers.
- Higher interest rates and slower growth will make it harder to stabilize debt over the next five years especially for European emerging market economies.
- Many countries will need to cut spending in non-critical areas and remove tax inefficiencies.
- Credible upfront commitments to fiscal consolidation will also help central banks restore price stability.
Productivity improvements through concerted structural reforms in product and labor markets can lift potential growth and achieve fiscal goals at lower economic cost; such efforts cannot be left for later.

Europe must avoid premature celebrations and re-establish price stability on the first attempt.
Central banks should remain resolute and data dependent; fiscal policymakers should rebuild fiscal buffers to support disinflation.
Europe has shown it can rise to big challenges; the current episode need not be different.

Source: Europe Must Succeed in Restoring Price Stability, Alfred Kammer, October 13, 2023.