Here’s Why the EU is Unlikely to Slip into a Recession

Caught Between a Rock and a Hard Place

Russia’s invasion of Ukraine aggravated what was already a tricky scenario for policymakers, pushing the EU into the dilemma of curbing inflation without dampening economic growth.

Skyrocketing natural gas prices have made inflation the most burning issue for policymakers. The only weapon in the ECB’s arsenal is its benchmark interest rate. Higher interest rates curb inflation by dampening demand. However, lower consumer spending slows economic growth.

Are the Markets Overreacting?

The situation is worrisome but not without silver linings. There are a few bright factors that could help the common bloc stave off a technical recession.

Slow & Steady

To begin with, the ECB has moved cautiously. Developments on the other side of the pond indicate how jittery policymakers can get. The US Federal Reserve has already hiked rates to 3%-3.25%.

The ECB raised rates, but very gradually, from -0.5% to 0% in July and then from 0% to 0.75% in September. Despite these hikes, the benchmark rate remains well below what economists widely suggest is an economy’s neutral rate (which represents neither stimulation nor tightening), at about 1.5%. This gives the ECB ample room for further tightening.

What’s Recession Anyway?

The term recession is often used rather loosely to mean a slowdown in economic growth or even a brief period of contraction. However, by definition, recession is two consecutive quarters of negative growth, which didn’t even happen during the pandemic slowdown.

A Resilient Economy

Notwithstanding the Russia-Ukraine war, the European economy delivered robust growth in the first half of 2022, triggered by strong trade and some opening of supply chain bottlenecks. In addition, the easing of covid-related restrictions helped a rebound in contact-based service industries, such as tourism. The recovery in turn helped tourism-dependent countries like Greece, where summer tourism is estimated to be higher than the pre-pandemic levels. This is also reflected in the overly positive sentiment for the EU, as seen in Acuity’s Sentiment Widget.

The ECB expects the further easing of supply chain bottlenecks and continued robust growth in travel and tourism to support economic growth in the third quarter. Yes, real GDP growth will face headwinds from nearly double-digit inflation, raw material and energy disruptions, and interest rate hikes. The central bank projects sequential growth of 0.1% in the third quarter.

Tackling Energy Costs

Gas prices have eased. Sentiments have been buoyed by Russia’s failures and Ukraine’s successful counteroffensives. Government have also stepped in to take some of the blow. Germany, for example, announced a €65 billion package to help households and businesses meet energy costs. The ECB expects that fiscal stimuli will lower energy prices to 1.4% of GDP in 2022, a sizeable and targeted sum that should be invested to dampen inflation. The EU also has an agreement in place, which can be voluntarily accepted by members, to reduce natural gas usage by up to 15%. Implementation by members would help ease demand pressure on the dwindling gas reserves and sources. Natural gas futures are on a downturn, indicating that market expects spot prices to decline from their current levels.

Although Russia’s oil exports to western nations have contracted by 1.3 million barrels per day (bpd), the upward pressure on oil prices is being offset by an increase in global oil production and fears of a slowdown in global economic growth. Oil prices have also been weighed down by the prospects of a return of Iranian crude, which accounts for 1% of global demand. Supply continues to be tight, but OPEC+ production is nearly at pre-pandemic levels. The influence of oil prices on inflation may ease, heading into the final quarter of the year.

Fuelling Growth

There is also the prospect of increased business investment from the Next Generation EU program in some countries in the medium run. The urgent need for European countries to reduce their dependence on Russian energy supplies has also led to proposals such as the REPowerEU, which provide promise in the long term and GDP-stimulating investment opportunities in the short run.

The Euro Parity

The euro depreciation may boost exports from the EU. It spurred growth in net exports through the summer and could provide more support for the remainder of 2022. Net exports from the EU are projected by the ECB to make a neutral contribution to GDP growth in 2022 and a positive one in 2023.

The ECB has projected GDP growth of 3.1% for 2022. Although there could be a contraction in real GDP in the fourth quarter, effective policy could keep the economy chugging along in 2023, until supply chains can regain their pre-pandemic heights.