The Russia-Ukraine conflict is hitting economies worldwide just as activity is recovering from COVID-19. As close neighbors to Russia and Ukraine, European countries are among the most exposed to the latest shock. Yet, the eurozone economy is coming out of the pandemic in a position of strength, with large buffers to protect itself against a full-year recession, unless severe downside assumptions materialize.

Tailwinds from the recovery are still strong

Survey data, such as the Purchasing Managers' Index, confirms that the recent omicron wave has done little to derail growth, with the expansion in services picking up in February. More precisely, sectors most hit by the pandemic like hospitality, tourism, and retail have not yet recouped their end-2019 levels of activity (see chart 1). A full recovery of the two most affected sectors--arts and entertainment and wholesale and retail sales, transport, and accommodation--would add about 1 percentage point to eurozone GDP this year.

Plus, manufacturing output remains 5%-6% below pre-pandemic levels in Germany, Spain, and France, mostly due to supply chain bottlenecks. Demand for industry remains elevated, with order books at record highs in the eurozone (see chart 2). This suggests industrial production is likely to pick up as bottlenecks ease, which could contribute to another 0.8 point in growth alone. The Federal Reserve Bank of New York's global supply chain pressure index for February 2022 suggests that bottlenecks remain elevated but eased in the first two months of the year.

What's more, the carryover from 2021 GDP is unusually high. Should GDP not increase at all during the four quarters of 2022, it would still be 1.9% higher than in 2021, given the past recovery from the pandemic.

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Households and firms are in a better position than before the pandemic

Households have accumulated a lot of excess savings during the pandemic, which accounted for about 6% of GDP by the end of third-quarter 2021 (see chart 3). Excess savings are tilted toward the higher income classes, but less than in the U.S. Plus, fiscal policy is working to lessen the impact of higher energy prices on low-income households. What's more, the labor market has staged a strong recovery, with consumer confidence close to a record high ahead of the conflict. The unemployment rate is now at its lowest since the euro was introduced in 1999 and close to its natural rate (see chart 4 and "A Deep Look At Europe’s Stronger, Smoother, And More Inflation-Resistant Labor Market," Feb. 28, 2022). That means workers are in a good position to bargain for higher wages, which may offset some of the higher inflation pressures on their purses. Good employment prospects and savings will help buffer the shock of higher prices on household purchasing power. Companies, meanwhile, so far have been able to pass on higher input costs to consumer prices, leaving them with still relatively strong margins and ample cash to face this new shock (see chart 5).

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Policy support also remains ample

On the fiscal side, governments still have to spend large parts of their recovery packages. As such, we expect most of the increase in government investments to come in 2022 and 2023. Even in France, where the rollout of the program started early, the rise in public investment is still below what the budget suggests, pointing to a sharper rise this year. Some countries like Spain are also running a bit behind schedule on the implementation of Next Generation EU programs. So far, 16% of grants and 5% of loans from the Next Gen plan have been disbursed to member states. Meanwhile, governments have introduced new support measures to shield households from higher energy bills. In France, those measures already amount to around €22 billion and €16 billion in Italy.

On the monetary policy side, the European Central Bank still maintains very loose financing conditions (see chart 6). Even though it is reducing its net asset purchases gradually to €20 billion in June, we don't expect that to give a material lift to long-term rates, given the size of the ECB's balance sheet and the ongoing reinvestments. Those should last for the next couple of years at least, also considering that the average duration of the ECB's bond portfolios slightly exceeds seven years, which should continue to apply forceful downward pressure on yields.

Chart 6

Yet another external shock to producer and consumer prices

Notwithstanding this strong recovery momentum, the eurozone is faced with a new external shock as the conflict in Ukraine carries on. The main transmission channel is higher prices, even though Russian energy supplies to Europe remain unaffected so far. If they decrease, the impact would be sizable because Russia provides about one-quarter of the EU's energy supplies and Europe would have a hard time substituting those with other energy sources. For example, the ECB finds that a 10% cut in gas supply could endanger around 0.7% of the eurozone's GDP (see "Natural gas dependence and risks to euro area activity," ECB Economic Bulletin, Issue 1/2022).

Oil and gas prices have increased markedly since the beginning of the conflict, adding to already high inflationary pressures in the eurozone. Over the past six months, energy prices contributed to more than one-half of headline inflation pressure. We now expect this to be the case for the rest of the year (see charts 7 and 8). Meanwhile, firms' higher input costs, from supply chain issues, have been passed on to consumers more quickly than usual because of the high demand for durable goods (see chart 9). That means companies may even have managed to preserve their profits. (During the first three quarters of 2021, nonfinancial corporations had a gross operating surplus exceeding 40% of gross value added). We find that supply chain bottlenecks contributed to about 0.8 point to the rise in inflation in 2021. With sanctions against Russia and the war with Ukraine impeding trade with or even production in those two countries, we expect renewed supply chain disruptions to push up industrial goods and food prices. Russia and Ukraine are key exporters of industrial and food commodities (see "Russia-Ukraine Conflict: Implications For European Corporate and Infrastructure Sectors," published March 16, 2022). To cite just a few examples, Russia is a key supplier of fertilizers, Ukraine provides the bulk of neon gas for semiconductor production globally, and together they produce 30% of global wheat.

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Chart 9

Overall, we now expect inflation in the eurozone to reach 5% this year, 2.2% in 2023, and around 2% from then on. This is equivalent to prices being 4.3% higher in 2023 than in our previous baseline. In other words, consumers will see their purchasing power squeezed this year, more or less depending on the fiscal support granted to them, which will differ from one country to another. We expect the conflict to shave off about 1.5 point of their purchasing power this year alone compared with our November expectations, which will translate into lower consumption and aggregate demand. On the one hand, it seems that the pre-pandemic regime of low inflation has been left behind. On the other hand, wages are not adapting rapidly. Negotiated wages increased 1.6% year on year in fourth-quarter 2021, barely accelerating from the third quarter and still lower than in the previous years (2% year on year on average).

Meanwhile, as uncertainty about the outlook has mounted, the shock is also shaking confidence. This is visible through higher volatility in financial markets since the onset of the crisis. But broader confidence is also at stake, with consumer confidence down to -18.7 in March from -8.8 in February, a drop that is about half that in 2020 when the first COVID-19 restrictions were adopted. Plus, confidence was at a record high ahead of the conflict. While for now, the feedback effect on growth is limited, heightened uncertainty could compel companies to delay some investments in the next few years, while consumers may increase precautionary savings, anticipating potential adverse effects on their incomes. At some point, consumers may also tend to save more to avoid eroding the real value of their financial assets if inflation remains higher for longer.

Finally, trade channels will play a more limited role in transmitting this crisis to European economies. Exports to Russia already dropped markedly after the first sanctions were adopted in 2014 (to around 1.5% of total exports from close to 3%) and have not recovered since (see chart 10). That said, sanctions on trade with Russia and the war in Ukraine are still likely to affect supply chains, with some key components produced in Ukraine not readily obtainable elsewhere (see chart 11, see "Moving The Russia-Ukraine Scenario Needle: European Output At Risk," published on March 16, 2022). Overall, economies closer to Russia, particularly the Baltics, are much more exposed to a drop in trade as Russia's economy slows down (see chart 12).

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Taken together, we expect higher inflation, prolonged supply chain bottlenecks, and lower confidence to lower GDP growth to 3.3% this year. That's down 1 percentage point from our November baseline. We forecast 2.6% in 2023 (see table 1 below). Nevertheless, downside risks prevail because the evolution of the conflict remains so uncertain.

The ECB will still be in a position to start raising rates at the end of the year

While the initial second-round effects on inflation may be relatively muted--with workers potentially worrying about job security--the rise in food and consumer durable prices is more likely to lead to a more sustained increase in inflation expectations. Those have already moved up in the past months. Higher price pressures are also likely to develop in coming years from structural trends, such as the reshoring of supply chains, in response the pandemic and tensions with Russia as well as the need to transition away from fossil fuels.

The ECB will start withdrawing monetary policy support as the eurozone moves away from the low-inflation regime of the pre-COVID-19 years and as long as the growth effects of the Russia-Ukraine conflict remain contained. Thus, after it phases out net purchases in the third quarter, we expect the ECB to raise rates 25 basis points a quarter from December until they reach 1.5% by mid-2024 (see "The ECB Opens The Door To A Rate Liftoff," Feb. 8, 2022). Given the forward guidance on quantitative easing and rates that the ECB communicated at its last meeting, the window for a first hike in rates would open as soon as September. However, we believe the ECB might be tempted to wait for the release of its 2026 inflation forecasts in December before acting. What's more, it will take time for the ECB to start reducing the size of its balance sheet. Reinvestments from the PEPP (pandemic emergency purchase programme) are set to occur until the end of 2024, which will continue to place downward pressure on long-term rates. Until now, the ECB has not considered active quantitative tightening--the outright sales of its bond portfolio as a policy option. As such, we expect the German Bund to remain below 1% until the start of 2024.

To sum up: the eurozone economy is strong enough to avoid a full-year recession in the face of the current shock, according to our baseline assumptions. In a more severe scenario, downward effects on growth and upward effects on inflation may be amplified by:

• A higher and longer oil price shock. In our models, a 10% increase in the oil price, which is almost equivalent to a $10 a barrel increase now, lifts consumer prices 0.5% and lowers GDP 0.2% over term.
• Outright cuts to the gas supply. As already stated, the ECB finds that a 10% cut in gas supply could endanger around 0.7% of the eurozone's GDP.
• Stronger confidence effects that would lead households to save more, especially if wages fail to catch up with inflation. For now, the drop in consumer confidence is about half that in 2020 when the first COVID-19 restrictions were adopted.
• More acute supply chain challenges, like punctual production stoppages, especially at small and midsize companies, with a risk of knock-on effects, if substitutes for industrial and food commodities imported from Russia prove difficult to find.

In both the baseline and the severe scenario, we see rising inflation despite a weaker growth outlook as an argument for the ECB to start normalizing monetary policy this year, but without rushing.

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