According to the most recent data, the eurozone economy slowed markedly during winter. Recent surveys have been quite negative following Russia's invasion of Ukraine, although the easing of Covid containment restrictions is a positive development. In fact, while the Economic Sentiment Indicator's drop to 108.5 in March is among the sharpest in the survey's 36-year history, the final composite Purchasing Managers Index only declined by 0.6pts to 54.9, as the services index posted a 0.1pt rise over the month.
Short-term growth outlook
The impacts of Russia's invasion of Ukraine have been felt strongly in Europe. The effects have been unfolding through several channels: energy prices, trade, disruption in supply chains, financial market shocks, and the impact on confidence.
Our April baseline forecast sees GDP growth of 2.8% this year and 2.7% in 2023 (Chart 1), leaving the eurozone economy around 1% below our February pre-conflict baseline. Meanwhile, we have increased our average inflation expectation sharply to 5.9% in 2022.
Chart 1 - GDP growth is slowing this year
Source: Oxford Economics
Moreover, Russia’s invasion of Ukraine also means that more negative scenarios are now plausible alternative developments. In this grimmer scenario, which sees the fighting lasting well into 2023 alongside a series of sanctions imposed by the West and retaliation from Russia via a cut in gas supplies, the eurozone would not post any quarterly growth for the rest of 2022 (Chart 2).
Chart 2 - There are large downside risks to the outlook if the war is prolonged
Source: Oxford Economics/Haver Analytics
Key drivers of our short-term forecast
Inflation to take a toll on consumption growth. In our pre-conflict scenario, household consumption was expected to post a robust outturn this year, but with inflation remaining higher for longer and confidence already declining, this assumption is no longer valid. While we still expect a rebound in Q2 as the economy emerges from the Omicron outbreak, headwinds are mounting for the rest of the year. Moreover, a stronger hit to confidence, together with a slower normalisation in savings rates and higher inflation, could prompt some consumers to delay or cancel their purchases, resulting in slower economic activity than expected.
Supply chains to be impacted. While manufacturing sub-sectors in the eurozone's largest economies do not have a high proportion of production inputs coming from Russia, there is evidence that the ongoing war has hurt the supply of some crucial parts in certain sectors, such as the automotive industry. Russia and Ukraine account for a sizeable share of European imports in some key areas, beyond energy commodities. Hard data available are not yet showing the impact from this, but looking ahead, we expect surging energy and input costs, supply bottlenecks, and high transportation prices to intensify and become a drag on the industrial recovery. This will mean that industrial activity will remain subdued.
Chart 3 - Consumption growth in 2022 is increasingly reliant on households' savings
Source: Oxford Economics/Haver Analytics
Inflation to average 6% this year. The war in Ukraine has exacerbated a number of recent price dynamics, causing eurozone flash inflation to jump to a record 7.5% y/y in March, up from an already strong 5.9% in February. Board-based price pressures were behind the surge, with inflation in Spain close to 10%, Germany at 7.6%, Italy around 7%, and France at 5.1%. Skyrocketing energy prices remained the main driver, with energy inflation picking up by 45% y/y in March. Food prices and core inflation increased strongly over the month as well.
We see inflation remaining higher for longer and now expect it to average 5.9% this year, up from 3.9% in our pre-conflict forecast. But our current expectation that gas prices will decline from Q4 2022 onward, assuming the conflict ends by the end of this year, entails a high level of uncertainty and upside risk.
Monetary policy support starting to be withdrawn. While the ECB remained open to a rate hike this year, it retained large flexibility given the high level of uncertainty. We think that the central bank will end up using that flexibility. We therefore stick to our view that, while a rate hike this year is still possible, it is more likely the ECB will raise rates early next year, when the impact of the war in Ukraine on Europe should be clearer.