Concern over inflation in Europe has been brewing even before Russia invaded Ukraine in February. While some argued it was transitory, others warned that it was a sign of a deeper crisis. Now, half a year since the start of the war in Ukraine, a new debate is gripping Europe: is a recession inevitable?
Every passing day seems to foreshadow a downturn. After Moscow decided to temporarily suspend its gas supply to Germany, gas prices surged to €295 per Megawatt-Hour. Data released on Tuesday showed that business activity in Germany and France contracted in August due to falling demand and rising prices. The euro hit a new 20-year low against the dollar, making it more expensive to purchase energy on international markets, which is paid with the greenback. The Germany’s central bank, Bundesbank, forecast that inflation, which stands at 7.5%, will hit double digits in fall. And the severe drought sweeping Europe has led to a decline in hydroelectric production when it is needed most. The drought has also led to record-low water levels in rivers such as the Rhine, where some vessels cannot pass, a problem that is causing major disruptions to water freight.
The beginning of 2022 was dominated by alarm over the omicron variant, but now there is more concern about the cost of the MWh than infection figures. The US bank Citigroup predicts that inflation in the United Kingdom will hit a devastating 18.6% in 2023. And on Monday, Belgian Prime Minister Alexander De Croo warned that the next “five or ten winters will be difficult.” Not even the booming tourism industry, which has bounced back from the pandemic, has been able to stave off worries, with worker shortages leading to thousands of flight cancellations.
Europe is facing a long list of problems. Capital Economics says that most European countries will be harder by the soaring gas prices than the oil crisis in 1974 and 1979, which were both “followed by recessions.”
Indeed, the word recession is popping up more often in economic forecasts. On Tuesday, the Dutch bank ING reported that the composite PMI – which tracks business trends in the manufacturing and service sectors – fell below 50 points. “Anything under 50 indicates falling business activity, so the survey is hinting at a contraction that started in the third quarter,” it stated, in reference to July.
The same conclusion was reached at Goldman Sachs. In a report last week, the North American investment bank forecast a mild recession in the second half of the year due to disruptions to the gas supply as a result of the war in Ukraine. It warned: “A full stop to Russian gas deliveries could trigger a severe downturn in Europe.” The report indicated that the countries most dependent on Russian gas – Germany and Italy – would be the hardest hit by the downturn.
New interest rate rise?
As inflation erodes citizens’ purchasing power, forcing people to cut back on expenses, there is growing pressure on the European Central Bank (ECB) to raise interest rates. Inflation in the eurozone rose to 8.9% in July, and the euro continues to falter against the dollar. In this context, the ECB looks poised to hike interests by another 50 basis points in September. That said, there is the chance the ECB will hold off on further rate hikes due to pessimistic economic forecasts.
The concern over a possible recession is linked to energy prices. The most optimistic economists argue that the current energy crisis has been sparked by the war in Ukraine, meaning it is circumstantial and not a sign of a systematic problem. As a result, this view argues that any downturn would be temporary. But there is no sign that the war in Ukraine will end any time soon. What’s more, Europe is also undergoing structural changes to meet its climate objectives.
In the meantime, experts have downgraded their forecasts for economic growth. Oxford Economics, for example, reported: “Global growth prospects have worsened further over the last month. We have lowered our forecasts for world growth by 0.2ppts to 2.8% this year and by 0.1ppt to 2.3% in 2023, making next year’s forecast growth the lowest outside a recession year since 2008.”
Europe versus the US
While in the US there are already signs of improvement – inflation fell in July from 9.1% to 8.5% due to the drop in gas prices – Europe continues to pay for its dependence on gas. Inflation in Europe already exceeds the figure in the US, and this gap could widen over time, according to Aneeka Gupta, a researcher at WisdomTree. “The Euro area is contending with an energy-shock and inflation far greater than in the US. “With energy prices, up 42% year on year (YoY) in June 2022, energy contributed to more than half of the 8.9% YoY inflation reading in July,” she wrote in a post.
Falling food prices and the drop in the cost of oil have not been enough to offset the rise in gas prices in Europe. But some analysts argue that a recession could help tackle inflation, as long as it is not a prolonged downturn. “Ultimately, and unfortunately, the best possible medicine for high inflation is often an old-fashioned recession,” economists Ariel Bezalel and Harry Richards, of Jupiter AM, explained in an article.