According to the European Central Bank (ECB) the European economy will grow at 4.2% this year. Inflation will remain high, averaging 3.2% during 2022, but get back below the 2% target before the year end.
Many in the financial world are optimistic about further recovery in 2022, taking the economy above pre-pandemic levels during the first quarter. This is despite the impact of high inflation on real incomes, and despite the tightened restrictions on people owing to the latest wave of the pandemic. The ECB continues to provide monetary assistance with the M3 money supply growing at 7.3% a year on the November figures and with a generous support scheme for the banking system via the TLTRO programme of lending to banks.
Chart: Base money supply
Downside a concern
The ECB offers this relatively-benign forecast and says the risks are equally balanced to the downside and upside. It also suggests by its decisions it is more worried about downside to growth and activity. For this reason, unlike many other central banks it rules out any increase in interest rates this year from the zero level. It will also continue with money creation and bond buying, though it plans to gradually reduce the quantities.
The ECB will also consider buying Greek government debt... should that become necessary.
The formal PEPP pandemic programme creating an additional €1.85 trillion for bond purchases will end as planned in March, but the Asset Purchase Programme will then be stepped up to €40bn a month. It will still be running at €20bn a month in the fourth quarter, and will need to be stopped before any consideration of an interest rate rise.
Meanwhile, the large stock of bought-in debt under the PEPP pandemic programme will stay topped up with purchases to replace every bond that is repaid on maturity. The ECB will also consider buying Greek government debt, ruled out as it does not have investment status, should that become necessary to help the Greek banking system and economic recovery.
The emphasis on growth rather than on inflation has led to a much faster rate of inflation than the ECB forecast last year. It has now hit 4.9%. The ECB claims it will be temporary, and attributes it half to an energy price surge and half to prolonged supply shortages brought on by the pandemic response. This is likely to be another year of looking through any excess inflation rather than toughening policy more, alongside upward revisions of forecasts of prices as necessary. The ECB does now concede it needs to watch wages to avoid a wage/price spiral.
Growth the priority
The bias towards growth is reflected in EU policy towards public spending, debts and deficits. The Treaty rules state deficits must not exceed 3% of GDP and the total stock of national public debt must be brought down to 60% of GDP. These rules were suspended for the pandemic and remain suspended this year.
Highly-indebted countries are advised to be prudent in further debt build ups without a ceiling or control. From 1 January 2023 the rules will come back into effect or a revised version of them will be introduced. The aggregate fiscal support for economies in the bloc is assessed at 7% of total GDP in 2021 and forecast at 3.4% this year. On top is the EU’s new borrowing facility, adding another 0.5% this year as disbursements from the fund are paid to member states.
Fiscal retrenchment too soon would repeat the mistakes of the austerity policies followed after the great recession and banking crash of 2008.
There is a substantial divide over whether to relax the long-standing rules next year. The spenders, led by France and Italy, think they should. They point out Italy will have to run very high state surpluses to get its state debt down from 160% of GDP. They think fiscal retrenchment too soon would repeat the mistakes of the austerity policies followed after the great recession and banking crash of 2008.
Chart: Outstanding government debt as % of GDP
Meanwhile, the lower-debt countries led by the Netherlands, Sweden, Denmark and Austria (and probably with German assistance) want the old rules reinstated fully. They do not think countries such as Greece and Italy should be able to borrow huge sums based on a common low ECB rate of interest which needs northern prudence to retain market support. They are also upset by the current surge in inflation, which has not proved as temporary or as moderate as the ECB claimed.
It will take time for the member states this year to sort out a compromise with the Commission over future budgets and borrowings. Some want a large borrowing programme for public-sector-led investment in their green transition. Some argue public-sector investment generally must not be curtailed by severe debt rules.
Some say the EU is now too inflation prone and too careless about public finances. This year will see continued fiscal and monetary support for growth with some insouciance towards inflation. Next year may well see a sharp slowdown in total assistance and in growth. Markets need to price this in and to expect more noise in this debate before it is settled.
Chart: Change in government surpluses & deficits as % of GDP
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