Europe’s central banks and finance ministries made a textbook response to the pandemic, employing massive fiscal and monetary stimulus. Unprecedented support for financial markets, workers and firms prevented spending and companies collapsing when activity plummeted, facilitating a V-shaped recovery. After years in a muddle, economic theory appears to have been useful.

The region’s relatively high vaccination rates and associated unlocking mean we now expect eurozone growth of 5.2 per cent this year, returning GDP to its fourth-quarter 2019 level. Next year’s growth could be 4.0 per cent as grants from the European Union’s EUR750 billion recovery fund boost investment, and our 1.9 per cent forecast for 2023 is considerably above our estimate of longer-term trend growth.

Remarkably, such growth would mean the permanent economic scarring normally associated with deep recessions appears to have been headed off. Not only has economic disaster apparently been avoided, Europe seems to have emerged stronger.

However, the vast labour-market support, plus liquidity and debt guarantee schemes for companies, must be wound down without derailing the recovery. If the eurozone’s growth results simply from pumping up demand with loose policy, the recovery won’t be as triumphant as it seems.

Inflation is the chief economic risk. We expect the eurozone’s inflation rate to peak at 3.7 per cent in November – the highest level in 23 years, stoked by surging electricity and gas prices. Reflecting similar factors, UK inflation could stay high through 2022.

Ending emergency short-time working schemes may raise unemployment in the near term, curbing pay growth, but high inflation, even if temporary, could lead to increased pay settlements that company profits cannot absorb.

We still expect the European Central Bank to regard the inflation rise as mostly temporary. So with activity back to pre-pandemic levels, we think it will end net asset purchases under its Pandemic Emergency Purchase Programme as planned in March. But to prevent a sharp tightening in policy, we expect it to add EUR200 billion to the continuing EUR20 billion a month Asset Purchase Programme for the rest of 2022.

But market expectations of a eurozone interest-rate rise before mid-2023 look premature. Our central case is that the ECB announces its intention to end quantitative easing in December 2023, with the first increase since 2011 before mid-2024.

By contrast, hawkish Bank of England comments suggest a rate rise earlier than previously expected. This partly reflects the tight labour market, with skills mismatches, unattractive wages, and some migrants less willing or unable to return to their pre-pandemic jobs.

We expect the Bank to wait to see the impact of September’s ending of the Job Retention Scheme before hiking and now expect a rise to 0.25 per cent in February 2022, to 0.5 per cent in August and to 0.75 per cent in February 2023.

Rising inflation is itself a triumph of economic theory. The huge policy stimulus and sharp rise in post-lockdown demand, coming up against still-recovering supply, has raised prices.

Much of the inflation should be temporary, but there are risks. And even if they recede without significant monetary tightening, the large structural deficits must be reduced to put public debt on a sustainable path.

Economic theory has done very well in tackling the immediate impact of the pandemic. It must now respond with equal success to the continued COVID-19 challenges.


First published 7th October 2021.

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