Philip R Lane: The euro area outlook - some analytical considerations

Speech by Mr Philip R Lane, Member of the Executive Board of the European Central Bank, at Bruegel, Brussels, 5 May 2022.

The views expressed in this speech are those of the speaker and not the view of the BIS.

Introduction

There are three main analytical challenges in assessing the economic and inflation outlook for the euro area. First, the pandemic remains a first-order driving force. Over the winter, pandemic restrictions still limited economic activity in the euro area. While these restrictions are currently being lifted and case numbers are declining, the current set of restrictions in China is contributing to a further wave of bottleneck pressures in global supply chains and limiting domestic demand in a major region of the world economy. At the same time, the re-opening of the European economy and the prospects for a more normal summer tourist season are set to provide significant momentum in the coming months, especially for services sectors and tourist-intensive countries.

Second, the significant jump in energy prices since the summer of 2021 represents a major macroeconomic shock. In particular, since oil and gas are primarily imported into the euro area, this constitutes a major adverse terms of trade shock, reducing the aggregate real income of the euro area. In addition to the adverse implications of lower real income for consumption and investment, a persistent increase in energy prices may reduce aggregate supply capacity by making it uneconomic to operate energy-intensive production technologies at full capacity in some industries. This concern applies especially to the tradables sector to the extent that there has also been an increase in the relative price of energy in Europe compared to other parts of the world. In terms of inflation dynamics, even if a rise in energy prices is ultimately a level effect, a protracted phase of temporarily-high inflation runs the risk of affecting medium-term inflation dynamics through a re-setting of inflation expectations.

Third, the Russian invasion of Ukraine is a watershed for Europe. The economic impact of the war is operating through several mechanisms including: the amplification of the energy shock; a new set of bottlenecks; and downward revisions in consumer and business confidence. Moreover, the war constitutes a significant source of uncertainty, which is acting as a further drag on economic activity.