The ECB opens the door to recession in Europe if the war in Ukraine continues and Putin cuts the gas

The specter of recession looms over the forecasts of the European Central Bank. Even if it is in the most pessimistic fork. “Given the current uncertainty surrounding the economic outlook for the eurozone due to Russia's war in Ukraine, the pessimistic scenario involves a complete cutoff of Russian gas as well as maritime oil flows to the eurozone, with few possibilities of accessing alternative sources of gas supply”, affirms the ECB analysis: “It also assumes higher prices of raw materials, greater uncertainty, weaker trade and a deterioration of financing conditions compared to the scenario reference. Therefore, economic activity would suffer stronger adverse shocks and would be considerably weaker than in the baseline projections, with GDP growth sharply negative next year. Inflation would be higher especially in the medium term”.

Thus, if the average forecasts give a growth of 0.9% of the GDP for 2023, the pessimists give a -0.9%. In that scenario, inflation would also be much higher in 2023, at 6.9%, instead of 5.5%.

The scenario assumes that the war in Ukraine “is very protracted, implying persistent geopolitical tensions. It is assumed that all sanctions regimes would remain in place, leading to larger and more lasting disturbances in the euro area. The scenario presents an increase in uncertainty, which translates into a substantial adjustment in the spreads of corporate bonds and equity markets and a deterioration in the credit conditions of banks, both nationally and globally.”

In contrast to the baseline projections, the most negative scenario assumes “no substitution possibilities for gas supply and less substitution possibilities for oil, the absence of a coordinated response to energy shortages, and unusually warm winter weather. cold that would trigger a higher energy demand.”

The September 2022 baseline projections assume “substantial substitution of Russian gas through alternative suppliers, no oil shortage, full implementation of the EU-wide plan to reduce gas consumption, and normal winter weather conditions. Worst-case scenario tighter power supply conditions, only rebalancing in the medium term, combined with limited demand adjustments, in part due to assumed severe winter weather, would lead to even higher power prices than expected. underlie the baseline projections, but some also need to ration the energy used as an input in production. Countries dependent on Russian oil and gas supplies would have to implement production cuts.”

On the other hand, in the negative scenario, “the total cut off of the supply of Russian gas to Europe, which is not supposed to return to the market during the projection horizon, causes gas prices to rise considerably (53% above the value of reference for the entire horizon) in the midst of a very tight European gas market. The scenario also assumes that oil flows from Russia to the EU stop abruptly from the fourth quarter of 2022, once the oil embargo comes into force.

Regarding food products, “the scenario assumes a cut of around 30% in cereal and corn exports from Russia and Ukraine. Rising energy costs and fertilizer prices push global food prices even higher. The food crisis lasts all of 2023, with the shortfall only gradually being offset by other supplies, resulting in international food commodity prices being 24% above baseline assumptions in the first quarter of 2023 and 33% higher in 2024.”

In the negative scenario, “global GDP (excluding the euro area) would be lower relative to the September 2022 reference levels, by 0.2% in 2022 and 1.3% in 2023. A longer war and intense and any additional sanctions would remain in place until 2024, together with higher commodity prices, would be the main contributors to the decline in global GDP relative to baseline projections. Greater internal economic uncertainty would imply a significant revaluation of market instruments and a deterioration of the credit conditions of the banks. The scenario assumes a renewed increase in uncertainty between September and December 2022, reflecting the continuation of the intense conflict and the deterioration of energy supply. This increases volatility in financial markets, which would negatively affect business, consumer and financial confidence."

The downside scenario would imply weaker average economic growth in the euro area in 2022 and a contraction in 2023, followed by a strong but incomplete rebound in 2024. The effects of production disruptions are based on an assessment of the scope of energy substitution in the economy.

Compared to the baseline scenario, euro area real GDP growth would be 0.3 percentage point lower in the downside scenario in 2022 and 1.8 percentage point in 2023, before leveling off in 2024 at the growth rate of the reference scenario. Average annual growth in 2022 would still be positive, but GDP would decline sharply in the last quarter of 2022 and the first quarter of 2023. One of the key factors in the adverse GDP profile is production disruption due to supply shortages. of energy. As the impact of supply disruptions fades due to a gradual substitution of energy inputs and economic adjustment, the recession would be followed by moderate GDP growth, although the level of GDP in the downside scenario remains below below the baseline scenario at the end of the horizon.

Large increases in commodity prices imply strong upward pressures on prices, prolonging the expected period of high inflation. The impact of higher energy and food commodity prices, as well as energy-related production cuts, would result in headline inflation considerably higher than in the baseline scenario in 2022 and especially in 2023.

The longer-lasting upward price pressure anticipated in this scenario is largely due to the persistently higher paths in commodity prices implied by the protracted conflict, although it would be tempered by the dampening effect of falling prices. demand later on the horizon.

“This analysis is surrounded by a considerable degree of uncertainty regarding the evolution of the price of energy, the possibilities of substitution and the response capacity of the energy demand of the economy”, says the ECB, “some central characteristics of the scenario on the downside are surrounded by great uncertainty. Commodity prices, especially gas prices, in Europe are very volatile at the current juncture. In addition, the effects of production interruptions caused by energy quantity restrictions (rationing) depend critically on the extent to which Russian gas is replaced by alternative gas sources, the extent to which gas can be replaced by other inputs in production processes and how the economy adjusts to the price environment. The scenario also does not take into account possible monetary policy responses and government reactions that could stabilize output, protect low-income households, and/or mitigate the pass-through of higher commodity prices to retail prices. consumer".