Nordea Group Chief Economist: Risk of recession in the Euro area is real

Prospects for the global economy have deteriorated over the summer. Europe in particular has been hit hard by the current energy crisis and high inflation, while growth prospects for the US are more affected by capacity constraints; although the higher interest rates are now starting to feed through to the important housing market.  Lastly, the upswing in China is dampened by the authorities’ zero-COVID approach and the downturn in the housing market. 

Against this backdrop, we have again significantly revised down our estimate for the global economy to 3.1% this year and 2.3% in 2023. In our first estimates for 2024 we expect global growth to rise again to 2.6%.

The main risks to the growth prospects are related to the uncertain geopolitical situation, high inflation and resulting monetary policy tightening, as well as the outbreak of new strains of COVID-19, which may reignite the pandemic during the autumn. If so, global supply chains may be affected again.

Especially the European economy feels the heat of high energy prices due to the heavy reliance on Russian gas.

The EU Commission has thus encouraged its member countries to run national energy savings campaigns and ensure that gas inventories are quickly filled before the winter. However, the success of the strategies depends on how hard the winter gets and how much Russia will open the gas taps to the “unfriendly EU countries”. The risk of energy rationing over the winter is thus real across Europe. It will most likely tip the Euro area into recession.

The record-high inflation is drastically eroding households’ purchasing power. And nothing indicates that it is going down any time soon. As a result of high commodity and energy prices, manufacturing costs are still high. The extremely warm and dry summer has also affected river transport and food production in several European countries. This may add further upward pressure on producer prices and eventually consumer prices.

Central banks on both sides of the Atlantic will now seek to mitigate the high inflation through aggressive monetary policy tightening. Experience from the 1980s shows that monetary policy must be tightened swiftly and sharply to curb inflation. This will affect demand in society and hurt economic activity.  In the US, the Federal Reserve has hiked its policy rate by 2.25% points since March, while the ECB caught the markets by surprise in July with a hefty 0.5% point rate hike. That marked the end of an 8-year period with negative interest rates in the Euro area.

There is surely a lot more to come from the central banks, but the process to bring inflation back in line with the 2% target could be long and cumbersome. In light of the strong labour markets, the risk of second-round effects in the form of high wage increases is very high. This could trigger a wage-price spiral, which may affect long-term inflation expectations.

There is no doubt that it is currently difficult to administer the right dose of monetary policy tightening – not least in the Euro area where a particularly large part of inflation stems from the supply-side,  which cannot be controlled by monetary policy. Also, imported inflation is high as a result of the significant weakening of the euro against the dollar and the Chinese renminbi.

Moreover, monetary policy changes impact the real economy with a certain time lag and therefore risk having a procyclical effect on an already declining demand in society. The expected monetary policy tightening could thus tip economies into recession.

So, central banks are facing a delicate balancing act in the coming period when uncertainties about economic growth will be particularly rife, not least due to challenges posed by the war in Ukraine.

This is also the case for the Nordic central banks, which have now really stepped up their reaction to the historically high inflation. First Norges Bank hiked aggressively then the Riksbank followed and the top is still far off. This is also the case for Finland and Denmark.

The much higher cost of living combined with rising interest rates are undoubtedly a toxic cocktail for the housing market. This is also the case in the Nordic countries, where prices sky-rocketed during the pandemic. That period is definitively over, but the correction in home prices will vary from country to country, just as the derived effects on the economy will.

The common denominator for the Nordic countries is their strong starting point before Russia's invasion of Ukraine thanks to high personal savings, strong public finances and robust job creation, which have continued up until now.

So all in all, this gives the  economies a buffer and some degree of resilience during this dramatic time in world history.

This article originally appeared in the Nordea Economic Outlook: Feeling the squeeze, published on 7 September 2022.