The conflict in Ukraine will weigh on activity and raise inflation – a dilemma for the ECB


Katharine Neiss, Chief European economist at PGIM Fixed Income, comments on the economic impacts of the Russian invasion of Ukraine.

Our base case scenario:

  • The crisis in Ukraine will reduce euro area growth from 4.2% to 3.7% in 2022, delaying but not definitively derailing the recovery
  • Euro area budget deficits will widen further, possibly by 1 to 3 percentage points as a share of GDP
  • Monetary policy is expected to remain lower for longer, with no rate hike in 2022

Our worst-case scenario:

  • Long-term disruption of Russian gas supplies could reduce the euro area’s GDP growth by as much as 5 pp in 2022, to -1% for 2022
  • The conflict in Ukraine will affect some euro members, such as Italy, more than others. Such fragmentation could lead to an even more dovish stance by the ECB and greater fiscal integration across the euro area

The economic impact of Russia’s invasion constitutes a clear negative supply shock for the euro area that creates a dilemma for policymakers. On the one hand, higher energy prices will hit economic activity, reduce confidence and damage trade and financial links. On the other hand, the conflict will raise inflation for firms and households.

ECB President Lagarde’s statement last Friday, 25 February, that “the ECB is closely monitoring the evolving situation” makes clear that the bank is keeping its options open. We expect it to maintain its dovish stance on 10 March, with a gradual tapering in asset purchases as announced last December.

Recent events also offer the ECB an opportunity to regain control of the inflation narrative: higher-than-expected inflation outturns are clearly due to an external shock outside of its control. All else equal, sustained higher energy prices will slow the pace of monetary policy normalisation in the eurozone, with a 2022 rate hike now unlikely.

Our base case scenario foresees a delayed, but not a derailed, euro area recovery

Our base case scenario assumes that gas from long term contracts with Russia continues to flow, as it did throughout the Cold War. Additional supply from the US and Norway can cap further price rises, possibly helped by mild weather and the end of winter in western Europe. This scenario, the blue line in Figure 1, sees euro area GDP (gross domestic product) grow by 3.7% in 2022, 0.5 percentage points below our 4.2% projection before Russia invaded.


Euro area GDP projections (Index, Q4 2019 = 100)

Source: PGIM Fixed Income

Despite higher energy prices, however, momentum in the eurozone economy remains strong. Deeper budget deficits can therefore lead support to households and firms, with accommodative monetary policy as a facilitator. The corresponding increase in national budget deficits could plausibly lie in a range of 1 to 3 percentage points (pp) of GDP. Centrally-issued European Union (EU) debt, first conceived during the pandemic, would probably support member states’ deficits. And appetite for a more radical overhaul of the bloc’s Stability and Growth Pact, away from austerity, is likely to grow among its members.

Beyond the immediate support to households and firms, additional outlays could encompass investments first tabled to address climate change. These would include spending on alternative gas supplies, accelerating the conversion to renewable energy and slowing down the phase-out of nuclear power. As demonstrated by German chancellor Olaf Scholz’s €100 billion initiative unveiled on Monday, defence spending is expected to rise as well.

Politically, the conflict in Ukraine has reinforced the eurozone’s recent direction of travel: accelerating the transition to a green economy, further integrating member states’ economies, and reinforcing its so-called “open strategic autonomy” – the ability to rely on the euro bloc’s own resources while working with external partners, such as the US, when needed.

Featured News

This Week’s Most Read

Wealth DFM