December 1, 2023


FRANKFURT – The latest drop in economic sentiment is a major concern, suggesting the eurozone economy could suffer a massive hit from Russia’s war against Ukraine, according to European Central Bank chief economist Phillip Lane.

In an interview with POLITICO Monday, Lane pointed to “quite significant and substantial” drops in sentiment indices both for consumers and companies, calling them a “major concern” for ECB policymakers. Last week, eurozone consumer sentiment posted the second sharpest decline on record, while companies’ output expectations collapsed. 

Front and center is surging inflation, which Lane summed up bluntly. “Europe may have to get used to higher prices,” he said, but added that most inflation will “fade away.”

“The momentum — where every month inflation is higher than the previous month — we do think will decline,” he said. “Inflation will decline later this year and will be a lot lower next year and the year after compared to this year.”

If the deteriorating growth outlook would risk inflation falling below target, this could compel the ECB to state it’s ready to change course on its plans to wind down its massive bond buys. Lane reiterated that position Monday, saying the ECB would react flexibly should the war wreak even greater havoc on the economy than projected. 

The fact that eurozone inflation has almost hit 6 percent — almost three times the ECB’s target — prompted the ECB’s Governing Council earlier this year to accelerate its exit from large-scale asset purchases. At the time, the ECB also changed its policy guidance to say it would raise interest rates “sometime after” the end of asset purchases, rather than soon after — a signal that it won’t rush into raising rates.

Lane also addressed the ECB’s latest staff projections, which saw the economy expanding by 3.7 percent and inflation averaging 5.1 percent this year. He declined to say whether latest data renders that forecast obsolete. However, he noted that some indices are pointing toward an upside risk on energy prices while others point to downside risks on growth.

Any revision of the growth and inflation outlooks at the ECB’s June meeting would need to “see a significant decline in the medium-term inflation outlook” for the ECB to continue its bond buys beyond the third quarter of this year, Lane added. 

Whether the central bank’s first interest rate hike in over a decade would then follow later this this year hinges on incoming data, he said.

“We are trying to be as clear as we can that monetary policy will be data-driven,” Lane said. “There are scenarios where it would be appropriate to start to normalize interest rates later this year. And then, of course, there are scenarios where it could be appropriate to move at a later point.”

Lane pointed to a high level of uncertainty surrounding the economic outlook given the war, the recovery from the pandemic shock and the latest twists and turns of the pandemic — like China’s call to impose a strict lockdown on Shanghai.

“Under these conditions, trying to give calendar guidance is not helpful,” he said. “The commitment is we will be making sure our monetary policy responses, the right way to make sure that in the medium-term inflation will stabilize at 2 percent.”

Too rosy?

Lane defended the ECB’s recent staff projections, which include alternative scenarios that assume an immediate boycott of Russian gas and oil. These projections had come under criticism for being far too optimistic. Even in the most severe scenario, the ECB still sees the eurozone growing by 2.3 percent this year and next.

The ECB’s forecasts stand in stark contrast to those of private sector economists and the German government, who insist that an immediate ban of oil and gas would push Europe into the next recession. 

Indeed, German Chancellor Olaf Scholz on Sunday evening lashed out at economists who have suggested that the eurozone’s economy could weather an immediate boycott of oil and gas. They are not only “wrong” but “irresponsible” to make such suggestions base on “some mathematical model that in the end don’t really work,” he told German television. 

Lane tried to strike some distance from the debate.

“Let’s be clear that these were two scenarios, but they were explicitly not intended to be tail scenarios,” Lane said of the ECB staff’s adverse and severe scenarios. The severe scenario assumes that the interruption of energy supplies is just temporary, and that Europe will have found alternative source of supply toward year-end.

“If you impose a longer period of interruption of energy supplies, then you would have a more significant drop in GDP,” he said.

Lane also underscored the eurozone is still emerging from the pandemic-induced recession, so that the war’s “substantial” hit to the economy — which is assumed in all scenarios — is partially offset by a strong recovery from the recent trough as consumers spend on delayed purchases.

“The most important issue … is we’ve laid out a monetary policy framework with flexibility and optionality, which is essentially expressly designed to be capable of responding to whatever unfolds in terms of a medium-term outlook,” Lane said. 

Fiscal players 

Lane also weighed in on the proposed reform of the Stability and Growth Pact, the fiscal architecture that underpins European economic governance that looks to be changed amid calls for more flexibility from countries like France and Italy. 

Lane noted the core importance of the expenditure rules calling for budget deficits under 3 percent of GDP. At the same time, “you still need a debt anchor,” he added. “Those countries with high debt do need to see those debt ratios come down.”

While the current rules require countries with high debt levels to reduce their debt incrementally by 5 percent to eventually reach a ratio of 60 percent to GDP, Lane suggests a “milder” reduction of 3 percent coefficient rather than the current rate of 0.5 percent coefficient. 

“The pandemic has shown the value of common European funding, whether that’s SURE or Next Generation EU,” he says, referring to the Commission’s landmark recovery programs during the pandemic. “We face very significant carbon challenges. Climate, in particular, but you can also think about other dimensions of that.”

“[Any] response to carbon shocks having carbon forms of finance, either of the SURE dimension or Next Generation EU, should be part of the broader fiscal recipe for Europe,” he added.

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