Weekly Update - War in Ukraine: Europe's economic policy response will be key

The war in Ukraine is shaking up financial markets and the global economic outlook.
Some transmission channels of the conflict to the economy are already identifiable: (i) a certain tightening of financial conditions (Chart 1), which accompanies the strong turbulence observed on the markets (ii) a sharp increase of various commodities prices (Chart 2) and (iii) an increase in uncertainties that will alter the decisions of economic actors. All in all, economic growth is likely to be lower than expected before the conflict and inflation significantly higher, particularly in the Euro area due to its geographical and commercial proximity. At this stage, however, a stagflation scenario, with zero or negative growth, does not seem to us to be the most likely scenario. Indeed, activity should continue to benefit from the easing of sanitary conditions, while households and companies still have healthy balance sheets that will allow them to absorb part of the shock. However, the response of economic policies will be decisive, both in terms of the real support they provide and their ability to maintain the confidence of economic actors.
 
On the monetary policy side 
The context of higher inflation and moderating economic activity complicates the task of central banks. The European Central Bank seems inclined to continue the normalization of its policy already announced. The new wave of inflation to come in the Euro area will nevertheless remain mainly caused by a negative supply shock and will be more penalizing for economic activity.
 
On the fiscal policy side
The management of the COVID crisis has already led to a sharp increase in government debt and seems to leave less room for maneuver. However, various recent announcements point to a potentially significant and common support to all Euro area countries. On March 8, the European Commission announced a plan to counteract rising energy prices. This plan contains a short-term component in which the Commission authorizes member states to subsidize energy prices for households and businesses, while it will set up community funds to finance these subsidies. The second part consists of an investment plan in the energy sector that aims to reduce energy dependence on Russia by 60% by the end of the year. In addition, significant military spending has been announced by the states. By increasing aggregate demand, this new spending should further support the Euro area economies.

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