When the COVID-19 pandemic hit the world, governments and central banks responded with a single voice. They eased fiscal and monetary policies to ease the pressure on economies gripped by lockdowns.
As a result, inflation escalated in the months that followed. It took many by surprise, including central banks, as they are now racing to raise interest rates from historically low levels.
But the eurozone economy was hit the hardest out of all major economies. That is because Russia decided to invade Ukraine in February of this year.
The Western nations’ response was unanimous support for Ukraine. A wave of international sanctions has hit Russia and the eurozone economy.
Therefore, in 2023, the war in Ukraine will still have a major impact on the eurozone economy. Also, it will impact the European Central Bank (ECB) ‘s decision on interest rates as it is finding it difficult to set the right rates given high inflation and geopolitical risk.
A key factor for the European economy is how Europe will go through the winter months. If Europe avoids energy rationing, the economy might have more room to grow.
But the risk here is that war escalation and gas rationing will lead to a severe recession that may last many months into 2023. Or, perhaps, the whole year.
The ECB is in a tough spot. On the one hand, rising inflation forced the central bank to hike rates. It would likely add another 75bp in the next couple of meetings.
On the other hand, recession risks loom large. A central bank should cut rates on the risks of a recession increasing.
High energy prices might send inflation further into double-digit territory, limiting the ECB’s ability to deliver a proper response.
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