KfW Business Cycle Compass: War has dashed hopes of a vigorous economic recovery

• In addition to the pandemic, material bottlenecks and energy price rises worsened by the war are weighing on the economy
• KfW Research expects German GDP to grow by 1.6 % in real terms in 2022 and 1.2 % in 2023; euro area: 2.5 % (2022) and 1.3 % (2023)
• Inflation rate in Germany is forecast at 6.3 % in 2022 and 3.0 % in 2023; euro area 6.4 % (2022) and 3.1 % (2023)
• Forecast uncertainty is exceptionally high as further develop-ment of Ukraine war is nearly impossible to anticipate

While the dampening effects of the pandemic response in Germany are waning and contact-intensive services are recovering, Russia’s war of aggression is prolonging global material bottlenecks, sending energy costs soaring and weighing on private purchasing power. The impact of China’s zero-COVID policy and the strict lockdown in the globally important economic hub Shanghai are putting added strain on already disrupted global supply chains. But even in this environment Germany’s first quarter 2022 gross domestic product (GDP) – adjusted for price, seasonal and calendar variations – managed to grow by 0.2 % on the previous quarter. These developments will hamper economic growth in Germany in the coming quarters as well. As a result, the recovery of consumption in the summer half-year is likely to turn out relatively weak, and in the winter half-year the economy will nearly stagnate. KfW Research has therefore downgraded its forecast for real growth in Germany to 1.6 % (previous forecast from shortly before the outbreak of the war: +3.2 %). In 2023 the German economy is even likely to grow by a mere 1.2 % (previous forecast: +2.9 %), with the unfavourable start to the year putting significant downward pressure on the growth rate. The new forecast assumes persistently high energy prices but no natural gas embargo.

Germany’s monthly inflation rate can be expected to start trending downward in the course of the second half of 2022 so long as energy prices at least stagnate. On average for 2022, the inflation rate will likely settle in at 6.3 % based on the Harmonised Index of Consumer Prices. The ongoing pass-through of higher production costs to consumer prices and an increase in wages, among other things due to the sharp rise in the minimum wage introduced in October 2022, are set to keep inflation at 3.0 % in 2023 as well, which is still well above the monetary policy target of 2 % on average.

“The once hoped-for vigorous recovery is being choked off by the war. In contrast to what was expected before Russia’s attack on Ukraine, a broad economic recovery is unlikely before the inhibiting factors subside”, said Dr Fritzi Köhler-Geib, Chief Economist of KfW. “Because of the war, energy prices will remain high over the longer term, weighing on purchasing power. Besides, even small COVID-19 outbreaks can always create additional global supply chain disruptions because of China’s strict lockdowns. I therefore expect only moderately positive quarterly growth rates in Germany for the rest of the year, and stagflationary tendencies are also quite possible.”

The same major forces are at work in the overall euro area economy as in Germany: the war in Ukraine, material bottlenecks, energy price increases and the coronavirus pandemic. Differences in the growth profiles of the euro countries and between individual countries and the euro area as a whole are essentially a result of differences in timing of individual pandemic waves including the related health policy interventions and their interplay with the countries’ economic structure. After the outbreak of the pandemic and the strict lockdowns imposed, gross domestic product in the other three large euro countries Italy, France and Spain had dropped much more steeply in 2020 than in Germany, where the high share of industrial activity initially acted as a stabiliser. Accordingly, the pace of the recovery there in 2021 was higher after the removal of the pandemic restrictions, so that the euro area was able to start off the year 2022 with significantly more momentum than Germany. On balance, significantly higher real growth of 2.5 % can therefore be expected for the euro area for this year, as was already the case in 2021 (previous forecast: +3.6 %). But in 2023 real growth will again be much more similar to Germany’s and likely sit at 1.3 % (previous forecast: +2.7 %). Average annual European consumer price inflation is expected to be 6.4 % for 2022 and 3.1 % for 2023, only insignificantly higher than in Germany.

Since the further development of the Ukraine war and the sanctions yet to be imposed are nearly impossible to anticipate, forecast uncertainty is currently much higher than normal. Besides, the coronavirus pandemic continues to simmer and might impact the German and euro area economies directly, for example if a new variant makes economically relevant restrictions necessary again, or indirectly, as currently illustrated by the strict lockdown in Shanghai. Besides the obvious worsening of supply chain problems, recurring or broad lockdowns in China might also trigger a global slump in demand. The latter may also occur if central banks go too far in the fight against inflation or if the very high current inflation rates can only be lowered by a monetary policy-induced recession. Another scenario that is particularly acute is that of a Russian natural gas embargo. Besides an additional rise in inflation from even higher energy prices, rationing may then also have to be introduced which, under the current legislation, would primarily affect manufacturing.

However, positive surprises that may generate more growth than predicted are also possible, particularly in the coming year. Thus, the substitution of Russian energy and commodities may run more smoothly than currently expected, for example because new supply sources are quickly developed or if the transition to renewables speeds up substantially. A peaceful solution for Ukraine that is accepted by all sides would eliminate the uncertainties created by the war in one fell swoop, give businesses much more confidence in the future and initiate reconstruction, and could thus provide new economic impetus through investment, especially in Europe.

The current KfW Business Cycle Compass is available at: www.kfw.de/konjunkturkompass