1. Managing the Upswing in Uncertain Times
Author: International Monetary Fund. European Dept.
Language:
English
Keywords:
REO; wage growth; core inflation; labor market; monetary policy; central bank; financial crisis; labor force; advanced economy; EU level; Labor force participation; Asset prices
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Abstract

The chapter was prepared by a staff team comprising Vizhdan Boranova, Raju Huidrom, Sylwia Nowak, Faezeh Raei, and Yan Sun. Phillip-Bastian Brutscher and Miroslav Kollar of the European Investment Bank contributed to Box 1.2. The team was led by Emil Stavrev under the general guidance of Jörg Decressin. Laura Papi provided useful advice and comments. Lian Veluz provided administrative support. The chapter reflects data and developments as of April 19, 2018.

Economic Activity Continues to Firm Up

Europe continues to enjoy a strong growth spurt. Growth has firmed up in many European economies, including all the major ones except the United Kingdom. Also, activity has broadened: for the first time since the global financial crisis all economies are growing. Real GDP increased by 2.8 percent in 2017, up from 1.8 percent in 2016. The expansion is largely driven by domestic demand (Figure 1.1, panel 1), initially mainly by vibrant private consumption but now also by investment (Figure 1.1, panel 3; Box 1.1).

Figure 1.1.
Figure 1.1.

Real GDP Growth Developments

Sources: Haver Analytics; IMF, World Economic Outlook; and IMF staff calculations.Note: Data labels in the figure use International Organization for Standardization (ISO) country codes.1 Domestic-demand-led growth implies net exports contribute less than a fourth of total growth, and export-led growth implies domestic demand contributes less than a fourth of total growth.

  • Advanced European economies grew by 2.4 percent in 2017, up from 1.9 percent in 2016 (Figure 1.1, panel 2). The upward revision of 0.2 percentage point since the November 2017 Regional Economic Outlook: Europe is due to higher-than-expected net exports growth (Figure 1.1, panel 4).

    • In the euro area, quarterly growth has been positive for the last 19 quarters, and annual growth in 2017 reached 2.3 percent, up from 1.8 percent in 2016. The recovery is broad-based across countries and sectors, with a positive feedback loop between jobs, consumption, and investment. Moderate but sustained rises in wages and real disposable income and recovering asset prices are boosting household incomes and wealth. In Germany, household consumption grew by 2.1 percent in 2017, the largest increase since 2000. Business investment is being spurred by strong demand on the back of high capacity utilization, accommodative financing conditions, and gradually rising corporate profitability.

    • Nordic economies expanded by 2.2 percent in 2017, broadly the same as in 2016. Sweden enjoyed robust growth, with unemployment declining to near precrisis low levels. However, weaker-than-forecast net exports in the second half of 2017 resulted in a downward revision of growth to 2.4 percent in 2017, from 3.1 percent in the November 2017 Regional Economic Outlook: Europe. Norway’s economy accelerated to 1.8 percent in 2017 from 1.1 percent in 2016, supported by the recovery of business investment, stronger consumer spending, and higher oil prices.

    • Growth in other advanced European economies was largely unchanged at 2 percent in 2017. In the United Kingdom, GDP growth slowed to 1.7 percent in 2017. Domestic demand is being held back by slower real income growth following the sharp depreciation of the pound as well as Brexit-related uncertainties that held back investment. However, favorable foreign demand and a cheaper pound led to a rise in exports of goods and services. In contrast, economic activity in the Czech Republic surged to 4.3 percent in 2017, due to strong private demand and increased absorption of the new round of EU Structural and Investment Funds (Figure 1.2).

  • In most of emerging Europe, the strong cyclical upswing that took hold several years ago continued. The region more than doubled its annual real GDP growth rate to 3.7 percent in 2017, from 1.6 percent in 2016, a six-year high. The actual growth exceeded already strong projections in the November 2017 Regional Economic Outlook: Europe by 0.6 percentage point, despite an unexpectedly large drag from net exports of about 1 percentage point.

  • In Central Europe, growth increased to 4.4 percent in 2017, and in Southeastern European EU member states (SEE-EU) growth increased to 5.8 percent. Activity was mainly driven by strong consumption on the back of high wage growth, higher public investment boosted by EU funds, and a modest recovery of private investment. As expected, the absorption of the new round of EU Structural and Investment Funds picked up pace after a slow start (see the May 2017 Regional Economic Issues: Central, Eastern, and Southeastern Europe). In 2017, EU funds financed an equivalent of about half of public investment in Romania and Hungary, and a third elsewhere (Figure 1.2). Growth was further supported by discretionary fiscal spending in Poland and procyclical fiscal policy in Romania.

  • In Turkey, growth accelerated sharply to 7 percent in 2017, from 3.2 percent the previous year. A sizable credit impulse (driven by state loan guarantees and relaxed macroprudential measures) and strong policy stimulus in the wake of the 2016 coup attempt stimulated domestic demand. In addition, exports increased considerably on the back of stronger external demand and a sizable depreciation of the lira.

  • Russia’s oil-dependent economy expanded by 1.5 percent in 2017, supported by higher oil prices, easier domestic financial conditions, and improved domestic demand. However, momentum softened in the second half of 2017. Economic activity in the other members of the Commonwealth of Independent States (CIS) also picked up in 2017 to 2.2 percent, with Belarus bouncing back from a two-year recession and recording growth of 2.4 percent.

  • Growth moderated in the Western Balkan countries to 2.3 percent in 2017 from 3.1 percent in 2016, reflecting mainly a temporary slowdown in Serbia caused by a prolonged drought and electricity disruptions.

Figure 1.2.
Figure 1.2.

EU Funds’ Absorption in Selected New Member States, 2017

Sources: Haver Analytics; IMF, World Economic Outlook; and IMF staff calculations.Note: Data labels in the figure use International Organization for Standardization (ISO) country codes.

In addition to upward revisions to growth, the pickup in investment has also led to higher estimates of potential growth in 2018, by 0.2 percentage point in advanced Europe and by 0.1 percentage point in emerging Europe. While the estimates of potential growth and output gaps are uncertain (November 2017 Regional Economic Outlook: Europe), output gaps appear largely closed in most of the region (Figure 1.3). However, a broader set of indicators paints a mixed picture of overheating pressures in the largest European economies (Table 1.1). Many countries are seeing buoyant activity and unemployment rates below historical averages, with the notable exception of France, Italy, and Spain. Output is above precrisis levels but still below precrisis trend in most countries. However, inflation remains below central bank targets almost everywhere (partly reflecting slack, as discussed in Chapter 2), except in Turkey and the United Kingdom. Also, external indicators generally do not suggest overheating. Similarly, indicators of financial stability appear mostly benign, with a few exceptions (including high credit growth in Turkey and a rapid increase in house prices in Romania).

Figure 1.3.
Figure 1.3.

Output Gap, 20181

(Percent of potential GDP)

Sources: IMF, World Economic Outlook; and IMF staff calculations.Note: Data labels in the figure use International Organization for Standardization (ISO) country codes.1 Output gaps reflect IMF country desks’ estimates.
Table 1.1.

Overheating Indicators for Selected European Countries

2017 estimates above the 1996–2015 average, except as noted below, by

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Sources: Bloomberg Finance L.P.; Haver Analytics; IMF, World Economic Outlook, and IMF staff calculations.Note: For each indicator, except as noted below, economies are assigned colors based on estimated 2017 values relative to their 1996–2015 period average. Calculations are based on annual data except for capital flows and financial indicators, which are based on quarterly data. Each indicator is scored as red = 2, yellow = 1, and green = 0; summary scores are calculated as the sum of selected component scores divided by the maximum possible sum of those scores. Summary colors are assigned red if the summary score is greater than or equal to 0.66, yellow if greater than or equal to 0.33 but less than 0.66, and green if less than 0.33.

Level of output more than 2.5 percent above the precrisis trend (1996–2006) is indicated by red; less than 2.5 percent by green; orange otherwise.

Output gaps reflect IMF country desk estimates. Red is assigned for positive gap greater than 0.5 percent; yellow for gaps between −0.5 and 0.5 percent; and green for gaps smaller than −0.5 percent.

The target inflation rate is used instead of the 1996–2015 period average in the calculation of the inflation indicator.

The indicators for credit growth and capital flows refer to the latest available quarterly values in percent of GDP. Red is assigned if the annual change is greater than 5 percentage points, yellow if greater than 3 percentage points but less than or equal to 5 percentage points, and green if the annual change is equal to or less than 3 percentage points.

In percent of GDP; difference between an average over 1996–2015 and the 2017 estimate.

High-frequency data and indicators point to continued expansion in the near term, though likely with fewer upward surprises. Manufacturing purchasing managers’ indices (PMIs) remain firmly in expansion territory (Figure 1.4). However, the March readings softened from their long string of gains. Russia’s PMI came in barely above 50, and the composite index for the euro area has declined by a cumulative 4 points since the end of 2017—the largest three-month decrease since May 2012. Similarly, confidence among euro area and Nordic households eased in March, though it remains historically high. Hard data paint a similar picture: the trends remain favorable, but there is some softening. Industrial output continued to expand in January 2018 at about 3.6 percent in advanced Europe and 4.6 percent in emerging Europe, but the most recent growth rates are lower than in the second half of 2017. In Germany, industrial orders fell almost 4 percent, and factory sales edged down 0.2 percent month over month in January 2018. Looking ahead, Citigroup’s Economic Surprise Index suggests that upside surprises are now less frequent than last year, especially in the euro area (Figure 1.5).

Figure 1.4.
Figure 1.4.

High-Frequency Indicators

Sources: Haver Analytics; and IMF staff calculations.Note: PMI = purchasing managers’ index.
Figure 1.5.
Figure 1.5.

Citigroup Economic Surprise Index1

(Percent; period average)

Sources: Haver Analytics; and IMF staff calculations.1 The index measures macroeconomic data surprises relative to market expectations. A positive reading means that the data releases were stronger than expected. Selected advanced markets (AMs) and emerging markets (EMs) comprise the Czech Republic, Hungary, Poland, Turkey, and 16 other countries.

Inflation Still Subdued in the Euro Area but Gathering Pace in Eastern Europe

Price pressures are diverging across the region, but this is mostly visible in headline rates, owing to different weights of energy and food in household consumption baskets. Inflation rates are low in advanced Europe but gradually closing in or surpassing targets in eastern Europe. But even there, core inflation is still quite low in most economies, despite higher wage growth.

  • In many advanced European economies, inflation remains subdued (Figure 1.6, panel 1). In the euro area, headline inflation declined to 1.1 percent in February 2018, below the European Central Bank’s (ECB’s) target, most recently reflecting mainly lower food prices. On the back of sluggish wage growth, core inflation remains low (Figure 1.6, panel 2). Inflation is similarly subdued in the Nordic economies, with readings at 1.5 percent in February 2018. By contrast, inflation in the United Kingdom reached 2.7 percent in February 2018.

  • In other advanced European economies, inflation has risen moderately, with the impact of high wage growth becoming increasingly visible. In the Czech Republic, inflation surpassed the 2 percent target of the central bank starting in early 2017 before declining at the beginning of this year. In the Baltics, inflation reached almost 4 percent in the second quarter of 2017, but then dropped to 2.8 percent in February 2018.

  • Regarding emerging Europe, headline inflation in Central and Southeastern Europe increased appreciably to about 2 percent at the end of 2017, mostly owing to higher energy prices. Core inflation, however, while inching up, remains subdued at about 1 percent despite strong wage growth. In Poland, headline inflation hit 2.5 percent—the central bank’s target—in November 2017 but has fallen since then, and core inflation has hovered around 0.8 percent in recent months. Among the Southeastern Europe (SEE) economies, headline inflation has increased steeply in Romania as the effects of tax and other administrative adjustments are dissipating. In the non-EU SEE economies, headline inflation, after picking up sharply to 2½ percent in mid-2017, declined somewhat in the second half of 2017, as inflation in Serbia fell to 3 percent. Core inflation remains relatively low at about 1 percent in SEE countries.

  • In Russia, inflation has declined further amid tight monetary policy, a weaker-than-expected recovery, and a good harvest. The decline continues to be broad-based, and both headline and core inflation reached record lows of 2.2 and 2 percent, respectively, during January–February 2018.

  • In contrast, inflation remains elevated in Turkey, reflecting strong domestic demand, expansionary fiscal and insufficiently tight monetary policies, and the pass-through of lira depreciation. Core inflation has picked up noticeably to about 12 percent in recent months, from about 10 percent in August 2017.

Figure 1.6.
Figure 1.6.

Inflation

(Year-over-year percent change)

Sources: Haver Analytics; and IMF staff calculations.Note: CIS = Commonwealth of Independent States; SEE = Southeastern Europe.

Different Wage Dynamics Continue across Europe: Sluggish in Most Advanced Economies but Strong Growth in the Newer EU Member States

Wage growth continues to be low in most of advanced Europe, but is strong in the rest of the region owing to tighter labor supply (Figure 1.7). While employment growth has been robust and there are notable reductions in indicators of labor market slack, wage growth is still subdued in the euro area and many other advanced European economies. However, recent wage negotiations in some euro area economies (such as Germany) suggest that employers are willing to accommodate demands for higher wage growth in tightening labor markets. In contrast, wage growth continues to be strong in the newer EU member states (Czech Republic, Baltics, Central Europe, SEE economies)—significantly outpacing inflation as unemployment rates dip below precrisis lows.

Figure 1.7.
Figure 1.7.

EU: Labor Market Slack

(Percent of active labor force1)

Sources: Eurostat; and IMF staff calculations.Note: EU = European Union.1 Additional slack comprises persons available but not seeking work, seeking work but not immediately available, and underemployed part-time workers.2 Selected advanced EU countries comprise the Baltics, the Czech Republic, the Slovak Republic, and Slovenia.

Differences in wage growth dynamics in the region are also the result of differences in labor productivity growth, wage-setting mechanisms, and inflation expectations. As examined in Chapter 2, wage Phillips curves appear alive and well, having broadly stable parameters, with a modest slope in the EU15 and especially strong wage responses to slack in the newer EU member states. Wage growth has generally been synchronized with labor productivity in most of advanced Europe. In contrast, in the newer EU member states, wage growth has outpaced productivity growth, though the gap narrowed as labor productivity rose strongly in late 2017. In advanced Europe, low inflation expectations and external competition have been important factors in muting the response of wages to slack. As a result, corporate profitability has been broadly stable. In comparison, corporate profitability declined moderately in Eastern Europe in recent years, although it is still about 10 percentage points higher than in advanced Europe (Figure 1.8).

Figure 1.8.
Figure 1.8.

EU: Corporate Profitability and Wage Growth1

(Year-over-year percent change)

Sources: Eurostat; and IMF staff calculations.Note: EU = European Union.1 Corporate profit share is the four-quarter average of seasonally unadjusted data.2 Selected advanced EU countries comprise the Baltics, the Czech Republic, the Slovak Republic, and Slovenia.

Credit Is Picking Up

After a long creditless recovery, credit growth has been picking up since 2016 in many European countries, but it continues to lag domestic demand and output. As investment gains further strength, credit growth should follow, with beneficial effects for bank profitability and balance sheets (see Box 1.2 for an in-depth discussion comparing the current recovery to the previous ones).

  • In the euro area and other advanced European countries, bank credit to the private sector is picking up (Figure 1.9). However, growth in credit to businesses remains uneven across countries (Figure 1.9, panel 4) and is particularly weak in countries with high levels of nonperforming loans (NPLs). In the Nordic economies, credit to businesses is robust, in line with a pickup in investment and exports, while credit growth to households has slowed somewhat following the recent macroprudential measures aimed at containing the housing boom and elevated household debt levels.

  • In emerging Europe, outside the CIS, credit growth to both nonfinancial corporations and households is increasing, particularly in Central Europe and the SEE-EU region, in line with continuing strong real GDP and investment growth (Figure 1.9, panel 3). On a transactional basis, credit growth may be even higher in countries where the cleanup of loan portfolios has lowered credit stocks (for example in Albania, Croatia, and Hungary). In Russia, the decline in credit seems to have stabilized as the economy has exited the recession (Figure 1.9, panel 3). In the rest of the CIS, credit has continued to contract, albeit at a slower pace. In Turkey, credit growth initially slowed in 2016 in the aftermath of the failed coup attempt, but by way of various stimulus measures, notably a credit guarantee program for lending to businesses, it has since rebounded strongly to about 20 percent year over year in early 2018 (Figure 1.9, panel 4).

Figure 1.9.
Figure 1.9.

Private Sector Credit Growth1

(Year-over-year percent change; 12-month moving average)

Sources: Eurostat; Haver Analytics; IMF, International Financial Statistics (IFS); and IMF staff calculations.Note: Data labels in the figure use International Organization for Standardization (ISO) country codes. CIS = Commonwealth of Independent States; EA = euro area; SEE = Southeastern Europe.1 The source of data on private sector credit for euro area countries is Eurostat. The series are adjusted for sales and securitization.

NPL levels have declined, but still weigh on bank profitability and credit supply in several countries (Figure 1.10). In advanced Europe, NPLs in the euro area have been substantially reduced since their peak in 2014, but the stock remains high in some countries. In Ireland, Italy, and Spain, the reduction of NPLs and the recent pickup in NPL sales is encouraging. However, for a sizable part of the banking system, the return on equity is persistently below the cost of equity (IMF 2017). The economic recovery may not be enough to boost returns to meet investor expectations or resolve the structural challenges faced by the least profitable banks; further consolidation and restructuring will be needed. NPL levels have been declining across emerging Europe but remain higher than 10 percent in half of the countries. While disentangling demand and supply factors is difficult, high NPL levels are weighing on profitability and credit growth. More actions are needed to repair bank balance sheets and facilitate the underlying corporate restructuring.

Figure 1.10.
Figure 1.10.

Nonperforming Loans

(Percent of total gross loans)

Sources: European Central Bank, Consolidated Banking Statistics; IMF, Financial Soundness Indicators; World Bank, World Development Indicators; and national authorities.Note: Data labels in the figure use International Organization for Standardization (ISO) country codes.1 Peak is defined as the highest value during the first quarter of 2011 (or earliest available) to the fourth quarter of 2017 (or latest available). Data for Serbia and Switzerland are based on annual numbers.

External Positions Have Strengthened Relative to before the Crisis

Stronger fundamentals have been accompanied by appreciation of the real effective exchange rate of the euro and some other European currencies. Since the beginning of 2017, the euro has appreciated by 7 percent in real effective terms (Figure 1.11) mainly driven by improved euro area prospects, as shown in the November 2017 Regional Economic Outlook: Europe. The Czech koruna appreciated about 10 percent, following the lifting of the Koruna-euro floor in early 2017, and on the back of a more recent increase in the policy interest rate and strong growth performance. The Polish zloty and Hungarian forint also experienced some appreciation due to strong growth and subdued inflation. The depreciation of the Turkish lira in 2017 by about 6 percent follows a depreciation of a similar size after the coup in the second half of 2016, amid above-target inflation and a widening current account. The Russian ruble has depreciated by 6 percent since February 2017, following the 2014–16 depreciation and recovery The British pound has also moved broadly sideways since the depreciation in 2016. Meanwhile, the Swiss franc has depreciated since early 2017, given the negative interest rate differential with the euro.

Figure 1.11.
Figure 1.11.

Exchange Rate Movements

(Percent; depreciation (-)/appreciation (+); March 2017-March 2018)

Sources: IMF, Information Notice System; and IMF staff calculations.Note: Data labels in the figure use International Organization for Standardization (ISO) country codes.

Thus far, current account balances remain noticeably stronger than before the global financial crisis in most countries. Net external debtor countries that had persistent and large current account deficits prior to the crisis have seen sizable current account adjustments (Figure 1.12), driven by both a permanent reduction in the level of demand and some labor cost reductions. Meanwhile excess external surpluses have persisted.

Figure 1.12.
Figure 1.12.

External Sector Developments

Sources: Eurostat; Haver Analytics; IMF, World Economic Outlook; and IMF staff calculations.Note: Data labels in the figure use International Organization for Standardization (ISO) country codes. CE = Central Europe; EU = European Union; SEE = Southeastern Europe.

  • In advanced Europe, the euro area members that had current account deficits prior to the crisis have achieved surpluses (Estonia, Portugal, Spain) or reduced their deficits appreciably (Greece, Latvia, Lithuania) over the past several years (Figure 1.12, panels 1 and 2), partly driven by adjustments in unit labor costs. However, negative net foreign asset positions remain elevated in many of these countries (Figure 1.12, panel 3). Recent indicators of competitiveness, while not conclusive, suggest some erosion of competitiveness in the Baltics, where real effective exchange rate appreciation, fast wage growth, and modest productivity gains have led to a notable increase in unit labor costs, bringing them close to the precrisis peak (Figure 1.12, panel 4). Excess current account surpluses have persisted in Germany and the Netherlands, and in Germany remained stronger than implied by medium-term fundamentals and desirable policy setting, indicating that adjustment mechanisms are weak, partly reflecting currency arrangements but also likely structural features (see the IMF 2017 External Sector Report).

  • In emerging Europe, many economies managed to adjust from large current account deficits to small surpluses, but here too the net external liability positions remain elevated (Figure 1.12, panels 2 and 3). In Central Europe and the SEE-EU region, real effective exchange rates have edged up somewhat as wages outstripped productivity in the last two years (Figure 1.12, panel 4). The level of economy-wide profit shares in these economies is higher than the EU average (Figure 1.8), which suggests that companies have some room to absorb the higher labor costs. However, the impact of high wage growth on competitiveness needs to be monitored closely.

  • In Turkey, the current account deficit has stayed around 5 percent of GDP. Although exports have performed well, higher fuel prices and strong domestic demand have led to a wider current account deficit.

Key Forces Shaping the Outlook: Favorable External Conditions and Still-Accommodative Macroeconomic Policies

The external environment and macroeconomic policy setting remain supportive for Europe’s near-term outlook. The synchronized global expansion remains on track, with global growth projected to edge up from 3.8 percent in 2017 to 3.9 percent in 2018 and 2019, partly reflecting spillover effects of expansionary fiscal policy in the United States (see Chapter 1 of the April 2018 World Economic Outlook). The continued recovery in global investment has spurred stronger manufacturing activity and an upturn in global trade (Figure 1.13, panel 1). Global PMIs for early 2018 indicate that the global growth momentum will continue into the first half of 2018, and Europe is enjoying significant goods trade momentum and upbeat foreign demand (Figure 1.13, panel 2). The recent agreement between the United Kingdom and the European Union for a 21-month Brexit transition period mitigates the risk of a disorderly UK exit from the European Union and reduces the uncertainty facing firms and households.

Figure 1.13.
Figure 1.13.

Global Activity

Sources: European Commission; Haver Analytics; IMF, World Economic Outlook; and IMF staff calculations.Note: PMI = purchasing managers’ index.1 Measured by volume of goods and services imports.2 Proxied by extra-EU exports of goods.

Commodity prices started the year on a bullish note. Oil prices, boosted by healthy global growth prospects and expectations for continued oil production curbs by the Organization of the Petroleum Exporting Countries and Russia, increased to above $65 a barrel (about 30 percent above the projection in the October 2017 World Economic Outlook). Higher oil prices will aid the cyclical recovery in Russia and could put some upward pressure on headline inflation elsewhere. Futures markets point to some oil price declines over the next few years from current levels.

Despite recent equity market turbulence, financial conditions remain supportive of growth, although signs of tightening conditions are gradually appearing in some markets (see Chapter 1 of the April 2018 Global Financial Stability Report). Financial stress indices tightened modestly in late 2017 (Figure 1.14, panel 1). Sovereign bond yields edged up in many euro area economies, in response to better-than-expected growth outcomes and an expectation of earlier monetary policy normalization, and in the Czech Republic and Romania, which began normalizing their monetary policy (Figure 1.14, panel 2). However, yields actually declined in about a quarter of European economies, most notably in Greece, Portugal, and Ukraine. In the euro area, still-easy financial conditions are underpinned by large asset holdings by the ECB. Despite the lower purchase schedule, net purchases are expected to remain substantial at least through September 2018 relative to the projected net issuance of government debt (Figure 1.14, panel 3).

The recent stock market corrections have thus far left no lasting scars. Market volatility rose substantially for European equities in early February 2018, but since then has declined to the average level observed in 2016 –17 (Figure 1.14, panel 4). Portfolio flows to emerging Europe remained robust through January 2018, especially bond flows (Figure 1.14, panel 5). Weekly data indicate that portfolio flows reversed slightly amid the global equity market correction in the first half of February, but have recovered since. The correction was mild compared with outflows during the “taper tantrum” of 2013 (Figure 1.14, panel 6). However, volatility is still a concern, given the recent stock movements and ongoing trade tensions.

Continued accommodative macroeconomic policies will further support activity, with almost all central banks in the region maintaining negative real policy rates (Figure 1.15, panel 2).

  • Monetary policy normalization in the large advanced economies is expected to be gradual and predictable (Figure 1.15, panel 1). In the United Kingdom, monetary policy remains accommodative but the Bank of England has started to consider the case for the normalization process. It raised the policy rate for the first time in 10 years, to 0.5 from 0.25 of a percent. Central banks in the rest of advanced Europe are signaling a tightening bias. In the Czech Republic, the Czech National Bank has raised rates three times since August 2017, after almost five years of a supportive stance, and is expected to continue gradually normalizing monetary conditions.

  • In emerging Europe, markets expect modest tightening of policy rates in almost all countries, although some central banks are maintaining a very accommodative monetary stance (Hungary, Poland). In Romania, the policy rate was raised twice in 2018 by a cumulative 50 basis points. In Turkey, the increase of the effective interest rate by almost 5 percentage points in 2017 has not been enough to contain inflation and prevent inflation expectations from increasing, prompting markets to expect further tightening of monetary policy in 2018. In contrast, Russia’s central bank has cut policy rates by a cumulative 275 basis points since March 2017 as inflation stabilized below its 4 percent target. Russia and Turkey remain the only large European economies with positive real policy rates.

Figure 1.14.
Figure 1.14.

Financial Conditions

Sources: Bloomberg Finance L.P.; European Central Bank; Haver Analytics; and IMF staff calculations.Note: Data labels in the figure use International Organization for Standardization (ISO) country codes. ECB = European Central Bank; V2X = Euro Stoxx 50 Volatility Index; VIX = Chicago Board Options Exchange Volatility Index.1 The indices capture markets movements relative to averages or trends to proxy for the presence of strains in financial markets (banking, securities markets, and exchange markets). For details see IMF (2009) and Balakrishnan and others (2009).2 ABSPP = asset-backed securities purchase program; CBPP3 = covered bond purchase program 3; CSPP = corporate sector purchase program; PSPP = public sector purchase program.
Figure 1.15.
Figure 1.15.

Monetary Policy Conditions and Expectations

Sources: Bloomberg Finance L.P.; Haver Analytics; IMF, World Economic Outlook; and IMF staff calculations.Note: Data labels in the figure use International Organization for Standardization (ISO) country codes. EA = euro area.1 Based on monthly average of federal funds rate futures for the United States; overnight interbank swap rates calculated using the overnight unsecured lending between banks (SONIA) for the United Kingdom; and the euro interbank offered forward rate (EONIA) for the euro area; updated April 19, 2018.2 Real policy rate is calculated as the difference between nominal policy rate and one-year-ahead inflation forecast (for example, IMF World Economic Outlook forecast for 2019; average of period). Market expectation of interest rate is calculated as the difference between one-year-ahead interest rate swap rate and three-month interbank rate. Positive values indicate expectations of monetary tightening.

Fiscal policy is also projected to continue supporting economic activity, despite closed output gaps in most economies—procyclicality has been a feature of fiscal policy during the recovery. The fiscal stance is expected to be neutral or expansionary in the region in 2018, except in Iceland, Italy, Russia, the Slovak Republic, and the United Kingdom (Figure 1.16, panel 1). The aggregate fiscal stance in the euro area is forecast to remain broadly neutral in 2018–19 and to tighten only gradually in 2020 (Figure 1.16, panel 2). Procyclical loosening is projected in Southeastern Europe and Turkey.

Figure 1.16.
Figure 1.16.

Fiscal Policy Conditions

Sources: IMF, World Economic Outlook; and IMF staff calculations.Note: Data labels in the figure use International Organization for Standardization (ISO) country codes.1 The fiscal stance is considered to have tightened if the ratio of the structural primary balance to potential GDP improves by at least 0.25 percent a year, to have loosened if that ratio deteriorates by at least 0.25 percent a year, and to have remained neutral otherwise. General government non-oil primary structural balance is used for Russia, and structural non-oil balance in percent of mainland trend GDP is used for Norway. No data for ALB, BLR, MDA, MKD, MNE, SMR, and UVK.

Favorable Outlook Expected to Continue

Against this backdrop, growth is expected to further improve in the short term, but slow gradually over the medium term. Europe’s growth forecasts for 2018 and 2019 have been revised up relative to the forecast in the November 2017 Regional Economic Outlook: Europe (Table 1.2). The upward growth revisions reflect largely stronger domestic demand, with investment accounting for almost half of the revision in both advanced and emerging Europe (Figure 1.1, panel 4). While more dynamic investment growth has resulted in upward revisions of potential GDP, most of the growth revisions are attributed to cyclical factors (Figure 1.17).

Figure 1.17.
Figure 1.17.

WEO Forecast Revisions: April 2018 versus April 2017

Sources: IMF, World Economic Outlook (WEO); and IMF staff calculations.
Table 1.2.

Real GDP Projections

(Year-over-year percent change)

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Sources: IMF, World Economic Outlook (WEO); and IMF staff calculations.

Pink shading indicates a downward revision.