All warning lights are red. Russia’s war with Ukraine, a sluggish recovery from the effects of the Covid-19 pandemic and a drought across much of the continent have led to a severe energy crisis, high inflation, supply shortages – and uncertainty about Europe’s economic future.

Governments are trying to get help to the most vulnerable quickly. Amid all the confusion, however, there is agreement on one thing: a recession is imminent.

How severe the economic downturn will be depends on how severe the impact of the energy crisis is and how policymakers react to it. This week, energy prices hit record levels: over €290 ($291) per megawatt-hour (MWh) for benchmark gas deliveries in the fourth quarter of the year (the usual pre-pandemic price was around €30) and over €1,200 per MWh for Daily electricity in the same quarter in Germany (before that the price was around €60). As gas is used for peak demand in most European electricity markets, it is generally price setting.

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The European economy was in a reasonably strong position before the crisis. The labor market is still relatively stable, with an unemployment rate of 6.6% – which by European standards is almost equivalent to an economy with full employment. Wage growth is likely to accelerate in the coming months as long-term contracts are renegotiated. Consumer confidence fell when the war began, but consumption has not collapsed. Inflation forecasts have weakened somewhat.

But the next few months will look much bleaker for three reasons. Firstly, the industry is under pressure. In the spring, executives at Europe’s biggest producers said that cutting off Russian gas supplies too quickly would plunge the continent into a serious crisis. Despite the high prices, industrial production has remained strong so far. “This is partly because companies are still working through the backlog of orders from the past,” says Michael Hüther from the German Economic Institute, a think tank.

But those backlogs won’t last forever and some key economic indicators are looking bad. “Orders less inventories, which means the orders that keep companies going – have collapsed,” said Robin Brooks of the Institute of International Finance, which represents banks and international investors. This slump reflects the weakening of the global and especially the Chinese economy. According to Brooks, such a drop can mark a turning point in the economic cycle.

The hardest hit industries will likely be found east of the Rhine. Recent surveys of industry leaders in Germany and Austria point to an economic downturn. Germany’s unhealthy dependence on the Chinese market poses a risk that demand for goods across the German supply chain will fall. Italian industry is in free fall. Poland and the Czech Republic, both outside the euro zone, are also at risk. An exception is Hungary, where production is showing healthy growth thanks to investments in battery plants, the boom in electric vehicles and long-term energy contracts (although some of which are about to expire).

The second reason for the gloomy outlook is that the cost of services is not a significant pillar of the continent’s economy. In the summer, the strong season in the tourism sector helped economic growth, particularly in France and southern Europe, where tourists generously spent the savings they had accumulated during the pandemic. But sentiment is clouding as consumers tighten their belts in preparation for a long, cold winter. dem s

Finally, Europe will almost certainly see that the energy shock will be coupled with rising interest rates. Having underestimated inflation like many other central banks around the world, the ECB is now determined to bring the annual inflation rate back to its 2% target from an alarming 9.1% in August. At the recent meeting of central bankers in Jackson Hole, Wyoming, Isabel Schnabel, a member of the ECB’s Executive Board, advocated holding the economy more accountable to get the job done.

Economists therefore expect that at its next meeting on September 8, the ECB will try to underpin its anti-inflation credibility by raising interest rates significantly, possibly by three-quarters of a percentage point. As a result, yields on short- and longer-dated European bonds have risen over the past month. Still, the euro has continued to fall, reaching dollar parity for the first time in two decades.

This, and the decision by international investors to look elsewhere, reflects the deteriorating prospects for the European economy. This worries European policymakers as a weaker currency fuels inflation through more expensive imports, affecting real incomes and hence consumption.

All of this suggests that the European economy is certain to enter a recession, led by Germany, Italy and Central and Eastern Europe. For the fourth quarter of this year, analysts at JP Morgan Chase Bank expect annual growth rates of -2% for the euro area as a whole, -2.5% for France and Germany and -3% for Italy. Italy’s problems and its high level of debt could unsettle European bond markets. Politicians in Europe have spent a lot of time thinking about how to respond to high energy prices. They may soon face wider crises.

The article first appeared in The Economist under the title “Europe is heading for recession. How bad will it be?” was published and translated by Andrea Schleipen.