The full-year Europe-wide contraction would be the first since 2009, when a 4.3 percent drop in the wake of the U.S.-led banking crisis exposed the over-borrowing and imbalances that plunged Europe into its sovereign debt troubles.

Financial markets “remain still rather fragile, but there are also signs of stabilization,” Rehn said.

The euro pulled off its high against the dollar after the forecasts were published, trading at $1.3313 at 10:16 a.m. in London, up 0.5 percent on the day, after reaching $1.3343 earlier.

The growth downgrade went along with a higher inflation forecast, potentially limiting the European Central Bank's scope for a further cut in its main interest rate from 1 percent. Euro-area inflation will reach 2.1 percent, topping the central bank's 2 percent limit, the commission said. In November it had counted on 1.7 percent inflation.

With countries along the Mediterranean rim plagued by too much debt and too little competitiveness, divergences within what is supposed to be a unified continental economy have become more “pronounced,” the commission said.

Declining employment, two years of budget cuts and financing constraints for businesses will combine for a “substantial drop” in Italian domestic demand in 2012, the commission said.

It painted a similar picture in Spain, stuck with a 22.9 percent unemployment rate and mounting doubts whether Prime Minister Mariano Rajoy's government will meet deficit-reduction targets.

Growth Differentials

Spain is still suffering from the aftershocks of the burst housing bubble, compounded by fiscal austerity and high corporate debt that is holding back business investment, the commission said.

“Growth differentials are set to remain substantial,” the commission said.

The divergences carried through to the three countries — Greece, Portugal and Ireland — forced to fall back on a combined 386 billion euros of financial aid to stave off default.

Greece met with the sharpest downgrade, with this year's contraction now seen at 4.4 percent compared with 2.8 percent in November. Portugal's economy will shrink 3.3 percent, compared with the previous forecast of 3 percent. Ireland, by contrast, will grow 0.5 percent, expanding for the second straight year.

Germany, Europe's largest economy, will muster 0.6 percent growth, down from a November estimate of 0.8 percent. Germany will get away with a “temporary interruption” of its economic momentum instead of tipping into a technical recession, the commission said.

Germany's decoupling from southern Europe was reflected in a greater-than-expected increase in business confidence, according to a separate report by the Ifo institute today.

The EU forecast for France, the second largest, was scaled back to 0.4 percent from 0.6 percent. In a potential fillip for the struggling re-election campaign of President Nicolas Sarkozy, the commission said France too will escape a recession, commonly defined as two consecutive quarterly contractions.

Overall, the EU was more downbeat than private-sector analysts surveyed by the ECB, who on Feb. 16 predicted a 0.1 percent decline. The ECB's latest projection, released in December, was for 0.3 percent growth. It will put out new forecasts next month.

The economic retrenchment will be “rather mild and temporary, but the turnaround of the trend needs to be confirmed in coming months,” Rehn said.

Bloomberg News

Copyright 2018 Bloomberg. All rights reserved. This material may not be published, broadcast, rewritten, or redistributed.