Euro Area -- 2002 Article IV Consultation, Concluding Statement of the IMF Mission on the Economic Policies
July 12, 2002
Outlook: Changing Risks to Growth and Inflation
1. Until recently, our expectation was that the gradual upturn of economic activity that began in the first quarter of this year would accelerate to above potential during the latter half of the year, before settling down close to potential in 2003. The genesis of this recovery was, as had been the case in the initial stages of past recoveries, a boost from net exports. This was expected to be succeeded fairly quickly by a resumption of domestic demand growth.
2. Recent developments have unsettled this outlook:
- Short-term indicators suggest the recovery is off to a soft start. For the time being at least, there is little evidence of the prompt turnaround in domestic demand built into the baseline outlook.
- Global equity markets have sold off sharply. This will dampen euro-area demand, indirectly in particular via the United States and directly via negative wealth effects on consumption and increased financing costs for investment.
- The euro has appreciated. While this reflects primarily a generalized shift away from the dollar rather than a shift in favor of the euro, this is in our view a positive development, although one with implications for policy. In the short run, the appreciation generates a positive terms of trade effect and should bolster confidence in the euro, developments that have traditionally boosted consumer confidence and spending, and should, therefore, be supportive in kick-starting domestic demand growth. There are, of course, less favorable implications for net exports, though this effect may take more time to materialize, partly because competitiveness remains substantial and partly because we expect trade responses to the appreciation to be muted and slow, as they were to the depreciation.
Overall, absent a stronger global recovery, recent developments suggest that growth in 2002 may be somewhat weaker than expected. Moreover, uncertainty and downside risks have increased looking forward. However, barring significantly more pronounced shocks than we have seen so far, the basic prospect would seem to remain one of an upswing back to potential growth.
3. The inflation outlook in the baseline was more of a concern, mainly because of a renewed spurt in headline inflation and stubbornly high core inflation at the beginning of the year. Although attributable in good part to one-off weather, energy, and euro changeover effects, the acceleration also coincided with wage pressures, increases in inflationary expectations, and supportive monetary conditions. In this environment, inflation was expected to recede only slowly to just below 2 percent in 2003.
4. While questions remain about the nature of recent inflation shocks and monetary trends, recent developments should assuage concerns on the inflation front at least to some extent:
- The appreciation of the euro relieves price pressures, particularly as direct pass through of dollar declines to import prices for energy and other commodities tends to be quick and substantial.
- Somewhat slower expected growth and increased risks to prospects reduce the likelihood of domestic inflation pressures.
Monetary Policy Considerations
5. The immediate implication of these developments is to ease the pressure on monetary policy. The dilemma of the past months, created by the difficult-to-decipher increase in core inflation while recovery remained weak, has diminished. The favorable effects of the appreciation of the euro together with the increased downside risks to growth provide breathing room to ascertain inflation prospects. In the same vein, the required strengthening of domestic demand necessary for sustaining growth prospects also argues for a delay in the timing of the increases in interest rates that need to accompany the recovery.
6. Looking back at the record of monetary policy, the responses to the shocks that hit the area over the last three years were appropriate. Despite this broadly shared view, perceptions of the ECB's monetary framework and how it relates to policy decisions, though improved, remain more mixed. This is despite empirical evidence, including our own work, indicating that markets' ability in predicting the ECB's decisions has been broadly comparable to that of other major central banks. In our view, these perceptions owe in part to the two-pillar strategy, which seeks to bring to bear the distinctive perspectives of traditional monetary and inflation targeting frameworks. The prominent role of money in the first pillar has its roots in the area's collective monetary history, and is supported by evidence indicating a strong link between nominal money growth and inflation over long periods. This link is, however, more tenuous over shorter periods, and the framework has thus proved taxing for communicating policy decisions. In our view, communication would be made easier if policy decisions were related more clearly to the different time horizons of the two pillars.
7. Critics have argued that the ECB's definition of price stability does not provide the clearest guide for inflationary expectations and that the stated price stability objective may be too low. In this regard, we note the recent statements by ECB officials recognizing the need for vigilance were inflation to fall toward an excessively low level, and that a small positive rate of inflation, "say between 1 and 2 percent" would significantly reduce the risks of getting trapped in a deflationary spiral. These statements are consistent with our reading of the interest rate decisions of the ECB over the past 3 ½ years. If this interpretation is correct, these statements are a helpful clarification of the ECB's price stability objective. They help dispel concerns about potential asymmetries in policy responses at low rates of inflation. Our reading of the evidence is that trend rates of inflation in the upper half of this range would provide reasonable insurance against the risk of getting stuck in a liquidity trap while allowing room for relative wage adjustments among the members of the union in the face of nominal downward rigidities.
Fiscal Policy Requirements
8. The main fiscal issue confronting the euro area is for the three largest countries to deliver on their commitments to achieve fiscal positions close to balance or in surplus by 2004 and thereby impart badly needed credibility to the SGP framework. In our view, the framework is sound and well-suited to the fiscally decentralized structure of the union. It permitted use of the automatic stabilizers last year and affords necessary flexibility to those who meet its fundamental requirements. Moreover, despite the controversies attaching to individual members' difficulties in meeting their commitments, we view the decisions to date as still affording the prospect that these countries will adjust in the upswing phase of the cycle.
9. We estimate the three largest countries' current commitments to imply underlying (i.e. cyclically adjusted) adjustment of ½ to ¾ percent of GDP per annum. Adjustments of this magnitude are difficult but doable. Indeed, a ½ percent of GDP per annum pace (free of one-off measures) is essential from the standpoint of getting the SGP over its transition phase and of addressing the procyclical bias of fiscal policy in upswings. Beyond the quantitative targets, however, it is the quality of the adjustment—the extent to which it addresses longstanding issues in key spending areas—that is crucial to the sustainability of the consolidation effort. In this regard, it is important that tax cuts be financed by upfront expenditure restraint.
10. It is unfortunate that adjustment policies need to be pursued at a time when the upswing is potentially less buoyant. In this context, it would be inappropriate to reinforce the envisaged pace of adjustment in order to achieve particular nominal targets in the face of weak growth. That is, the automatic stabilizers should be allowed full play around the envisaged adjustment paths. Demand effects would also be contained by the increase in the credibility that would result from completing the transitional adjustments, benefits that would accrue to all members. Credibly implemented, such policies would also provide a basis for a shift in the policy mix—tighter fiscal and easier monetary. This is also appropriate in the context of an appreciating euro.
11. Fiscal adjustment and the teething phases of a new fiscal framework are bound to be somewhat noisy processes. Recent developments suggest that this will continue as countries seek to steer clear of the 3 percent deficit limit in the face of the revenue-adverse composition of demand so far this year and weak growth. In this regard it would be helpful to limit the implications of the inevitable pressures to test the limits of the SGP through more timely reporting requirements and speedier disposition of issues as regards acceptable and unacceptable "fiscal measures."
Structural Reforms: Addressing the Delivery Gap
12. Although much remains to be done to bridge the gap between words and deeds, there appears to be a new impetus to reforms in financial, product, and labor markets:
- The agreement on the Lamfalussy process for speeding up the implementation of the Financial Services Action Plan (FSAP) is a major procedural success, and awareness that an integrated European capital market is vitally important for economic growth and job creation is clearly on the rise. But the backlog of FSAP directives awaiting adoption by the Council and the European Parliament is large and meeting the 2005 deadline will be a significant challenge.
- Increased integration of the product and services markets has been a long-standing rationale for the EU's very existence. Following remarkable progress in some areas, recent evidence suggests that progress in integrating goods markets is being hampered by the slow progress in liberalizing trade in services, thereby limiting market access.
- Notwithstanding recent successes in reducing unemployment, the EU's overall utilization of labor resources remains at a low level—as highlighted by the Lisbon strategy's ambitious numerical targets to raise employment rates. Labor market reforms, therefore, need to remain a key priority. We welcome the recent reform initiatives in some key countries, but it remains to be seen whether there will be enough momentum to address the key obstacles to better functioning labor markets highlighted in the Barcelona Summit conclusions, including high tax and contribution burdens on low-wage workers, cumbersome employment contract regulations, and the duration and eligibility criteria for out-of-work benefits.
13. A successful completion of the Doha round would hold the promise of large benefits for all trading nations. We are concerned, however, over the recent deterioration in transatlantic trade relations and over the impact this might have on progress under the Doha Round. It is important that all parties do their utmost to avoid a further escalation of these conflicts. Moreover, progress under the Doha round is likely to require that the EU pursue a flexible approach on issues (environment, labor standards, competition) that go beyond the traditional core of trade negotiations. On the market access front, the determination to reduce and perhaps eliminate tariff peaks and escalation on non-agricultural products is welcome. On agriculture, the reforms set out in the mid-term review of the Common Agricultural Policy (CAP) would significantly ease market distortions if adopted. The EU has taken a significant and welcome step in improving market access conditions for least-developed countries under the Everything-but-Arms initiative, and aims to conclude cooperation agreements with the African, Caribbean and Pacific (ACP) countries. The proliferation of regional and bilateral agreements should not, however, stand in the way of multilateral liberalization.