The euro area economy has shown remarkable resilience in the aftermath of
Russia’s invasion of Ukraine and the largest terms of trade shock in
several decades, thanks to a strong policy response. However, economic
activity has weakened and inflation—although gradually declining—remains
elevated. Monetary policy must continue to tighten to bring inflation to
target in a timely manner. Fiscal consolidation should also proceed to ease
inflation pressures and rebuild fiscal space. A swift agreement on the
reform of the EU economic and fiscal governance framework would support
fiscal sustainability over the longer term. Recent bouts of financial market turbulence underscore the need to
continually monitor vulnerabilities, further increase capital buffers, and
complete the Union’s financial architecture. Structural policies should
focus on delivering the green transition and addressing structurally weak
productivity growth.
Growth in the euro area is likely to pick up gradually following a
significant weakening
. The 2022 growth outturn exceeded the initial post-invasion projections,
thanks to a swift policy response and a strong rebound in contact-intensive
services. Activity nevertheless weakened considerably in the second half of
the year and slipped into a mild technical recession in early 2023 as
financial conditions tightened, real wages dropped, and consumer confidence
plummeted following the spike in energy prices. Growth is expected to pick
up modestly throughout 2023 and 2024, supported by a slow recovery in real
incomes, a further easing of supply constraints, and firmer external
demand, even as financial conditions continue to tighten. Looking towards
the medium-term, output is likely to remain below pre-war trend for an
extended period given the costs of adjusting to persistently higher energy
prices.
Inflation has peaked, but the two percent target remains far off
. While headline inflation has fallen sharply since 2022Q4 thanks to lower
energy prices, core inflation has proven more persistent and has begun to
decline only recently. This reflects in part the delayed transmission of
lower commodity prices into consumer prices and firms’ ability to protect
or increase profits. Looking ahead, inflation is projected to continue to
decline as tight financial conditions restrain demand and supply shocks
dissipate further. The convergence to target is projected around mid-2025,
assuming nominal wage growth remains moderate, firms absorb part of the
wage increase through lower profits, and import prices continue to
decrease.
Uncertainty surrounding the outlook remains high, with risks to growth
tilted to the downside and risks to inflation to the upside
. A reemergence of financial turbulence, possibly caused by distress in
global markets, could weigh on the economic recovery by leading to a sharp
contraction in credit or increases in broader risk aversion. Weaker
external demand would also negatively affect the bloc’s growth prospects,
particularly if it emanates from an abrupt slowdown in key trade
partners--the United States or China. More persistent inflation than
expected would require a tight policy stance for longer, weighing on
domestic demand. In this regard, stronger-than-expected wage growth in the
context of tight labor market conditions, especially if profit shares do
not adjust, would push inflation up and potentially lead inflation
expectations to de-anchor. In addition, renewed supply shocks, which could
result from an escalation of the war in Ukraine and a related increase of
commodity prices, or a further intensification of geoeconomic fragmentation,
would raise inflation and hurt growth. On the upside, the economy could
again prove more resilient than expected, especially amid a still large
stock of excess savings.
Reducing Inflation while Preserving Financial Stability
With inflation persistently high, monetary policy should continue to
tighten and maintain a tightening bias
. Recent policy rate hikes have shifted market rates up and brought the
monetary policy stance into contractionary territory. Going forward, the
inflation outlook and the high uncertainty regarding inflation persistence
suggest that a more restrictive stance than at present, maintained over
sustained period, will be needed to keep inflation expectations anchored
and return inflation to target in a timely manner. That said, a continued
flexible and data-dependent approach to monetary policy decisions remains
appropriate as it provides the flexibility to change course should incoming
data indicate a need.
The Eurosystem should continue to trim its balance sheet gradually and
cautiously, consistent with a learning-by-doing approach, with the
policy rate serving as the primary policy tool
. The ECB Governing Council's decision to reduce the Eurosystem's bond
holdings in a predictable manner during the current monetary policy
tightening cycle is welcome as it would reduce its footprint in financial
markets. In the meantime, the tightening of the monetary policy stance
should be achieved primarily through the key policy rates as their
transmission to financial conditions and economic activity is better
understood and their changes are easier to communicate. Moreover, building
conventional monetary policy space would reduce the risk of hitting the
effective lower bound in a possible downside scenario.
Economic conditions call for a tight fiscal policy stance.
Tighter fiscal policy would help reduce inflation pressures, lessening the
upward pressure on interest rates and reducing the risk of financial market
disruptions. Smaller fiscal deficits are particularly critical in high debt
and deficit countries, which need to rebuild fiscal space. In this context,
it is important that revenue windfalls are saved, and energy support
measures introduced over the past year are allowed to expire, to achieve a
meaningful deficit reduction. Should energy prices rise significantly again,
any new support measures should be targeted to the most vulnerable to assist
the consolidation efforts and strengthen the incentives for energy
conservation.
The euro area’s banking system has proven resilient but tightening
financial conditions could expose vulnerabilities
. Overall, euro area banks have robust capital and liquidity positions and
have benefitted from higher profits as the return on their assets has risen
faster than the cost of their liabilities, given sticky deposit rates.
Looking ahead, rising funding costs because of upcoming repayments of the
ECB’s Targeted Longer Term Refinancing Operations and increased competition
for deposits, and deteriorating credit quality could erode bank profits and
potentially reduce capital. It is therefore advisable to increase the
capital buffers of banks in jurisdictions where banks are experiencing
temporarily high profits. Pockets of vulnerability related to the effects
of higher interest rates on bank balance sheets and the impact of actions
to shrink the ECB’s balance sheet on liquidity conditions deserve close
monitoring. Continued stress-testing and disclosures of bank credit,
interest rate, and liquidity risks—ideally including less-significant
institutions—would help assuage concerns about financial stability risks.
Vulnerabilities in the nonbank financial intermediation (NBFI) sector
also require close monitoring and an upgraded macroprudential policy
toolkit
. Increased volatility in financial markets raised liquidity demands by
some NBFI entities with large positions in financial derivatives. In
addition, investment funds (including those investing in real estate) may be
forced to reduce leverage as markets cool and financial conditions tighten.
So far, deleveraging in the NBFI sector has been orderly, but a wider
implementation of macroprudential tools that limit leverage and liquidity
mismatches in the sector would help reduce systemic risk. Given the
significant cross-border activities of the NBFI sector, close cooperation
between national authorities regarding the prudential regulation of the
sector is key. Finally, closing data gaps and improving data quality is
essential to ensure effective oversight of this sector.
Recent financial turbulence underscores the need to further strengthen
the EU’s financial architecture
. The Commission’s proposal for a reform of the Crisis Management and
Deposit Insurance (CMDI) framework, which would extend the EU’s resolution
powers to more banks and improve resolution funding arrangements, is a step
in the right direction. However, more flexibility in the deployment of
resolution funds would be welcome as it would help the authorities to
handle bank failures nimbly and contain systemic risk. Fully ratifying the
European Stability Mechanism treaty to create a backstop to the Single
Resolution Fund and agreeing on a European deposit insurance scheme would
pave the way for a deeper, more resilient Banking Union. Europe is a long
way from having a single capital market, undermining investment,
innovation, and dynamism. In this context, progress toward the Capital
Markets Union would diversify financing options for firms, including for
the green transition. Finally, a full implementation of Basel III is
essential, as recent events outside Europe point to the danger of selective
implementation of banking regulation.
Safeguarding Fiscal Sustainability
A swift agreement on the EU economic and fiscal governance reform is a
priority given the medium-term fiscal challenges
. Euro area public debt increased sharply in 2020 and is set to remain well
above pre-pandemic projections over the forecast horizon. The European
Commission’s legislative proposal for economic governance reform would
appropriately promote a differentiated, risk-based medium-term fiscal
adjustment. Relying on net primary expenditure as the operational target
simplifies the framework and allows countercyclical automatic stabilizers
to operate. At the same time, cautious implementation of the framework
would be critical. The possibility to extend adjustment periods in return
for growth-enhancing reforms and investment is positive but relying on
overly optimistic growth estimates must be avoided. In this context, an
Independent European fiscal council could add credibility to the process.
An EU-wide fiscal capacity for macroeconomic stabilization and provision of
public goods would also strengthen the framework. It is vital that an
agreement is reached soon so the new framework can anchor fiscal policies in
2025 and beyond.
Delivering the Green Transition and Energy Security
Despite initial fears, the energy crisis is likely to be favorable for
the green transition
. European solidarity, diversification of supply, and greater than expected
demand adjustment—both due to the adaptability of the private sector and a
mild winter—have significantly reduced short-term energy security risks.
High energy prices have also boosted energy efficiency, made renewable
electricity production more cost-attractive, and accelerated green policy
initiatives. Early estimates suggest that this led to a drop in EU carbon
emissions in 2022 despite the increased use of coal for power generation.
At the same time, EU countries remain far off from achieving their
commendably ambitious emission reduction objectives, highlighting the
importance of maintaining policy momentum.
The EU is showing global leadership on the use of price-based carbon
reduction mechanisms
. The EU Emissions Trading Scheme (ETS) reform that is soon to come to
force is welcome as it will strengthen the EU’s climate policy instruments,
including by expanding the ETS-covered sectors, while supporting vulnerable
households in the energy transition. Over the longer run, it would be
important to align carbon prices across sectors to reduce potential
distortions in emission reduction incentives. The widening of the scope of
the Carbon Border Adjustment Mechanism (CBAM) to a broader set of goods
will also support global emission reduction efforts by encouraging cleaner
industrial production in non-EU countries. It will be critical to implement
the CBAM in line with WTO rules and based on actual embodied carbon content
of traded products rather than benchmarks.
The Green Deal Industrial Plan can support the green transition but has
elements that should be implemented carefully
. Measures aimed at streamlining regulatory and permitting processes,
enhancing skills, and fostering green innovation are welcome as they will
complement ongoing efforts to achieve climate neutrality. However, the
relaxation of state-aid rules, which allows Member States to grant
subsidies or tax incentives to match what is being offered by third
countries could potentially lead to high fiscal costs, as well as economic
inefficiencies and distortions, including to the EU Single Market. More
broadly, such industrial policies and measures to enhance the resilience of
EU’s supply chains could potentially increase the risks of global
fragmentation and undermine multilateral trade. Steps to engage with all
major trade partners and finding a common WTO-consistent approach in areas
such as tariffs and subsidies should remain a priority. Such an
approach—underpinned by thorough analysis of the measures’ climate and
economic effects—would limit distortions to international trade and improve
resource allocation and productivity.
An EU Climate Investment Fund could play a role in improving the
provision of common public goods related to energy security and the
green transition
. Such a mechanism, potentially under an EU central fiscal capacity would
help ensure the EU’s emissions reduction goals are achieved efficiently,
including by allocating funds to countries and sectors with the highest
rate of return on carbon abatement and ensuring that projects with strong
cross border spillovers get adopted. Moreover, an EU Climate Investment
Fund can help ensure a level playing field for green investments given
member countries’ differing fiscal space and ability to provide support.
Boosting Productivity and Growth
Ambitious actions to boost productivity are needed to increase euro
area growth
. A faithful implementation of the national Recovery and Resilience Plans
would boost growth by delivering much needed structural reforms and
investments. Reforms should be implemented as planned, though greater
flexibility on the timing of investments may be needed if countries have
constraints on their capacity to utilize funds. Furthermore, given ongoing
sectoral shifts, including due to the green and digital transitions,
additional policy action to foster the reskilling and upskilling of the
workforce, with a strong focus on digital skills, and continued improvement
in labor market flexibility, would be helpful to facilitate a smooth
reallocation of workers and boost economic dynamism. Policies to better
integrate immigrants across the EU could help them deploy their human
capital productively and alleviate some of the fiscal pressure caused by an
aging European population. Finally, a renewed emphasis on R&D
investment environment could bring Europe closer to the global innovation
frontier.