IMF Wraps Up 2023 Article IV Consultation on Euro Area

Washington, DC: On July 12, the Executive Board of the International Monetary Fund (IMF) concluded the 2023 discussions on common euro area policies with member countries[1]

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 swift policy response and a strong rebound in contact-intensive services. However, economic activity weakened significantly in the second half of 2022 and slipped into a mild technical recession in early 2023 as financial conditions tightened, real wages declined, and consumer confidence fell. Looking ahead, growth is expected to pick up gradually throughout 2023 and 2024, supported by a recovery in real incomes in the context of continued tight labor market conditions, a further easing of supply constraints, and firmer external demand, even as financial conditions continue to tighten. While headline inflation has fallen sharply recently after reaching record high levels, core inflation is proving more persistent. As tight financial conditions restrain demand and supply shocks dissipate further, inflation is set to decline further but is expected to remain elevated for an extended period.

Uncertainty surrounding the outlook is high. Turbulence in financial markets, including from distress elsewhere, could lead to a contraction in credit and broader increase in risk aversion, while weaker external demand would negatively affect the bloc's growth prospects. More persistent inflation, including due to strong wage growth, would require a tight policy stance for longer, weighing on domestic demand. 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 also push up 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.

Executive Board Assessment[2]

Executive Directors agreed with the thrust of the staff appraisal. They commended the authorities for their decisive policy actions, which supported the resilience of the euro area economy in the face of a complex economic environment. Directors concurred that growth is set to pick up gradually, even as financial conditions tighten further, but recognized that the outlook is surrounded by high uncertainty. In this context, they agreed that bringing inflation back to target, while preserving financial stability, remains the near-term priority. Sustained structural reforms to enhance medium-term growth are also needed.

Directors noted the need to maintain a tight monetary policy stance to ensure that inflation returns to target in a timely manner, with most Directors stressing that further monetary policy tightening is needed. More generally, Directors called for a continued flexible and data-dependent approach. They also agreed that the Eurosystem's bond holdings should continue to be reduced in a gradual and predictable manner, with the policy rate serving as the primary tool of monetary policy.

Directors welcomed that euro area banks are overall well capitalized and liquid. They stressed the importance of strong supervision and regulation of banks and nonbank financial intermediaries to mitigate risks related to asset valuations, liquidity, funding, and exposures to real estate markets. Directors called for making further progress toward completing the EU's financial architecture to enhance economic and financial resilience.

Directors agreed that a tighter fiscal stance, as planned in 2024, would help contain inflationary pressures. In addition, they stressed that a reduction in deficits is essential to safeguard fiscal sustainability in many high-debt countries, including by phasing out energy relief measures and saving any revenue windfalls. Directors emphasized the importance of protecting investment as public finances are consolidated. They supported the ongoing reform of the European economic governance framework and encouraged reaching an agreement swiftly to anchor medium-term fiscal policy making. A number of Directors also considered that an EU-wide fiscal capacity for macroeconomic stabilization and provision of public goods would help strengthen this framework.

Directors noted that ambitious structural policies and investments are instrumental to increase potential growth and support the digital and green transitions. In this context, they underscored that making progress toward the National Recovery and Resilience Plan targets, with further efforts to promote innovation, facilitate the sectoral reallocation of labor, and reskill and upskill the workforce are crucial to achieve these objectives. Directors also stressed the EU's critical role in promoting rules-based, open trade and welcomed its commitment to the World Trade Organization.

It is expected that the next consultation on euro area policies in the context of the Article IV obligations of member countries will be held on the standard 12-month cycle.