IMF Executive Board Discusses the Monetary and Exchange Rate Policies of the Euro Area and the Trade Policies of the European Union

This paper examines the monetary and exchange rate policies of the euro area and the trade policies of the European Union. The paper highlights that the overall economic performance of the euro area has been disappointing: growth has been weaker and inflation higher than generally expected. To a large extent, this is the result of a series of unanticipated shocks—oil prices and animal diseases earlier, and the global slowdown and the associated financial market turmoil more recently. However, the performance also appears to reflect a greater-than-anticipated vulnerability to shocks.


This paper examines the monetary and exchange rate policies of the euro area and the trade policies of the European Union. The paper highlights that the overall economic performance of the euro area has been disappointing: growth has been weaker and inflation higher than generally expected. To a large extent, this is the result of a series of unanticipated shocks—oil prices and animal diseases earlier, and the global slowdown and the associated financial market turmoil more recently. However, the performance also appears to reflect a greater-than-anticipated vulnerability to shocks.

On October 18, 2002, the Executive Board of the International Monetary Fund (IMF) concluded the discussion of the monetary and exchange rate policies of the euro area and the trade policies of the European Union. The background section of this PIN reflects information available at the time of the Executive Board meeting.1


The euro area is recovering gradually from the downturn that began in late 2000. The rebound abroad in early 2002—in North America and emerging Asia—supported a timid recovery in euro-area output, but export growth and significant policy easing failed to spur a broader-based recovery. Retail price hikes coinciding with the euro cash changeover at the beginning of 2002—and household perceptions of its impact well in excess of actual inflation trends—sapped consumers’ perceived disposable incomes and hurt spending, even as the labor market held up uncharacteristically well during the downturn. Capital spending has contracted for six consecutive quarters, and the inventory cycle is only beginning to turn. On the positive side, employment continues to grow and unemployment is up only slightly from its 10-year low. The resilience of the job market reflects wage moderation and structural reforms enacted in recent years that boosted the use of labor in production and lowered the Non-Accelerating Inflation Rate of Unemployment.

Despite the slowdown, inflation has been persistent. After receding to 2 percent in the second half of last year, headline inflation accelerated sharply in January, in part because of shocks to fresh food prices and price increases associated with the euro changeover. It eased back slowly to below 2 percent in the summer months, aided by lower energy and food prices. Core inflation (excluding unprocessed food and energy) rose continuously through 2000-01 and remained stuck at 2.6 percent in the first half of this year with the first tentative signs of a deceleration appearing only in July. While goods price inflation peaked in February this year and has declined steadily since, service price inflation has failed to decelerate so far.

Starting in May last year, and especially following the events of September 11, the European Central Bank significantly eased monetary policy. In the context of the ECB’s framework, the interest rate cuts were in response to reduced risks to medium-term price stability emanating from second pillar considerations (reduced growth and reversal of oil shocks). First-pillar signals from rapid growth of M3 were discounted as largely representing portfolio shifts in response to increased uncertainty in financial markets. The main refinancing rate currently stands at 3% percent, having been cut in four steps by a total of 150 basis points.

The overall fiscal stance in the euro area has been broadly neutral. The area-wide deficit rose from 0.8 percent of GDP (excluding UMTS receipts) in 2000 to a forecast 1.9 percent of GDP in 2002. This deterioration reflected the effects of the cycle, and the area’s structural deficit was broadly unchanged over the period at 1 percent of GDP. Performance across members of the area, however, diverged. In particular, while eight countries undertook significant cumulative fiscal adjustment over the past five years, the structural deficit (net of large one-off non-financial asset operations) of the three largest countries (France, Germany, Italy) increased over the period, a divergence that has more recently given rise to an intensive debate on the modalities of the Stability and Growth Pact (SGP).

Progress on structural reforms in labor, product, and financial markets has been mixed. On the one hand, labor and to a lesser extent product market reforms continued to lag behind the pace needed to fulfill the ambitious aspirations of the Lisbon agenda. On the other hand, the speeding up of the implementation of the Financial Services Action Plan based on the Lamfalussy process marks a major procedural success.

The baseline prospect remains a recovery, but at a more gradual pace than previously expected. The staff has scaled back growth projections for the euro area considerably, to growth of ¼ percent in 2002 and 2 percent in 2003. The staff’s projections see the year-on-year inflation rate as hovering around 2 percent in the remainder of 2002, reflecting in part base effects, then falling to about ½ percent by late 2003.

Executive Board Assessment

Executive Directors congratulated the authorities for the smooth and successful changeover to euro notes and coins at the beginning of the year, which marked another milestone in European integration. During the past year, overall economic performance in the euro area has been disappointing, with growth weaker and inflation higher than had been expected. Directors noted that while unanticipated shocks—including oil price increases and animal diseases earlier, the external slowdown and financial market turmoil more recently—contributed to this setback, it also reflects a greater-than-anticipated vulnerability of the euro area to shocks. Directors pointed in particular to structural rigidities as underlying factors responsible for the continued dependence of activity on foreign demand and for the persistence of inflationary pressures despite weak domestic demand.

Looking ahead, Directors expected the recovery to be rather gradual, with indicators pointing to continued tepid growth in the near term. The recovery should pick up in 2003, led by consumption, as past price shocks dissipate, and in step with global developments. This will be helped by the overall sound economic fundamentals and the progress achieved on structural reform as reflected in the relative robustness of the labor market. Directors noted, nevertheless, that considerable downside risks remain, including those related to the fragile external environment and the impact of the recent turbulence in financial markets. Against this backdrop, Directors agreed that policies should focus on increasing both the pace and robustness of the area’s performance thus helping to strengthen world growth and facilitate an orderly adjustment of international payments imbalances. In this regard, macroeconomic policy in the period ahead will need to take account of possibly heightened uncertainty, and decisive action on structural reforms will be key to lifting the euro area’s growth potential and reducing its vulnerability to shocks.

Directors considered that, in the current difficult environment, monetary policy has continued to strike the right balance between the risks to inflation stemming from adverse one-off supply shocks and the ongoing weakness of activity. With the recovery expected to be gradual and inflation expected to move back below the ECB’s 2 percent upper limit for price stability, Directors agreed that monetary policy should maintain its present accommodative stance. In view of the predominance and recent increase of downside risks to the recovery, they considered that a clear bias toward further monetary easing would be appropriate. A few Directors saw a case for an early rate cut.

Directors welcomed the steps taken by the ECB to further clarify to market participants the relation between the monetary framework and the policies that issue from that framework. They saw the de facto narrowing of the range of desired inflation outcomes to the upper half of the 0-2 percent official definition of price stability as a useful step toward balancing the benefits of an ambitious inflation objective against the benefits of providing for easier adjustment to shocks and guarding against the risks of deflation. A few Directors encouraged further consideration of an inflation target that would better take account of the challenges faced by members during their transition toward convergence. Directors also welcomed the ECB’s move toward integrating broader financial market and real developments into its analysis of first (or money) pillar developments. A number of Directors considered that this pillar continues to serve a useful purpose as part of the ECB’s two-pillar framework. A number of other Directors, however, noted that the first pillar is likely useful for predicting inflation only in the longer term, and felt that the prominence of money developments in the assessment of risks to price stability over the medium term will remain a challenge for the ECB’s communications to market participants. These Directors, therefore, suggested a further reduced emphasis on the role of developments in monetary aggregates, which should be used primarily as long-term information variables to support policy decisions. Several Directors highlighted, in this context, that money and credit developments can provide valuable signals of emerging financial imbalances that could lead to asset price bubbles.

Directors had a broad-ranging discussion on the appropriateness of the SGP as a fiscal framework for the euro area, and in particular on how, going forward, it should best guide the adjustment of members that have not yet met the Pact’s consolidation objectives. Directors generally considered that the thrust of the SGP is basically in line with the requirements of both the area members and the fiscally decentralized monetary union, and that it provides a forward-looking framework that is reasonably well-tuned to the long-term pressures and debt sustainability issues stemming from the costs of aging populations. But several Directors also highlighted that the SGP’s standing had been hurt by public perceptions that countries are held accountable for achieving nominal balance targets independent of cyclical developments, resulting in pro-cyclical fiscal policy responses. These Directors, therefore, welcomed recent announcements emphasizing the focus on structural balances, although a few Directors cautioned that these may be more difficult to explain to the public.

Directors welcomed the recent collective reaffirmation by the euro area authorities of their commitment to avoid excessive deficits and to the SGP objective of achieving and maintaining budgetary positions close to balance or in surplus over the economic cycle. They noted that a coordinated consolidation approach will be helpful for further enhancing the credibility of the Pact. Directors also noted the positive role that the Pact has played in supporting most members of the euro area in achieving a close-to-balance or surplus underlying fiscal position. They welcomed these fiscal consolidation efforts, and urged that fiscal policies in these countries allow full play to the automatic stabilizers, as envisaged by the Pact.

In several countries, most notably the three largest countries, fiscal adjustment has lagged, in particular during periods of strong growth. These countries, Directors suggested, face the particular challenge of striving to maintain the ambitious medium-term target of achieving fiscal balance while being cognizant of the shorter-term fragility of the cyclical outlook and the demand implications of adjustment. Meeting this challenge will require choosing a path of adjustment to medium-term fiscal targets that both signals credible adherence to SGP rules and maintains a sustainable pace of consolidation. In light of this, Directors endorsed the view that the best way forward will be a concerted and credible commitment by the three largest countries to adjust their underlying fiscal positions by at least ½ percent of GDP per year over the next several years until they reach close-to-balance structural positions. Such an approach would impart needed fiscal credibility at both the national and area-wide levels which could significantly lessen the short-term negative demand effects of the adjustment, particularly if fiscal consolidation is anchored in expenditure reforms. They also saw a need for a comprehensive understanding that—absent breaches of the 3 percent limit—the automatic stabilizers should be allowed to play fully around those adjustment paths. A few Directors considered that a higher priority should be given to supporting the recovery at the present stage, while making a decisive start with much needed pension and health care reforms.

Directors stressed that the scope for raising the area’s potential through structural reforms remains large, and that it has become increasingly urgent to implement the remaining agenda with perseverance, in particular to support the reabsorption of labor. The “new European paradigm” of employment-intensive growth has been a welcome development, but as the employment generating effects of past reforms wear off, further labor market reforms—together with continued wage restraint—become an increasingly pressing priority to maintain the paradigm and bolster the area’s resilience. Directors also emphasized the priority that should be given to the further integration of product markets, which is a long-standing rationale for the EU’s very existence and continues to be hindered by the slow progress in liberalizing trade in services. The new impetus to, and awareness of gains from, financial sector integration is welcome, and, in this context, Directors noted, in particular, the agreement on the Lamfalussy process for speeding up the implementation of the Financial Services Action Plan in securities markets, and the recent agreement on its extension to the banking and insurance sectors.

Directors acknowledged that area-wide statistics are adequate for surveillance purposes but called for improving the timeliness of quarterly national accounts data, and the quality of labor market and short-term business cycle statistics.

With respect to trade policies of the EU, Directors emphasized that, given its prominent role in world trade, the EU has a special responsibility to pursue liberal trade and agricultural policies, improve access to developing country exports, and advance the agenda of multilateral trade liberalization. They welcomed the leading role played by the EU in the successful launch of the Doha round of trade negotiations and the priority given by EU trade policy to further liberalization and better trade rules in the multilateral context. They were encouraged by the fact that further escalation over transatlantic trade disputes, which could have undermined progress under the Doha round, has so far been avoided. Directors considered that reform of the Common Agricultural Policy should be a key policy priority for the EU, given the costs it imposes on EU consumers, trading partners, and agricultural markets. The proposals under the mid-term review of the CAP, which involve delinking financial support from production, are a first crucial step in this direction, and determined political leadership is now required to pursue reform comprehensively, including by aiming to eliminate agricultural export subsidies.

Directors welcomed the EU’s commitment to increase developing countries’ access to its market and urged the EU to go further by being prepared to eliminate or reduce tariff peaks and tariff escalation, including on export products of interest to developing countries. In textiles and clothing trade, quota removals should be accelerated in order to help smooth the adjustment in both EU industries and in those developing country suppliers currently protected by the quota system.

Public Information Notices (PINs) are issued, (i) at the request of a member country, following the conclusion of the Article IV consultation for countries seeking to make known the views of the IMF to the public. This action is intended to strengthen IMF surveillance over the economic policies of member countries by increasing the transparency of the IMF’s assessment of these policies; and (ii) following policy discussions in the Executive Board at the decision of the Board.

Euro Area: Selected Economic Indicators

(In Percent, unless otherwise noted)

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Sources: European Central Bank; Eurostat; Bloomberg; and IMF staff projections.

Staff projections

Harmonized definition.

In percent of labor force.

Data do not include mobile telephone licence receipts.

July value for 2002

October 21, 2002.

Total reserves minus gold (Eurosystem definition); end September value for 2002.

September 2002 relative to 2001 average.


Under Article IV of the IMF’s Articles of Agreement, the IMF holds bilateral discussions with members, usually every year. A staff team visits the country, collects economic and financial information, and discusses with officials the country’s economic developments and policies. In the present case, Fund staff held discussions with European Union institutions, including the European Central Bank, in the context of the Article IV consultations with the euro area’s member states. On return to headquarters, the staff prepares a report, which forms the basis for discussion by the Executive Board. At the conclusion of the discussion, the Managing Director, as Chairman of the Board, summarizes the views of Executive Directors, and this summary is transmitted to the country’s authorities. This PIN summarizes the views of the Executive Board as expressed during the October 18, 2002 Executive Board discussion based on the staff report. The ECB’s observer at the Fund participated in that meeting.

Euro Area: Staff Report on the Monetary and Exchange Rate Policies of the Euro Area and the Trade Policies of the European Union; Staff Supplement; Public Information Notice on the Executive Board Discussion; and Statement by the Executive Director on Monetary and Exchange Rate Policies of the Euro Area
Author: International Monetary Fund