1. This supplement reports on economic and financial developments in the euro area since the issuance of the staff report. The new information does not alter the thrust of the staff appraisal.
2. The area’s export-led recovery remains on track. The latest indicators support the staff report’s outlook for a continued gradual recovery. In particular, industrial production in May rose at a solid pace (0.7 percent; m-o-m). But the indicators also suggest that, particularly in Germany, the transmission of growth momentum from external to final domestic demand remains sluggish, as illustrated by the weakening of area-wide retail sales in May (-0.9 percent; m-o-m).
3. The outlook for medium-term price stability remains favorable, although headline inflation eased only slightly in June. With oil prices at elevated levels, headline inflation declined only moderately to 2.4 percent in June, from 2.5 percent in May. At the same time, core inflation (headline excluding energy, food, alcohol, and tobacco) ticked up to 1.9 percent, after several months at 1.8 percent. On the wage front, there are, however, no clear signs that the energy-driven spike in inflation has caused a rise in wage pressures. Indeed, high-profile plant level agreements in Germany and France to raise weekly work hours without compensation are viewed as boding well for continued medium-term wage moderation. They also seem to point to greater labor market flexibility at the grassroots than sometimes perceived.
4. In financial markets, equity prices and bond yields have eased moderately since the issuance of the staff report, in line with developments in the United States. Inflation expectations in bond markets—based on ten-year break-even inflation rates—also declined, after peaking at 2.4 percent, but remain above 2 percent. During the first three weeks of July, the euro appreciated by 1½ percent against the U.S. dollar, reflecting in part expectations that the monetary tightening cycle in the United States is likely to proceed at a more measured pace than previously assumed.
5. The European Court of Justice has ruled that the ECOFIN Council overstepped its authority last November when it put the excessive deficit procedures against France and Germany in abeyance. In essence, the Council was wrong in seeking to act outside of the framework of Commission recommendations and past Council decisions. (The Council can only reject or amend recommendations made by the Commission, not issue its own recommendations or alter previous Commission recommendations accepted by the Council). As a result, the excessive deficit procedures against France and Germany remain open. By the same token, there is considerable agreement both on the substance of the requisite policies in the two countries and on the need for the procedures of the Pact to take better account of the economic circumstances. In this respect, the Court’s ruling has enabled a reopening of the discussion on how to resolve the issues confronting the Pact. In the aftermath of the ruling, the Commission has announced that it will consult with the Council and the ECB to formulate more specific proposals for “strengthening and clarifying the implementation of the SGP,” which would be discussed later in the year.
6. Implementation of the SGP has continued:
After the staff report was issued, ECOFIN gave a recommendation to Greece to eliminate its excessive deficit by 2005, requiring action to be taken by November 5, 2004.
It also addressed the excessive deficits in six of the new member states. While these countries are not subject to SGP sanctions, ECOFIN set target dates for bringing their deficits below the 3 percent of GDP reference value, with the dates reflecting these countries’ different starting points and budgetary plans (2005 for Cyprus; 2006 for Malta; 2007 for Poland and Slovakia; and 2008 for the Czech Republic and Hungary).
ECOFIN also opted not to issue an early warning to Italy, as the Italian government committed to implement measures to prevent its deficit from exceeding 3 percent of GDP in 2004. Nevertheless, the rating agency Standard & Poor’s downgraded Italy’s credit rating from AA to AA-, the first such event since the launch of the euro. There were no noticeable movements in bond yield spreads in response to the downgrade.
7. The Commission has tabled far-reaching proposals to overhaul the EU sugar regime. As expected, on July 14, the Commission among other measures proposed cutting back support prices for sugar, reducing subsidized sugar exports, and providing decoupled payments to sugar beet farmers to compensate for their income losses. The changes are proposed to be implemented over four years, with the reform process scheduled to start in July 2005. The proposals have been viewed by some member governments as too radical.