Economic outlook and risks

The authorities share staff’s overall assessment of the euro area’s economic outlook, with the economy showing remarkable resilience in a challenging global context. Europe’s robust and timely, coordinated policy response has managed to contain the impact of the energy crisis triggered by Russia’s war of aggression against Ukraine, in part thanks to a rapid diversification of supply and a sizeable fall in gas consumption. A record-strong labour market is bolstering the resilience of the EU economy, with the unemployment rate hitting historical lows, while participation and employment rates are at record highs. In light of the resilience of the labour market, the effects on long-term unemployment may be less pronounced than experienced in past shocks, leading to lower permanent output losses. Markedly lower energy prices are now working their way through the economy, albeit unevenly, reducing firms’ input costs from their peak levels. Consumers are also seeing their energy bills fall, although private consumption is set to remain subdued as household incomes lag inflation.

The authorities agree with the Fund’s assessment of the euro area’s external position and concur that the deterioration in the current account balance in 2022 is likely to be temporary. A gradual increase in the current account balance is expected over the forecast horizon, as terms of trade improve, external demand strengthens, and the services sectors, particularly tourism, fully normalize. The euro area aggregate current account is likely to stay somewhat below pre-pandemic levels over the forecast horizon and some of the dispersion in external positions of Member States will persist although there is high uncertainty around the assessment.

Still, a slowdown is materialising, with prominent downside risks, in particular linked to geopolitical tensions, resurgence of inflation and renewed financial stress. Uncertainty surrounding the economic outlook has diminished, but remains elevated. More persistent core inflation could continue restraining the purchasing power of households and could require a more restrictive monetary policy trajectory. Moreover, renewed episodes of financial stress could lead to a further surge in risk aversion, leading to stress in debt markets and a further tightening of lending standards. An expansionary fiscal policy stance might fuel inflation further, conflicting with monetary policy action. In addition, new challenges may arise for the global economy, related to wider geopolitical tensions. On the positive side, more benign developments in energy prices would lead to a faster decline in headline inflation, with positive spillovers to domestic demand.

Monetary policy and inflation outlook

The authorities share the Fund’s overall assessment of recent inflation dynamics. Euro area headline inflation has declined from its peak in October 2022 but is projected to remain too high for too long. The decline thus far reflected the easing of the shocks behind the surge in inflation, in particular supply bottlenecks and global commodity prices – particularly for energy. Indicators of underlying price pressure remain strong, although some show tentative signs of softening. Headline inflation is expected to continue its downward path, driven by unwinding energy and food inflation. In contrast, core inflation is expected to decline gradually as diminishing pipeline pressures are partly countered by increasing labour cost pressures. There is some heterogeneity of inflation across the euro area. Nominal wage growth is expected to remain above historical averages, gradually compensating for the loss in purchasing power. However, there is no sign of a self-sustaining price-wage loop at this stage and, going forward, firms’ profits may, in many cases, offer a buffer for wages to increase with limited or partially dampened second-round effects. Inflation expectations have remained well-anchored. Well-anchored inflation expectations are crucial for economic agents, notably to underpin well-ordered wage-formation processes and wage-price dynamics compatible with maintaining high employment over the medium term.

The ECB is determined to ensure that inflation returns to the two percent medium-term target in a timely manner. To that end, it has raised its key interest rates by 400 basis points since last July. A forceful transmission of monetary policy tightening to financing conditions can already be observed, while a considerable part of the impact on the economy and inflation is still in the pipeline. In parallel, reinvestments under the Eurosystem’s asset purchase programme (APP) have been discontinued as of July this year.

The ECB’s future decisions will ensure that its key interest rates will be brought to levels sufficiently restrictive to achieve a timely return of inflation to target and will be kept at those levels for as long as necessary. The ECB will continue to follow a data-dependent approach to determining the appropriate level and duration of restriction. In particular, interest rate decisions will continue to be based on the assessment of the inflation outlook, the dynamics of underlying inflation and the strength of monetary policy transmission. Barring a material change to the outlook, it is very likely that the ECB will continue to increase rates in July.

Fiscal policy

The authorities broadly agree with the Fund’s views on fiscal policy in the euro area. Consistent fiscal and monetary policies will facilitate the task of taming inflation and will allow Member States to rebuild fiscal buffers. Member States should adopt prudent fiscal policies in 2023–24 to ensure medium-term fiscal sustainability and, considering the inflation challenges present in their economies, to support the task of monetary policy. Euro area Member States will achieve the necessary overall restrictive fiscal stance in the euro area for 2024 by the implementation of the fiscal recommendations. Emergency energy support measures should be wound down, using the related savings to reduce government deficits, as soon as possible in 2023–24. At the same time, fiscal policy must adapt to changing economic circumstances. Member States should also support potential growth through preserving investment financed by national budgets and ensuring the effective absorption of RRF grants and other EU funds, in particular given common priorities such as the green and digital transitions and defence capabilities. If a renewed shock were to cause energy prices to increase to very high levels again, any support measures taken in response should be targeted and preserve an overall prudent fiscal policy. They should also preserve incentives for energy savings.

Economic Governance Review

On 26 April 2023, the Commission presented legislative proposals to implement a comprehensive reform of the EU’s economic governance rules. The Council of the EU has resolved to process possible next steps with a view to concluding legislative work in 2023. The Commission proposals aim to ensure sound public finances and prepare the EU for future challenges. A transparent and clear application would be key for a successful implementation. The Commission proposals also address the role of the national IFIs, and the Commission remains open to exploring how to strengthen the role of the independent European Fiscal Board while preserving the surveillance role conferred on the Commission. The authorities note the Fund’s support for the swift adoption of reformed fiscal rules. The various elements are encompassed in ongoing discussions in the context of the legislative process. The fiscal guidance proposed by the Commission in May 2023 already reflects elements of its legislative proposals it has assessed as consistent with the existing legislation.

Structural reforms

The authorities agree with the Fund on the need to accelerate the green transition and for growth-enhancing structural reforms and investment. In this respect, progress has been made in the implementation of the RRPs, albeit with uneven progress across Member States. It is very important that Member States accelerate the implementation of the RRP where needed, including by ensuring effective governance and adequate administrative capacity. The REPowerEU, the reformed ETS, and the Green Deal Industrial Plan (GDIP) are key to achieve energy security, reduce dependencies, and mitigate greenhouse gas emissions. An EU Climate Investment Fund could be valuable to help finance public investments with cross-border spillovers but, given possible political hurdles associated with establishing such a mechanism, the focus should be on implementation and absorption of the existing instruments from various initiatives towards the implementation of the 2030 objectives in the Fit-for-55 package.

The GDIP Communication of the Commission sets out ambitious actions to accelerate the green transition and protect the competitiveness of the European clean tech industry. The Plan is based on four pillars: a predictable and simplified regulatory environment, speeding up access to finance, enhancing skills, and open trade for resilient supply chains. The Temporary Crisis and Transition Framework for state aid adopted in the context of the GDIP allow Member States to use flexibility foreseen under State aid rules to help speed up investment and financing for clean tech production in Europe. There is a risk that, given the uneven fiscal space in the various Member States, these flexibilities may adversely affect the level playing field within the EU. On the other hand, granting aid to match that received for similar projects by competitors located outside of the EU is subject to enhanced scrutiny and is given only after providing evidence of material relocation risks, consistent with the EU’s commitment to a rule-based international trading system and to the WTO. In this context, the Commission has also proposed a Strategic Technologies for Europe Platform (STEP).

Openness and rules-based multilateralism are essential elements of trade policy. Trade openness is important to create opportunities for domestic and foreign industry providing access to important inputs. At the same time, to ensure sustainability of supply chains, de-risking through diversification is an important policy objective to strengthening resilience. To ensure the climate viability in the EU’s trade, Carbon-border Adjustment Mechanism (CBAM) will be implemented gradually with a two-year transitional period from October 2023–26 where only reporting requirements will apply and a gradual phase-in from 2026–34, as free allowances under the EU ETS are phased out. The EU will continue engaging and helping its trading partners preparing to comply with the new regime. The CBAM will support global emission reduction efforts by encouraging cleaner industrial production. In addition, for the EU, WTO reform is a core element in our overall trade policy and the next WTO Ministerial Conference is a critical opportunity to advance the WTO reform agenda, in particular with a view to restoring a fully functioning WTO dispute settlement system.

Financial sector

Bank capital, liquidity, and profitability remain resilient. Banks have benefited from the so far limited pass-through of higher policy rates to deposit rates leading to higher profits from net interest income. Unrealised valuation losses from banks’ securities portfolios at amortised cost, due to higher interest rates, are modest at aggregate level. The ongoing EBA-ECB bank stress test will be assessing bank resilience under an adverse scenario which considers a hypothetical aggravation of geopolitical tensions leading to stagflation.

While the banking system should be able to withstand the ongoing tightening cycle, vulnerabilities associated with tighter financial conditions nevertheless warrant continued monitoring. NPLs continue to decline thanks to NPL reduction strategies adopted over the last decade, but credit risk related to tighter financial conditions may materialize with a delay, as consumer, corporate and real estate loans could be exposed to an economic slowdown. As to the latter, supervisors and macroprudential authorities are making considerable efforts to address vulnerabilities in real estate markets.

On 27 June 2023, EU co-legislators reached a provisional agreement on implementation of the final set of international Basel III standards. It will make EU banks even more resilient to possible economic shocks, while contributing to Europe’s transition to climate neutrality. We recall that the EU applies Basel standards also to small- and medium-sized banks. Beyond the implementation of Basel III standards, the package also contains a number of measures to keep the EU prudential framework fit for purpose in terms of sustainability risks and in terms of supervision, including regarding third-country branches. It also provides stronger tools for supervisors overseeing EU banks.

The CMDI proposal is intended as an integral part of the Banking Union architecture, aimed at building a crisis management framework suited for all types of banks, including for small and medium-sized banks. The proposal is a response to the Eurogroup agreement of June 2022 which identified strengthening the common framework for bank crisis management and national deposit guarantee schemes as the immediate next step in its work on completing the Banking Union. Successful completion of the CMDI review could pave the way for possible further measures towards strengthening and completing the Banking Union. We note the Fund’s assessment on the need for a European Deposit Insurance Scheme.

We share the Fund’s assessment that non-bank financial intermediation (NBFI) requires close monitoring. Further work may clarify the use of regulatory tools for investment funds for macroprudential purposes and whether there is a case for more centralized coordination of such macroprudential tools in the EU. A report on the functioning of the EU money market fund regulation is being prepared by the Commission based on ESMA input.

In June, the Commission put forward a two-proposal ‘single currency package’ including a draft enabling framework for a possible future ‘digital euro’ and a proposal on legal tender and the availability of physical euro cash. A digital euro would operate as an additional form of currency – physical euro cash would continue to circulate in the economy. It would be provided by banks and other payment service providers, cheaply available and seamlessly usable throughout the euro area. Security, privacy, and inclusiveness would be key features. The legislative process is ongoing, and the ECB is continuing its investigation and development work. This work is still expected to take a few years before a decision can be taken on issuing the digital euro, based on the legal framework being in place. The EU will keep exchanging with the Fund and international partners on this important issue.

Since a strong European financial architecture is instrumental in attracting sustained investment, supporting innovation and job creation, and fast-forwarding the green and digital transitions, the EU is committed to deepen the Capital Markets Union. The Commission has reported on all elements included in its 2020 CMU action plan. The European Parliament, the current and incoming Presidencies of the Council of the EU, and the Commission pledged to finalise work on the legislative proposals in this area before the European Parliament elections in 2024. Five legislative proposals have already been agreed. The new rules on European long-term investment funds will apply from January 2024 and the European Single Access Point platform is expected to be operational from summer 2027. Political agreement has been reached on CSDR, CRR/D and MIFIR recently, albeit some technical work is still required to finalise the agreement.

Strengthening AML/CFT supervision remains a priority. The AML package contains three pending acts to establish a single EU rulebook and to set up an EU AML Authority, while the regulation providing for the travel rule for Crypto Assets Service Providers has been published in the Official Journal on 9 June 2023.