Economic outlook and risks

The authorities broadly share the Fund’s overall assessment of the euro area’s macroeconomic outlook. Economic growth is expected to remain steady in 2024 and to slightly strengthen in 2025. This is mainly supported by consumption and investment. Robust employment, unemployment rates at historically low levels and recovering real incomes support private consumption, while the easing of financing conditions as well as Next Generation EU funds help investment. At the same time, medium term growth is expected to be limited by subdued productivity growth and population ageing.

The authorities share the Fund’s overall assessment of recent inflation dynamics. Euro area headline inflation has declined strongly from its peak in October 2022 to 2.5% in June. Looking ahead, it is expected to move sideways over 2024, before moderating to the ECB’s 2 per cent medium-term target in the second half of 2025. The strong downward impact from unwinding energy inflation has faded, but the petering out of past upward shocks and the impact of tight financing conditions should lead to a further gradual easing of inflationary pressures. Domestic price pressures have been slower to ease, also reflecting strong wage growth driven by inflation compensation amidst tight labour markets. Wage growth is likely to remain high in 2024, but profits are expected to partly buffer the still strong labour cost pressures.

The authorities agree that risks to growth are tilted to the downside. The main downside risks to growth are external and related to geopolitical tensions and policy uncertainty, with potential negative effects on the energy market, confidence and in terms of trade fragmentation. These downside risks more than offset upside risks to growth, which comprise positive surprises on foreign demand and a faster decline in the household savings rate. As regards inflation, there are also downside and upside risks. The disinflationary process could accelerate if growth underperforms. Services inflation and firms’ smaller profit margins could prolong above-target inflation, in particular in a context of tight labour markets and if demand holds up better than expected.

Macroeconomic stabilisation

Restrictive monetary policy has eased somewhat recently and contributes to the ongoing disinflation process. After having held key interest rates steady for nine months, the ECB decided to lower them by 25 basis points on 6 June, reflecting the tangible progress toward a timely return of inflation to its medium-term 2 per cent target. However, the ECB is not pre-committing to a particular rate path; it will keep policy rates sufficiently restrictive for as long as necessary to achieve this aim and will continue to follow a data-dependent approach to determining the appropriate level and duration of restriction. In parallel, as of July 2024, the ECB is reducing its portfolio of pandemic-related asset holdings (PEPP) at a measured and predictable pace, intending to discontinue reinvestments in full at the end of 2024. The ECB remains attentive to the smooth transmission of its monetary policy.

The authorities broadly agree on the need for a gradual and sustained fiscal adjustment in many – although not all – Member States, to reduce the high levels of deficit and debt. The current contractionary fiscal stance may have a limited negative impact on output as a substantial part of the fiscal adjustment was an anticipated discontinuation of temporary measures. With the new economic governance framework having entered into force on 30 April, attention has now turned to the implementation phase and Member States are preparing their medium-term fiscal-structural plans to be submitted in autumn. Strengthening public finances while preserving or increasing investment and enhancing productivity remain essential for a competitive, dynamic, and resilient economy and are key concerns for Member States to consider when preparing their plans. Countries with higher public debt and deficit should ensure a credible fiscal adjustment over the medium term in line with the revised governance framework, but this should be carried out in a way that minimizes the impact on growth.

The authorities concur on the need to closely monitor risks to financial stability. Euro area banks have proved resilient to the increase of interest rates. Bank profitability is likely to have peaked but is expected to remain above pre-pandemic levels in the medium term. While uncertainty has diminished since late 2023, some risks remain, including as regards corrections to asset valuations, commercial real estate, as well as unmitigated liquidity mismatches and leverage in nonbanks. In addition, the uncertainty over the implementation of international standards by other jurisdictions increases the risk of regulatory and financial fragmentation. As for macroprudential policy, appropriate countercyclical capital buffers and adequate flexibility in using them in crisis periods should ensure resilience of credit flows at all times. Borrower-based macroprudential measures serve as structural backstops against risky loan origination, tackle risks stemming from the real estate sector and build financial sector resilience over time. Concerning nonbanks, the authorities agree on the need to assess the adequacy of existing policy frameworks, ensure effective implementation of microprudential tools, close data gaps and improve data access and data sharing.

Structural reforms

The authorities agree on the need to boost productivity growth and investment in view of the twin transition. A number of conjunctural factors has recently widened economic divergence between the US and the euro area. Still, there is also a more structural productivity gap to address, explained inter alia by subdued capital deepening, sectoral misallocation, lagging innovation, and slower adoption of innovative technologies. Member States reforms and investments in the context of the RRF will support growth and productivity. Activation policies, investments in up-skilling and re-skilling the labour force, measures to improve working conditions, to support fair intra-EU labour mobility and legal migration can alleviate labour and skills shortages, in line with the European Commission’s Action Plan on labour and skills shortages in the EU. Skills policies can also promote the adoption of new technologies. In addition, the recent migrant inflows, including from Ukraine have contributed to an easing of labour shortages, supporting labour supply. This was also due to policies that were put in place to integrate people fleeing the war in Ukraine in the labour force, most notably the adoption of the Temporary Protection Directive. However, further reforms are still needed in areas like housing, access to childcare, transportation, and healthcare.

A successful implementation of climate policies to meet the 2030 emissions target is key. The Fit -for -55 package comprised policies aimed at reducing EU net greenhouse gas emissions by 55 percent by 2030, relative to 1990 levels. Those, together with measures at the national level should achieve the goal. Member States have revised their National Energy and Climate Plans in order to achieve the targets. In addition, to mitigate the distributional impacts of the climate transition, the Just Transition Fund and Social Climate Fund were created. The Carbon Border Adjustment Mechanism (CBAM) is being put in place to avoid “carbon leakage” to countries with less stringent climate policies, and it is designed to be compatible with WTO rules. It has entered its transitional phase, during which only reporting obligations apply. Financial adjustment will gradually enter into force as from 2026. Engagement with trading partners will continue to ensure a successful and WTO-compatible implementation. The authorities take note of staff’s recommendation for an EU Climate and Energy Security Facility.

The authorities share the staff’s assessment that the increased risk of geoeconomic fragmentation requires a response that strengthens the single market. The EU remains committed to a rules-based, free, fair, open, sustainable, inclusive, and transparent multilateral trading system, with the WTO at its core, while acknowledging that progress in certain areas, such as environment, state intervention and agriculture, has been limited. EU industrial and trade and environmental policies are carefully designed to avoid distortive effects and are not a driver of fragmentation risks globally. The EU has developed analytical tools to identify and address potential vulnerabilities. The EU acknowledges the need to manage strategic dependencies, including by diversifying supply sources, with the objective to de-risk supply chains rather than to de-couple from some partners. The EU’s Economic Security Strategy aims to strengthen its toolkit along several dimensions, including investment screening and export controls. The EU is focused on reinforcing its sovereignty in strategic sectors and making Europe a technological and industrial powerhouse, while promoting an open economy. The EU’s state aid rulebook, which has been streamlined and updated to take account of green transition priorities, can help limit subsidies with detrimental effects on the single market and trade partners, while supporting the economy in the new context. The authorities take note of staff’s input on priorities for the EU budget and related considerations on the advantages of EU-level instruments and common procurement in areas such as the green transition and defence.

Developing the Capital Markets Union (CMU) is essential for strengthening competitiveness and innovation and for achieving policy priorities. Integrating capital markets would boost productivity and promote the much-needed investment, scaling up the European market and allowing for better risk-sharing. The EU has made substantial progress with legislative measures towards the CMU and the Eurogroup has identified a comprehensive set of further measures to be undertaken. Options such as “enhanced cooperation” and “28th regime” -style arrangements come with their own specific challenges and risks and may need to be carefully considered in each specific case. The authorities also agree on the need to complete outstanding Banking Union initiatives, in particular the reform of the Crisis Management and Deposit Insurance framework, as well as ratification of the ESM Treaty, notably to enact the common backstop for the Single Resolution Fund. CMU and the Banking Union together are critical for improving opportunities for investors, businesses, and citizens and promoting sustainable growth and financial stability.