Chapter 1: The European Economy: Macroeconomic Outlook and Policy

The economic recovery in Europe is expected to continue. GDP in the euro area is forecasted to grow by 2.0 per cent in 2006, remaining lower than in most other parts of the world. Inflation in the euro area is expected to reach 1.9 per cent this year. The labour market situation will only improve marginally. Macroeconomic policies in the euro area are heading towards an undesirable mix of monetary and fiscal policies. The ECB is likely to tighten monetary policy, whereas the stance of fiscal policy will probably remain more or less unchanged. Such a mix is inimical to growth. For reasons of long-run sustainability, structural budget deficits in the euro area should be reduced. This would leave room for a looser monetary policy than would otherwise be possible. Key to a better policy mix is a restoration of incentives for fiscal discipline, which were watered down by the 2005 reform of the Stability Pact. One way of achieving this could be for the ECB to reform its monetary policy framework, involving a rise in the inflation target, conditional on a strengthening of fiscal policy institutions. A small group of fiscally responsible EU states could also take the lead by entering into enhanced fiscal policy co-ordination.