Growth in the euro area is likely to stay moderate out to 2027 as trade tensions and elevated uncertainty are expected to weigh on activity, despite some boost from higher defence and infrastructure spending, the International Monetary Fund (IMF) has said.
The group said the geopolitical situation in Europe is expected to “dampen sentiment” and “weigh on investment and consumption”, despite looser monetary policy and projected gains in real income.
Headline inflation is projected to remain broadly at target from the second half of 2025, while core inflation will return to 2 per cent in 2026.
Risks to growth are on the downside while they are two-sided for inflation. Trade policy uncertainty, potential tariff escalations, and ongoing geopolitical tensions “may negatively impact” demand and growth more than previously anticipated.
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These factors are expected to outweigh any positive effects of unanticipated fiscal easing, particularly if countries increase defence spending, the IMF said.
Regarding inflation, lower-than-expected non-energy goods prices because of trade diversion, weaker-than-expected activity and wages, as well as the recent euro appreciation could result in inflation below the baseline.
On the other hand, fiscal spending could turn out larger or more inflationary than in the baseline, while geopolitical tensions, supply chain disruptions, and tariff escalation could lead to higher import prices, and wage growth may not moderate as strongly as expected.
In an increasingly challenging global environment, a “comprehensive policy strategy” is needed for “decisive EU-level actions” to boost Europe’s growth potential and financial resilience, it continued.
This includes reforms to strengthen the EU single market, enhance energy security, and orient the EU budget to invest in common public goods.
Ensuring debt sustainability and securing financial and price stability were “essential prerequisites” for the successful implementation of these reforms.
The IMF said the banking system was adequately capitalised and liquid overall, while some banks would “dip into their buffers” under stress.
It identified financial stability risks stemming from interlinkages with non-bank financial institutions and called on the authorities to enhance data sharing, strengthen systemic risk monitoring, and conduct system-wide stress tests.
While welcoming progress on several fronts, including the strengthening of banking supervision and introduction of the new Anti-Money Laundering Authority, fragmentation “continues to hinder” the development of more resilient, deeper, and integrated euro area-wide financial markets.
The IMF said that establishing arrangements for the Single Resolution Fund to offer guarantees – ideally supported by an EU fiscal backstop – was critical for enhancing the provision of central bank liquidity during bank resolutions and will boost the resilience of the euro area-wide financial system.
It also said the activation of the national escape clause of the EU fiscal rules should be limited to the initial phase of scaling up defence spending and not to finance recurring spending over an extended period.
Its directors concurred that non-defence net current expenditures should remain consistent with adopted medium-term fiscal plans and emphasised that it will be important to assess the impact of overall defence spending on debt sustainability on an ongoing basis.
