International Monetary Fund missions are undertaken as part of regular consultations under the IMF’s articles of agreement. IMF staff members--Tarak Jardak, Tara Iyer, Emil Stavrev and Michele Fornino--spent two weeks in Luxembourg holding “insightful and productive” discussions with the private sector, Luxembourg authorities, trade unions and businesses, before publishing a on 10 March.

“The Luxembourg economy has proven resilient, despite the challenging international environment,” said Emil Stavrev, deputy division chief and economist at the IMF. “We forecast the GDP growth to slow moderately this and next year--to around one and a half to two percent. This reflects mostly weak external demand and real estate activity.”

“Expansionary fiscal policy has alleviated the impact of the cost-of-living shock on demand, with the implemented energy price controls and a VAT rate cut temporarily reducing pass-through to domestic prices,” Stavrev added. They expect inflation to moderate, but “core inflation is stubborn,” and “is forecast to remain high--around 4%.”

Risks have become “less prominent recently,” noted Stavrev. These stem from “potentially recessionary pressures in major economies, tighter-than-anticipated monetary policy which could have adverse implications for inflation and growth trade-offs and disorderly financial market adjustments due to central bank decisions.” That being said, a more resilient global economy and pent-up demand in Luxembourg could boost growth.

Fiscal policy advice

Luxembourg has a strong labour market, said Stavrev. “In our view, fiscal policy for this year risks over-simulating demand, limiting incentives for energy savings and impeding adjustments of housing prices.” Therefore, the IMF staff recommends a “broadly neutral fiscal policy for this and next year, and better targeted support measures to help vulnerable people in need.”

Tax bracket adjustments

Regarding medium-term fiscal policy, Stavrev drew attention to a recommendation in the IMF’s concluding statement: more frequent adjustment of the tax brackets, which “should be done in a budget-neutral way.” “This is very important,” he highlighted. “A budget-neutral way means that the government balance won’t worsen after the adjustment of the tax brackets is done.” This should be carried out within a “comprehensive review of the tax benefit system of the country.”

Financial sector risks, housing recommendations

Risks in the financial sector have “intensified” since the IMF’s last mission in February 2022, “but the financial system appears in good position to weather shocks.” They recommend closely monitoring “pockets of vulnerabilities,” such as in the real estate sector.

“There is a structural disbalance between supply and demand in the housing sector,” Stavrev said in response to a question on proposals for what the government should do in the housing sector. It’s important “to act on alleviating constraints that are existing in the housing sector.” There are already some measures, such as increased taxation for unused land or unused dwelling--those measures contribute to improving supply conditions, noted Stavrov.

Stavrev mentioned that they’d like to see some housing projects brought forward, using government support, in order to “contribute to boosting supply.” Luxembourg is a small country that comes with space constraints, he admitted, “but within those constraints, you can do more,” such as relaxing regulations to allow the construction of taller buildings. This would allow for a “more efficient use of land, without necessarily having adverse implications for how communities look.” With the possibility of remote work, land outside of Luxembourg City--where there used to be less demand--could be used to build houses as well.

Reforming the wage indexation system

The grand duchy’s automatic wage indexation system “has not caused major challenges in a period of low inflation,” said Stavrev. The past few decades, in fact, have been called “the great moderation” by economists. But the large increase in energy prices--“energy price shock”-- has raised concern about wage-price spirals and the ability of firms to adjust to the shock of high energy cost increases, he added.

“Against this background, reforming the automatic wage indexation, together with measures to contain the cost of living--in particular housing--could help continue attracting talent to Luxembourg, as you’ve done over the past decades, while preserving competitiveness.”

The IMF mission’s concluding statement presents a few possibilities for this reform, said Stavrev, including: indexing wages to core inflation, targeted support for the most vulnerable parts of the population, introducing progressive considerations in wage indexation (meaning that more is given to lower income quintiles, and less to people in higher-income quintiles), and a rule-based suspension of the indexation system, taking into account elements of competitiveness (such as how wage costs evolve in trading partner or neighbouring countries).