By Jan Strupczewski
BRUSSELS, Oct 8 (Reuters) - The euro zone economy willshrink more than expected this year and barely grow in 2013because of an escalation of the sovereign debt crisis, whichwill remain the main risk to growth, the International MonetaryFund said on Monday.
"The highest policy priority in Europe is to resolve thecrisis in the euro area. Resolving the euro area crisis requiresprogress toward banking and fiscal union in combination withshort-term demand support and crisis management at the euro arealevel," the IMF said in its World Economic Outlook.
The IMF cut its forecast for euro zone growth this year to acontraction of 0.4 percent from 0.3 percent contraction expectedin July. Next year, the euro zone economy is expected to growonly 0.2 percent, rather than the 0.7 percent projected in July,the IMF said.
"The main new development was a further escalation offinancial stress during the second quarter in the euro areaperiphery, which, despite some easing, did not fully reverse inthe third quarter through mid-September," the IMF said.
The IMF also said with core inflation in the 17 countriessharing the euro currency under control there was room for lowerEuropean Central Bank interest rates.
"With large downside risks to the near-term growth outlook,there is a risk of core inflation undershooting targets," theIMF said.
It forecast inflation would be 2.3 percent this year and 1.6percent in 2013 - below the European Central Bank's target ofbelow, but close to 2 percent over the medium term.
The ECB's main refinancing rate is now at a historic low of0.75 percent and economists expect another rate cut this year.
"The ECB should keep its policy rate low for the foreseeablefuture or reduce it even further. The ECB should also continueto provide ample liquidity to banks," the IMF said.
The IMF, a global lender of last resort, is heavily involvedin fighting the euro zone debt crisis, helping to financeGreece, Ireland and Portugal after the three countries have beencut off from market lending at sustainable rates because ofbloated public finances and low economic growth.
The bad fortunes of countries under market pressure, whichalso include Spain and Italy are, however, also affecting strongeconomies, like the euro zone's biggest Germany, the engine ofEuropean economic growth, the IMF said.
Germany was likely to expand only 0.9 percent this year andnext, rather than 1.0 percent and 1.4 percent respectively asforecast in July, partly because of the crisis spillovers inEurope where trade and economic ties are close.
Second biggest France would grow only 0.1 percent this yearand 0.4 percent in 2013, rather than 0.3 and 0.8 percentrespectively as seen in July.
Recession in the third biggest economy Italy would be deeperthan previously expected with the economy shrinking 2.3 percentthis year and 0.7 percent in 2013. In July the IMF forecast acontraction of -1.9 percent in 2012 and -0.3 percent in 2013.
The fourth biggest Spain, already finalising a loan from theeuro zone to recapitalise its banks, would shrink -1.5 percentas expected this year but the contraction next year would betwice as big as previously thought at 1.3 percent.
Of the countries that are under a euro zone/IMF financingprogramme, only Ireland will show growth this year and next,expanding 0.4 percent and 1.4 percent respectively.
The IMF said while fiscal consolidation plans in the eurozone had to be implemented, governments should pay moreattention to deficit measures that exclude cyclical swings andone-off budget gains or losses, rather than headline figures.
"Attention should be paid to meeting structural fiscaltargets, rather than nominal targets that will likely beaffected by economic conditions," the report said.
(Editing by Neil Stempleman)
Keywords: IMF WEO/EUROZONE