By Jan Strupczewski
BRUSSELS, Oct 8 (Reuters) - The euro zone economy will shrink more than expected this year and barely grow in 2013 because of an escalation of the sovereign debt crisis, which will remain the main risk to growth, the International Monetary Fund said on Monday.
"The highest policy priority in Europe is to resolve the crisis in the euro area. Resolving the euro area crisis requires progress toward banking and fiscal union in combination with short-term demand support and crisis management at the euro area level," the IMF said in its World Economic Outlook.
The IMF cut its forecast for euro zone growth this year to a contraction of 0.4 percent from 0.3 percent contraction expected in July. Next year, the euro zone economy is expected to grow only 0.2 percent, rather than the 0.7 percent projected in July, the IMF said.
"The main new development was a further escalation of financial stress during the second quarter in the euro area periphery, which, despite some easing, did not fully reverse in the third quarter through mid-September," the IMF said.
The IMF also said with core inflation in the 17 countries sharing the euro currency under control there was room for lower European Central Bank interest rates.
"With large downside risks to the near-term growth outlook, there is a risk of core inflation undershooting targets," the IMF said.
It forecast inflation would be 2.3 percent this year and 1.6 percent in 2013 - below the European Central Bank's target of below, but close to 2 percent over the medium term.
The ECB's main refinancing rate is now at a historic low of 0.75 percent and economists expect another rate cut this year.
"The ECB should keep its policy rate low for the foreseeable future or reduce it even further. The ECB should also continue to provide ample liquidity to banks," the IMF said.
The IMF, a global lender of last resort, is heavily involved in fighting the euro zone debt crisis, helping to finance Greece, Ireland and Portugal after the three countries have been cut off from market lending at sustainable rates because of bloated public finances and low economic growth.
The bad fortunes of countries under market pressure, which also include Spain and Italy are, however, also affecting strong economies, like the euro zone's biggest Germany, the engine of European economic growth, the IMF said.
Germany was likely to expand only 0.9 percent this year and next, rather than 1.0 percent and 1.4 percent respectively as forecast in July, partly because of the crisis spillovers in Europe where trade and economic ties are close.
Second biggest France would grow only 0.1 percent this year and 0.4 percent in 2013, rather than 0.3 and 0.8 percent respectively as seen in July.
Recession in the third biggest economy Italy would be deeper than previously expected with the economy shrinking 2.3 percent this year and 0.7 percent in 2013. In July the IMF forecast a contraction of -1.9 percent in 2012 and -0.3 percent in 2013.
The fourth biggest Spain, already finalising a loan from the euro zone to recapitalise its banks, would shrink -1.5 percent as expected this year but the contraction next year would be twice as big as previously thought at 1.3 percent.
Of the countries that are under a euro zone/IMF financing programme, 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 euro zone had to be implemented, governments should pay more attention to deficit measures that exclude cyclical swings and one-off budget gains or losses, rather than headline figures.
"Attention should be paid to meeting structural fiscal targets, rather than nominal targets that will likely be affected by economic conditions," the report said.
(Editing by Neil Stempleman)
Keywords: IMF WEO/EUROZONE