April 17 (Bloomberg) -- The German economy will expand less this year than was predicted six months ago as the U.S. subprime mortgage crisis spills across the Atlantic, the leading government-sponsored economic institutes said.

The German economy, Europe's biggest, will grow 1.8 percent this year, the institutes said in a joint report today, after forecasting 2.2 percent expansion on Oct. 18. Gross domestic product growth will slow to 1.4 percent next year, less than the economy's long-term average of 1.5 percent, the institutes said.

``The negative effects of developments abroad will gradually filter through over the course of the year,'' Joachim Scheide, an economist at the Kiel-based IfW institute, said at a press conference in Berlin today.

The new forecast adds to signs that financial-market turmoil is damping Germany's economic expansion with a time lag. That's making it more difficult for the government to reach its goal of balancing the budget by 2011 and may fuel disagreement within Chancellor Angela Merkel's coalition on ways to cut spending in the run-up to next year's national election.

German investor confidence fell in April and manufacturing orders declined in February, according to figures published this month, with both reports defying analysts' expectations of improvements. Inflation in March accelerated more than initially estimated, eroding consumers' purchasing power.

`External Impetus'

The ``negative external impetus'' from market turbulence, the euro's record rise against the dollar, oil above $100 a barrel and soaring food prices will become increasingly noticeable during 2008, the institutes said.

Even so, the institutes' estimate for this year is still higher than the government's own prediction of 1.7 percent growth and an April 9 International Monetary Fund forecast of 1.4 percent expansion. The government will publish new forecasts on April 24, including its first outlook for growth in 2009.

``In spite of increased external burdens, there are good chances for the economic advance to continue, albeit at a slower pace,'' Economy Minister Michael Glos said in a faxed statement.

The institutes' forecast of 1.8 percent growth ``looks achievable, I don't see a big downside risk,'' Ralph Solveen, an economist at Commerzbank AG in Frankfurt, said in an interview on Bloomberg Television. ``After a good first quarter with quite a bit of momentum, most of the 1.8 percent is already in the bag.''

Budget Deficit

Finance Minister Peer Steinbrueck's aim of eliminating the federal budget deficit by 2011 is still at risk after his Cabinet colleagues drew up a list of extra outlays of 41 billion euros ($65.5 billion) over the next four years.

The government's medium-term budget plan assumes annual growth of around 1.5 percent. The institutes project expansion at an average annual rate of 1.5 percent in the five years through 2012. The economy grew 2.5 percent in 2007, the second- fastest pace since 2000.

For now, the economic situation in Germany has remained ``favorable'' throughout the spring, ``despite some adverse impetus,'' the institutes said. The economy has become ``more robust'' in recent years and the risk of a recession has become smaller, they said.

Growth will be driven by private consumption as real wages rise and unemployment falls by more than 500,000 on average this year to 3.2 million. Unemployment in 2009 will drop below 3 million for the first time since 1991, with the jobless rate dropping to 6.9 percent, according to the report.

The institutes advised the government to resist using a U.S.-style economic stimulus package to bolster growth, saying it should instead accept a higher budget deficit from growing unemployment benefit payouts should the economy cool further.

`Skeptical' on Stimulus Packages

``We're skeptical that stimulus packages are actually having the desired effects,'' Scheide said in an interview on Bloomberg Television. ``We're also skeptical whether the U.S. package will have a decisive impact.''

Americans receive tax-rebate checks under a $168 billion stimulus package passed by Congress and the U.S. administration in February. In Germany, reductions in corporate tax rates and unemployment insurance premiums are providing an impetus worth 0.5 percent of GDP this year, the institutes said.

Inflation in Germany will accelerate to 2.6 percent this year from 2.3 percent in 2007 before slowing to 1.8 percent in 2009, according to the report. Unit labor costs will increase 1.4 percent this year and 1.7 percent in 2009, hurting the competitiveness of German companies compared with recent years.

Union Wage Demands

While noting ``several fairly high'' pay accords, a wage- price spiral hasn't yet been triggered, Scheide said. Still, if unions insist on compensation for accelerating inflation, it will create a ``big problem'' for price stability, he said.

Based on their forecast of growth of at least 1.6 percent and inflation as high as 3 percent through 2009, the institutes said it's ``appropriate'' for the European Central Bank to keep its main lending rate at 4 percent.

The biannual report was compiled by the Kiel-based IfW; Essen's RWI in cooperation with Vienna's Institute for Higher Studies; Munich's Ifo together with the Swiss Technical College, or ETH, in Zurich; and a group comprising IWH, Vienna-based Wifo and the labor union-affiliated IMK.

To contact the reporter on this story: Rainer Buergin in Berlin at rbuergin1@bloomberg.net.

Last Updated: April 17, 2008 09:01 EDT