Strengthening Signals for the Eurozone

Robust domestic demand and investment growth are fueling economic optimism for the 2006 second half, but uncertainty looms over 2007

The economic fortunes of the eurozone, the economic grouping of the 13 European countries that share the euro as their common currency, appear to be brightening. On Sept. 6, the EU commission became the latest institution to lift its 2006 GDP growth forecast for the eurozone, now pegged at 2.5%. This is in line with the latest macroeconomic projections from European Central Bank staff, and Action Economics' own revised forecast.

Uncertainty about the outlook for 2007 is rising, however. We see a marked slowdown to just 1.8% growth, but the latest ECB staff projections foresee growth around 2.2%, with inflation expected to remain clearly above 2%. Given the stronger ECB outlook, it's not surprising that the central bank is eager to bring interest rates back to at least a neutral level—one which keeps both economic growth and inflation at acceptable levels—which we assume to be near 4%.

Eurozone second-quarter GDP data came in above expectations at a very strong 0.9% quarter-over-quarter, and first-quarter data were revised up to 0.8% quarter-over-quarter from an initially reported 0.6%. The breakdown showed that growth in the second quarter was mainly boosted by strong domestic demand, and especially investment growth. Private and government consumption were more subdued, and net exports contributed just 0.1% to the quarterly rate.


  The country breakdown showed 1.1% growth in France, and a still very strong 0.9% quarter-over-quarter in Germany. Italy lagged behind, with growth of just 0.5%. The recovery is now broadly balanced, and the pickup in domestic demand is encouraging.

Second-quarter private consumption decelerated to 0.3% quarter-over-quarter from an upwardly revised 0.7% in the first quarter. The first-quarter data were likely boosted by the fact that cost-conscious consumers held off making purchases around Christmas and waited for the January sale season instead. As such, an average of the last two quarters gives a more accurate indication of the underlying trend.

Looking ahead, the labor market seems to have bottomed out, which is good news. But energy prices remain high, and while a hike in Germany's value-added tax (VAT) will help to bolster consumption growth in the second half, this consumption will be pulled ahead from 2007. Consumers in countries with a high share of owner-occupied housing will also feel the sting of the ECB's rate hikes in the coming year, as home-price growth moderates.


  Government consumption decelerated to 0.4% quarter-over-quarter in the second quarter, from an upwardly revised growth rate of 0.8% in the first. Investment growth accelerated to 2.1% quarter-over-quarter in the second quarter, from 0.9% in the first. Improved demand has spurred investment, and companies continue to benefit from favorable financing conditions. Strong credit growth, eased lending standards, and still low interest rates will remain supporting factors in the second half.

Export growth decelerated to 1.3%, from a revised 3.9% in the first quarter. At the same time, import growth came off to 1.2% quarter-over-quarter, versus 2.9% in the first. Robust global demand still supports export growth despite a somewhat stronger euro. But, the import content of exports has increased too, and with many companies having relocated at least part of their production base abroad, a pickup in exports often goes hand in hand with stronger imports. The deceleration in export growth meant net exports added just 0.1% to the quarterly growth rate in the second quarter, vs. 0.4% in the first.

For the eurozone as a whole, the fact that growth is now broadly balanced between domestic and external growth also on a country level is a very good sign for the sustainability of the recovery. We do expect a deceleration in the quarterly growth rates in the second half, in line with the dip in recent survey findings. But annual growth should remain very robust. Therefore we have lifted our forecast for 2006 GDP growth to 2.5%, which is in line with the mid-point of the ECB staff projections, as well as the latest EU commission forecast.


  While the economic recovery this year looks much stronger than hoped for, there is considerable uncertainty about the outlook for next year. Growth will be hit by the three-percentage-point VAT hike in the eurozone's largest economy, Germany. More importantly perhaps, high oil and commodity prices as well as a cooling world economy will have an impact on the eurozone outlook. The ECB is playing down the importance of U.S. developments for the eurozone, but investors are not so convinced.

The German ZEW survey, which is the most forward-looking of all leading GDP indicators, has dipped sharply in recent months, and it seems investors still believe in the saying "if the U.S. sneezes, Europe catches a cold."


  The ECB is more optimistic, and the staff projections foresee a mid-point of 2.2% GDP growth in 2007. With inflation likely to remain above the ECB's upper limit for price stability this year and next, it is no surprise that the central bank is eager to bring official rates closer to neutral. Two more 25-basis-point hikes in the ECB's benchmark refi rate are likely in October and December, which would bring yearend rates to 3.5% from the current 3.0%.

ECB officials stress that they do not follow the concept of a neutral rate, but a recent research paper from the central bank suggests that the neutral real interest rate declined over the past decade and was slightly below 2% in 2004. This still puts a neutral nominal rate near 4%.

If we are right, and growth at the start of 2007 slows more than the ECB currently expects, the central bank may not stick to its current pace of rate hikes every two months. We expect a longer pause after the December hike.

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