Europe 2007: Slower Growth, Higher Rates

Households may well face growing pressure due to rising inflation pressures, higher interest rates, and an increased debt financing burden

There was plenty more life in the European economy in 2006 than economists had expected. Gross domestic product in the euro zone—the 13 countries that have the euro as their common currency—reached 2.7% in 2006, which considerably exceeds the 1.9% we at Action Economics and other forecasters originally projected.

But some of the wind should come out of the euro zone's sails in 2007. The better-than-expected performance was due partly to special factors that should unwind next year, leaving a projected 2.1% rate. Though slower, this is in line with the economy's growth potential, and is consistent with further rate hikes from the European Central Bank (ECB).

Gross fixed investment was the main driver of growth in 2006. Balance-sheet restructuring ran its course some time ago, and companies are benefiting from favorable financing conditions. The ECB's bank lending survey showed that banks have eased lending standards in recent years. Bank interest rates remain low, as do bond yields and spreads.

Buoyant Housing Markets

Meanwhile, capacity utilization has accelerated substantially in recent quarters, and is now reaching levels where companies have to address expansion in production capacity in order to meet increased demand. Investment growth is estimated at around 5% for 2006. While a slowdown in 2007 and 2008 is likely, levels should remain robust at around 3.8% and 3.3%, respectively.

Private consumption growth accelerated to 0.6%, quarter over quarter, in the third quarter, after a 0.3% rise in the second. Consumption has been boosted by several factors. Rising net worth has gotten a lift from buoyant housing markets and big house-price gains in some countries. This, in turn, has bolstered private consumption in countries such as Spain and France.

Also, there has been a gradual but steady improvement in labor market conditions, with unemployment coming down in the euro zone overall. Structural reforms have also helped to lift labor participation rates, and these improving job market conditions have lifted confidence and helped to sustain consumption growth.

German Tax Hike Ahead

Furthermore, in Germany there was a positive effect in 2006 from the World Cup matches. More important perhaps, there is evidence that the prospect of the 2007 hike in the country's value-added tax (VAT) prompted consumers to bring forward planned purchases of consumer durables, especially cars. Car sales have been very strong in recent months, as demand that was "pulled ahead" from 2007.

While a tightening labor market should continue to support consumption, there are some downside risks for 2007. First and foremost will be the impact of the German VAT hike, which may be used by some retailers to pass on previous cost increases and lift profit margins. If that is the case, we may see a larger-than-expected rise in German inflation at the start of 2007. This could not only reduce real disposable income, but could also undermine consumer confidence again amid the prospect of higher gasoline prices and health-care costs.

In other countries, rising indebtedness and still-large house price gains are risk factors at a time when interest rates are rising. So far, the signs are that the housing markets will cool off gradually, and house price gains will moderate over time. There still is some risk, though, of a sudden, sharp correction in house prices, as households come under pressure as a result of higher interest rates and the increased debt financing burden.

Solid Demand for Exports

On a more general level, there are still problems with high structural unemployment. Also, with governments trying to cope with the medium-term impact of an aging population, there is uncertainty about the future of the social security system, which is weighing on sentiment and the propensity to spend. Indeed, governments across the euro zone are promoting the build-up of private pension funds, and this is eating into funds available for other purchases.

All in all, an ongoing improvement in the labor market should support consumption, as will recent gains in consumer confidence. Nevertheless, in the light of the above-mentioned risk factors, we expect a slowdown in year-over-year private consumption growth, to around 1.6%, from an estimated 2% in 2006, before a renewed pickup in 2008.

World growth remains robust, and continues to support euro zone exports. The U.S. and Britain remain the most important trading partners, and the euro zone is posting large trade surpluses with both countries. Our central scenario is for still robust U.S. and world growth, and this should continue to support euro zone exports. Low-inflation countries such as Germany have also improved their international competitiveness considerably in recent years, and this is helping exports to remain robust.

Unions Gearing Up

However, import growth is also buoyant, and running very much in sync with exports as the import content of exports is rising and cheap producers in Asia are entering the market. Many companies have relocated part of their production to the new European Union (EU) member countries in the east, or Asia, and this is undermining net exports. Overall, we are looking for a slowdown in both export and import growth to around 5.7% in 2007, from an estimated 8% in 2006.

The benchmark EU inflation rate stood at 1.9% in November, which is slightly below the ECB's upper limit for price stability of 2%. We expect a marked rise at the start of 2007, mainly as a result of indirect taxes and administrative charges, with the German VAT hike the most important factor. So far core inflation has remained relatively subdued, at around 1.5%, and wage increases have remained surprisingly restrained.

But producer price inflation excluding energy accelerated substantially in 2006, and this indicates that previous energy price increases are now feeding through the product chain, and will be felt in consumer price inflation next year. Also, in the light of substantially stronger-than-expected growth, rising profit margins, and falling unemployment, trade unions are gearing up for higher wage demands. We are looking for average inflation of around 2% in 2006 and 2007, and only slightly below that in 2008.

With growth back around potential, and inflation at the upper end of the ECB's definition of price stability, we are looking for further rate hikes from the ECB. We are currently looking for another 25-basis-point hike in March, 2007, and would expect a yearend rate of 4%.

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