IfW Press Release September 28, 2006

EUROFRAME-EFN Report Autumn 2006
Economic Assessment of the Euro Area: Forecasts and Policy Analysis

The EUROFRAME – European Forecasting Network comprises ten of the most respected economic forecasting and research institutes in Europe, including the Kiel Institute for the World Economy. On behalf of the European Commission, it produces bi-annual reports on the euro area covering economic forecasts, regular policy monitoring and special policy topics. 

Today sees the launch of the network’s report for Autumn 2006. Among the findings contained in the report are the following:

• GDP growth in the euro area is forecast to rise in 2006 to 2.6 percent, well above the 2005 outturn of 1.4 percent and stronger than had been anticipated in our Spring report. Growth will ease in 2007 but, at 1.9 percent, will still be stronger than recent years. Growth for 2008 is forecast to be 2 per cent. 
• The reasons for the slowdown between 2006 and 2007 include the following: 
  • Less supportive external environment, especially the US which has been a main engine of global economic growth in recent years is forecast to slow from a growth rate of 3.5 per cent in 2006 to 2.6 per cent in 2007; 
  • Less supportive monetary conditions with short-term interest rates continuing to rise towards an approximately neutral level by the end of this year and the euro exchange rate having appreciated; 
  • Tighter fiscal policy, including an increase in German VAT rates at the start of 2007 which is likely to dampen demand and lead to some purchases being brought forward to 2006. 
• Inflation in the euro area will remain slightly above the ECB target in 2006 and 2007, at 2.2 percent and 2.3 per cent respectively. In 2008, inflation is forecast to ease to 2 per cent. 
• Although inflation is forecast to remain above the ECB target through 2007, the group forecasts that the ECB will increase interest rates to 3.5 per cent by the end of 2006 but that rates will then be left at this level. This is largely because of the expected slowdown in euro area growth between 2006 and 2007. 
• The euro-dollar exchange rate is assumed to rise slightly to €1.31 by the end of 2008. 

Given the forecast for a slowdown in the US and the possibility that the actual slowdown could be more severe, a detailed analysis of the impact of a softening in the US is included in the report. Using the NiGEM global economic model, the impact of shocks to US house prices and US housing investment are estimated. While the impacts on the euro area are found to be limited, the impact on the US current account imbalance is also limited. Hence, the cloud of US imbalances still hangs over the world economy.

A chapter within the report contains a detailed analysis of economic adjustment within the euro area, including the following conclusions: 

• EMU was successfully achieved with very little economic disruption. However, so far there have been no major asymmetric shocks affecting individual economies within the EMU and so the potential effects of the loss of policy options have not yet been fully tested. 
• Since the adoption of the single currency, the inflation rate in Germany has been the lowest in the euro area reflecting relatively weak demand and labour cost developments. 
• Over the same period, real interests rates in Germany were among the highest in the euro area. This may have contributed to the prolonged slump in residential construction although other drivers of the construction sector such as income growth and demographic change and excess supply from the reunification boom are probably more important. Conversely, in other euro area countries low real interest rates have been a factor behind a strong rise in house prices and strong activity in the construction sector. To manage any potential risk to economic and financial stability from the housing market it is important to prepare the ground for an appropriate use of fiscal policy. 
• Euro area countries are exposed to extra-euro area trade to a different degree. This may be a source of asymmetric shocks originating outside the euro area, in particular in the US. To adjust to such shocks, the flexibility of the economy should be promoted.

Contact:

Prof. Dr. Joachim Scheide
Phone +49 (431) 8814-264
joachim.scheide@ifw-kiel.de

Dr. Klaus-Jürgen Gern 
Phone +49 (431) 8814-262
klaus-juergen.gern@ifw-kiel.de