Kiel Institute Economic Outlook: Final Stages of the Upswing are Looming

Cargo ship at sea

Germany is entering the final phase of the current five-year upswing, and the downturn is likely to begin at the beginning of the next decade. This is the result of the autumn forecast presented today by the Kiel Institute for the World Economy (Kiel Institute). The experts have revised their forecast for the gross domestic product (GDP) growth rate for the coming two years slightly downwards again compared to the economic outlook in the summer and now expect a rate of 1.9 percent (-0.1 percentage points) for 2018 and a rate of 2.0 percent (-0.3 percentage points) for 2019. Looking back, exports and corporate investment in particular developed worse than initially predicted. In addition, official statistics have been revised, suggesting a somewhat weaker economic momentum overall.

Experts expect GDP to grow by 1.9 percent in 2020, but the reason for the still quite high rate is also the high number of working days. After adjusting for working days, the increase amounts to only 1.6 percent. "The boom in Germany is not over yet, but at the beginning of the next decade the cyclical counterforces will become stronger and stronger as capacity reserves continue to be exhausted, and Germany must prepare itself for the downturn," said Stefan Kooths, Head of the Forecasting Centre at the Kiel Institute.

Disposable incomes rise sharply

According to the experts, the business climate values in the service sectors, the construction industry, and also in the manufacturing sector have recently brightened significantly, indicating that the economic momentum will initially pick up again after a weaker start to the year. In addition to foreign business, it is above all consumer-related sectors that are contributing to the upswing in the domestic economy in its sixth and seventh years. The favorable labor market situation is leading to significant increases in wage income among employees, which is typical for the late phase of an upswing. In addition, the disposable incomes of households are increased by measures taken by the federal government, which provide for a reduction in tax rates and an expansion of social benefits, for example in the pension fund.

At 5.3 percent, the net wage bill is likely to rise next year as strongly as it has not since the reunification boom and will also increase more strongly than the corresponding gross figure. As a result, private consumer spending is likely to expand strongly, by 1.5 percent this year, by 2.2 percent next year and by 1.9 percent in 2020. The state is also increasing its consumer spending more significantly again. Inflation is likely to be around 2 percent over the entire forecast period.

In addition, thanks to the robust economy in the German sales markets, exports are also likely to increase significantly again, provided that protectionist initiatives or other political disruptive maneuvers do not once again put a spanner in the works of the global economy. The Kiel Institute experts anticipate export growth rates of 3.2 percent (2018), 4.7 percent (2019) and 4.8 percent (2020).

Capacity Bottlenecks Slow Down Production, Structural Red Zero in the Public Budget

"All in all, there are increasing signs that the German economy is entering the late phase of the upswing, as significantly tightened capacities, which are reflected in bottlenecks in personnel, intermediate goods, and equipment, for example, stand in the way of a stronger expansion of production," said Kooths. "The capacity squeeze is particularly pronounced in the construction industry, which has been booming for several years and recently recorded the highest price increase in 25 years. The overall picture of significantly tighter capacities is also confirmed by our estimates of the overall economic output gap, which we estimate to be at its highest level for the current year since 2008."

Due to the strong economy, public budgets are likely to record another record surplus in 2018, amounting to around 53 billion euros, or 1.6 percent of GDP. In the coming year, tax cuts, higher investments and social security benefit increases will lead to a reduction in the budget balance. In 2020, government expenditure will no longer be covered by tax revenues after adjustment for cyclical fluctuations. "Structurally, today's noticeable budget surpluses will turn into a red zero within two years," Kooths said. "With its tax and transfer policy, the federal government is fueling the boom instead of curbing it, as would be necessary in terms of stabilization policy. Provisioning for the looming weak growth in the 2020s would look different."

Euro Zone: Upswing Continues at a Slightly Slower Pace

GDP in the euro zone is expected to grow by 2.1 percent in the current year, with the growth rate likely to decline slightly to 1.9 percent (2019) and 1.7 percent (2020) over the next two years. Although the economy in the euro zone has lost momentum since the beginning of the year, the general conditions for a continuation of the upswing remain favorable. Low interest rates and a slightly expansive financial policy will continue to support the economy in the future, and many leading indicators point to a continued expansion of production, albeit at a more moderate pace than in the previous year.

The unemployment rate is declining and in 2020 it is likely to fall below its pre-global financial crisis low, which should lead to tensions on the labor market in many countries. Wage dynamics in the euro zone have recently shown a clear upward trend, and consumer price inflation is likely to be 1.7 percent in each of the years 2018 to 2020.

Global Economy: Positive Outlook despite Significant Risks

The upturn in the global economy lost some of its momentum this year. The renewed strong increase in global production in the second quarter followed a weak trend at the beginning of the year and probably exaggerated the underlying economic momentum. Economic trends are also showing a stronger international spread than in the previous year. In addition, the trade conflicts emanating from the United States and a withdrawal of financial investors from the emerging markets are currently weighing on the outlook. On the oil market, the imminent implementation of the Iranian sanctions could provide a further price push. Core inflation is likely to pick up gradually. For 2018, however, the Kiel Institute experts still expect global production to rise by 3.8 percent, while for 2019 they have reduced the forecast somewhat - by 0.1 percentage points - to 3.5 percent.

Uncertainties about the Economic Policy Course of the USA and Italy

Significant downside risks for this forecast lie above all in a worsening of the pending international trade conflicts. "This is also a challenge for German policymakers," warns Kooths. "The Federal Government should send clear signals for open markets in view of the spreading protectionist tendencies in the global economy. The stricter monitoring of foreign investors in corporate investments in Germany could easily be misunderstood as protectionist foreclosure, especially against the background of considerable current account surpluses."

The imminent withdrawal of the United Kingdom from the European Union is likely to leave its mark on the economy only in the absence of an agreement. There is also the threat of an institutional crisis in the euro zone unless the new Italian government gives in to budgetary policy. "A currency area cannot function without a fundamental monetary consensus. If Italy now dismisses this agreement, the euro will face turbulent times," Kooths said.