Economic outlook for the Euro area in 2009 and 2010

Abstract

- Economic policy will not be able to stop recessions in the developed economies during the first half of 2009; positive announcement effects will be limited because economic agents feel that a recovery is conditioned on a stabilizing financial sector. - For the recession to end, two conditions are crucial: first, government intervention into financial markets has to be effective for some time, so that agents revise their pessimistic views on the short term stability of systemically important banks. Second, the fall in house prices has to subside visibly, at least in the US, so that balance sheets of institutions holding assets based on real estate can stabilize. - In the euro area, the financial crisis will curb production in various ways. In particular, first, it aggravates the housing crisis in Spain and Ireland and undermines housing markets elsewhere; second, the end of the world wide investment boom hits producers of investment goods; and, last, the steep increase in risk premia for bonds issued by states with high debt levels or deficit quotas limits their scope for fiscal action. - As a consequence, our GDP growth forecast for 2009 has been substantially reduced, to -0.5%, with a slight recovery expected in 2010, to 0.8%. Industrial production forecasts have also worsened. The expected average growth rate has been revised downwards to a negative 3.1% for 2009 and will be only slightly positive (0.2%) in 2010. - Inflation expectations in the euro area have fallen sharply since the last report mainly due to the fall in energy prices and, more recently to the fall in food prices. We now forecast HICP inflation to be 1.1% in 2009 and 2.3% in 2010. The consolidation of the inflation reduction process paves the way for the ECB to further reduce the official interest rate during the next months.