Economic outlook for the Euro area in 2005 and 2006

Abstract

• In 2005 the upswing of the world economy slows down to moderate growth. Expansion dynamics are high in most emerging market economies and close to potential in the US; however, high commodity prices, in particular for crude oil, continue to dampen world economic growth. Moreover, China gives weaker impulses for world trade due to the restrictive measures of Chinese economic policy. • Rising interest rates and more cautious household spending behaviour will stabilise the current account deficit in the US at the end of 2005. As a result, the chances are good that the recent appreciation of the dollar versus the euro will last. Our forecast is an exchange rate of 1.27 for 2005 and 1.24 for 2006. • Despite quite favourable financial conditions, business investment will only gradually gain momentum in the euro area. In 2005, the y-o-y rates are positive, but show a slight downward trend. Acceleration is expected not before 2006. Private consumption will modestly increase. Consumers in the euro area appear to be cautious in view of the budget problems in many member states, as well as of sustainability problems affecting pay-as-you-go pension and health insurance systems, and the weak performance of national labour markets. • Since the first quarter of national accounts data indicated only a slow acceleration in the euro area, this outlook is a bit more cautious than the one published by the EFN in March. Also, oil prices are again on record levels, and economic sentiment indicators point to a reduction of economic growth in growth in 2005. • Due to the pressure of international oil prices, our inflation forecasts for the euro area have been revised upwards to 2.1% in 2005 in spite of a significant improvement in goods core inflation. In view of this figure, we continue to forecast that the European Central Bank is unlikely to change its reference interest rate until mid-2006. For this year we expect an inflation rate of about 2.0%. • The forecast is also slightly more pessimistic than some others, possibly due to our strictly econometrically based approach, with models not taking into account the recent structural reforms in some member countries. We think that the positive effects of these reforms will not materialise in a short period of time but rather gradually over the coming years. Neither is the burden of political turbulence inside the euro area on economic sentiment captured by these models.