Adjustment and Trade in the Euro Area

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Economic growth in the Euro Area remains rather weak, slowing from 1.7 per cent in 2004 to a forecast rate of 1.5 per cent in 2005 before rising to 2.0 per cent in 2006. We see much of the weakness driven by poor supply side performance, with our estimate of trend growth being around 1.6 per cent. Labour market problems in Germany, in part as a consequence of unification, have probably reduced trend growth to just above 1 per cent, whilst trade liberalisation has changed the structure of the Italian economy, and has probably reduced trend growth to around 1 per cent. Further evidence of slow supply side growth has been the increase in inflationary indicators that have been seen as a consequence of the 5 per cent fall in the euro that we have seen since the beginning of 2005. This, in combination with higher oil prices, has led us to revise up our inflation forecast for 2005 by more than 1/2 a per cent. However, a weaker euro is a factor behind strengthening growth in Germany. We expect Euro Area consumption growth to remain flat this year at just over 1 1/4 per cent and to rise modestly to about 1 3/4 per cent per annum over the medium term.

Risks to this forecast remain largely on the downside and stem not only from high oil prices and sustained global imbalances, but also from the apparent paralysis in policymaking that has beset Europe in the wake of recent economic and political shocks. These include, notably, the "No" votes to the European Constitution in France and the Netherlands as well as the breakdown in European budget negotiations last month. In addition the Stability and Growth Pact constrains slow growing countries such as Italy, the Netherlands and Portugal, from using active fiscal policy as a counter measure.

The outlook for European growth outside the Euro Area has also been revised down for this year, but remains more solid over the medium term. Marked downward revisions to annual growth rates in the UK and Sweden have contributed to a reduction in our EU-25 growth projection from 2 per cent to just over 1 1/2 per cent for 2005. Indeed, on June 20th the Riksbank lowered its policy interest rate by 50 basis points to 1 1/2 per cent in an attempt to combat a widespread slowdown in the Swedish economy. The authorities noted that a weak labour market and a fall in both public and private consumption were among the main macroeconomic components to erode at the turn of this year. However, this will help to keep annual inflation comfortably below the Riksbank's target of 2 per cent until the economy rebounds. Further spare capacity will evolve over the course of this year and next since a bleak outlook for the Euro Area will see a slowdown in Swedish exports to that region. The aggressive policy move by the Riksbank is seen by many to underscore its independence from actions taken by the ECB, especially in the face of Sweden's growing ties with the Euro Area.

Exports from the European Union's new member countries also face a weakened short term outlook resulting from slow growth in the Euro Area as well as from recent strengthening of their currencies against the euro, most notably in the Polish zloty and the Hungarian forint. However, the dynamic nature of these economies should help to ensure that overall growth in the medium term remains supported by robust investment and moderate consumption, where restraint in the latter component will improve large current account imbalances. We expect growth in this region to dip this year averaging around 3 1/2 per cent, year-on-year, before posting a strong recovery next year and settling around 4 3/4 per cent per annum over the medium term.

The downward revision in Euro Area growth is due to a number of factors, both country-specific and area-wide. Recessions have materialized in both Italy and the Netherlands with recent revisions to GDP figures uncovering two consecutive quarters of negative growth in each country that spanned the turn of this year. …