Economic outlook for the Euro area in 2007 and 2008

The European Forecasting Network (EFN) is a research group of European institutions, founded in 2001 under the auspices of the European Commission.• Our forecast for GDP growth in the euro area is 2.5% for 2007 and 2.1% for 2008. World financial markets will not be as supportive for growth in the rest of 2007 as they were last year. Asset prices will probably rise much slower, and risk spreads will be slightly higher. The mild deceleration of GDP growth in the US, combined with the US$/euro exchange rate, will not be supportive for exports. However, there will be a positive evolution of private consumption and investment, which will drive GDP growth in the euro area. From a supply-side perspective, the sectors experiencing higher growth will be industry and market and financial services • The favourable developments in the labour markets of the euro area will continue this year, with a further decline in the unemployment rate and an expected acceleration of wage growth. The latter will sustain an increase in private consumption that, as mentioned, will lead to higher GDP growth. • A main risk for our positive forecast, which might be even more relevant in 2008, is a possible downturn of the housing market in some countries that would lead to a slump in consumer demand. Spain might be particularly vulnerable, because the housing boom in that country is combined with a loss in competitiveness due to rising unit labour costs. A significant devaluation of the dollar is also another important risk to take into consideration. • Notwithstanding sustained GDP growth, there is a high probability that inflation in the euro area will remain below 2% in 2007. This is mainly due to the expected evolution in energy prices, which will compensate the higher core inflation in 2007 than in 2006, as well as the strength of the euro. For 2008, our forecast for euro area inflation is 2%. • Conditional on the forecasts for inflation and on the expected evolution of the real economy, there will likely be further increases in the ECB reference interest rate throughout 2007, up to 4-4.25%