Economic outlook for the Euro area in 2006 and 2007

The European Forecasting Network (EFN) is a research group of European institutions, founded in 2001 under the auspices of the European Commission.• The global economy has continued to expand briskly in the summer of 2006, but in the second half of this year and in the first half of 2007, the upswing of the world economy will lose momentum in the wake of slower growth in the US. In addition, monetary policy has become less expansionary in all important countries, threatening the widespread housing market boom. Finally, fiscal policy will be slightly restrictive in the US, in the euro area, and in Japan in 2006 and 2007. • In the first half of 2006 output in the euro area expanded at the fastest pace in five years, with particularly strong investment activity. Firms have at last reacted to conditions that have been beneficial for the past two years: cheap capital due to low real interest rates and rising equities, and a moderate growth in unit labour costs. • Demand in the euro area will expand at a more moderate rate in the second half of 2006 and in the beginning of 2007: exports will suffer from the appreciation of the euro relative to dollar and yen during spring and summer 2006, and from weaker stimuli from the world economy, in particular from the US. Economic policy will dampen as well: the ECB appears to be determined to reach a neutral monetary stance quickly; and in 2007 fiscal policy will be clearly restrictive in Italy and in Germany. • Conditions in the labour markets, however, will further improve, due to reforms in some countries and wage moderation in the past few years. As a consequence, consumer confidence is strengthening and will ultimately support private consumption. Therefore, after a weak spot in the coming autumn and winter, growth in the euro area will recover. • Our forecasts for GDP growth in the euro area are 2.4% in 2006 and 1.8% in 2007. Industry and market and financial services will be the motor of growth from a supply side perspective. Industrial production will grow by 3.5% in 2006 and 2.5% in 2007, driven by capital goods. • The forecasts for headline and core inflation in the euro area for 2006 have been revised downwards, to 2.2% and 1.4%, respectively. Considering the impact on euro area inflation of the three percentage point increase in the German VAT rate, and assuming that 80-85% of the rise will be transferred to consumer prices, our headline and core inflation forecast for 2007 are around 1.9% and 1.7%, respectively