Economic Assessment of the Euro Area: Forecasts and Policy Analysis

Economic Assessment of the Euro Area: Forecasts and Policy Analysis

Embargo: Friday 29th September 2006 at 00.01a.m.

EUROFRAME - European Forecasting Network

The EUROFRAME - European Forecasting Network comprises ten of the most respected economic forecasting and research institutes in Europe, including the ESRI. On behalf of the European Commission, it produces bi-annual reports on the euro area covering economic forecasts, regular policy monitoring and special policy topics.

Today sees the launch of the network's report for Autumn 2006. Among the findings contained in the report are the following:

· GDP growth in the euro area is forecast to rise in 2006 to 2.6 percent, well above the 2005 outturn of 1.4 percent and stronger than had been anticipated in our Spring report. Growth will ease in 2007 but, at 1.9 percent, will still be stronger than recent years. Growth for 2008 is forecast to be 2 per cent.

· The reasons for the slowdown between 2006 and 2007 include the following:
o The growth rate for 2006, at 2.6 per cent, is higher than the trend rate and so a reversal to the trend line is expected;
o The US is forecast to slow from a growth rate of 3.5 per cent in 2006 to 2.6 per cent in 2007;
o An increase in German VAT rates at the start of 2007 is likely to lead to some purchases being brought forward to 2006.

· Inflation in the euro area will remain above the ECB target in 2006 and 2007, at 2.2 percent and 2.3 per cent respectively. In 2008, inflation is forecast to ease to 2 per cent.

· Although inflation is forecast to remain above the ECB target through 2007, the group forecasts that the ECB will increase interest rates to 3.5 per cent by the end of 2006 but that rates will then be left at this level. This is largely because of the expected slowdown in the euro area between 2006 and 2007.

· The euro-dollar exchange rate is forecast to rise only marginally to €1.31 by the end of 2008.

Given the forecast for a slowdown in the US and the possibility that the actual slowdown could be more severe, a detailed analysis of the impact of a softening in the US is included in the report. Using the NiGEM global economic model, the impact of shocks to US house prices and US housing investment are estimated. While the impacts on the euro area are found to be limited, the impact on the US current account imbalance is also limited. Hence, the cloud of US imbalances still hangs over the euro area.

From Ireland's perspective, the important features of the forecasts include the following:

· The continued increases in ECB interest rates will lead to further increases in mortgage re-payments. However, the forecast of the group suggests that the end to interest rate increases is in sight.

· The US is likely to slow down in 2007. Although the impact on the euro area as a whole may be limited, the impact on Ireland will be stronger given our relatively stronger trade links. Flexibility within the Irish economy will be needed if the impact of any US shock is to be minimised.

The report contains a detailed analysis of macroeconomic differentials and adjustment in the euro area. The following conclusions are relevant for Ireland:

· EMU was successfully achieved with very little economic disruption. However, so far there have been no major asymmetric shocks affecting individual economies within the EMU and so the potential effects of the loss of policy options have not yet been fully tested.

· Over the period 1999-2005, the average annual inflation rate in Ireland has been the highest in the euro area reflecting primarily domestic costs developments. In particular, unit labour costs growth above the euro area average has been driven by the compensation per employee dynamics while labour productivity growth was less important.

· Over the same period, average annual real interests rates in Ireland have been the lowest in the euro area. While real interest rates have affected house price inflation, other drivers of the construction sector such as income growth and demographic change have been probably more important. Potential risk to economic and financial stability from the housing market should be closely monitored.

· Ireland has a high exposure to extra - euro area trade. This may be a source of asymmetric shocks originating outside the euro area, in particular in the US. To adjust to such shocks, the flexibility of the economy should be promoted.

For further information contact:
Prof. John Fitz Gerald, ESRI @ 667 1525 (office)
Dr. Alan Barrett, ESRI @ 667 1525 (office)
Dr. Iulia Traistaru-Siedschlag, ESRI @ 667 1525 (office)