EU growth moderates while inflation temporarily surges

Economic growth is expected to slow to 2.0% this year in the European Union (1.8% in the euro area) as some of the downside risks identified in the autumn forecasting exercise – the ongoing financial turmoil, a sharp slowdown in the US, and high commodity prices – have materialised. This is 0.4 percentage point less, for both areas, than forecast in November.   Inflation this year is expected to average 2.9% in the EU and 2.6% in the euro area following the strong rise in food and energy prices. This is ½ a percentage point more than compared to the previous forecast. But inflation is expected to return to more normal levels in the last quarter of 2008.

“Europe clearly begins to feel the impact of the global headwinds in terms of lower growth and higher inflation. Its increased resilience, thanks to the reforms already carried out, together with sound fundamentals, do help weather the storm. Past efforts to achieve budgetary balance or surpluses also pay off as automatic stabilisers can now play their full role in most cases. But, overall, the best way to cope with the current shocks facing the global economy is to maintain the course of structural reforms, sound and stable macro-economic policies and to deliver rapidly the follow-up actions to the financial turmoil as agreed in the October Ecofin roadmap,” said Joaquín Almunia, Economic and Monetary Affairs Commissioner.

Real GDP growth eased in the fourth quarter of 2007 to 0.5% from 0.8% quarter-on-quarter (QoQ) in the EU (and down to 0.4% QoQ in the euro area). For 2007 as a whole this is estimated to have resulted in an economic growth of 2.9% in the EU and 2.7% in the euro area, according to a recent Eurostat press release. 

For 2008, the Commission’s Economic and Financial Affairs Directorate General now forecast a growth of 2.0% in the EU and 1.8% in the euro area, which represents a 0.4 percentage point downward revision compared to the autumn forecast. This is calculated on the basis of new interim forecasts for France, Germany, Italy, the Netherlands, Poland, Spain and United Kingdom that together account for 80% of the EU’s GDP.

The global environment turns unfavourable

The global economic situation and outlook remain unusually uncertain at the start of 2008. The re-pricing of risk, which began in the summer of last year in the financial markets, is not over yet. As a result, conditions in the international financial system are fragile, as the functioning of several segments of the credit markets has been impaired. Spreads remain wide and the appetite for risk reduced.

The European economies were generally sound ahead of the recent turbulence. But the data for the fourth quarter of 2007 point to a certain moderation of activity, arising from the impact of both a tightening of credit conditions and a slump in the US, causing a slowdown in global growth, which remains nevertheless above its long-term average. The high oil and commodities prices are also playing a role..

At this point in time, survey indicators are of unusual importance to capture the impact of the change in the external environment. After peaking last summer, confidence indicators have been on a steady decline. However, the Commission’s economic sentiment indicator remains above its long-term average in both the EU and the euro area.

The update of the outlook for the seven largest EU economies also indicates that the deceleration in growth could be short-lived, as quarterly figures indicate a certain acceleration in the second half of 2008. This assumes a rapid upturn in the US economy spurred by the sizeable monetary and fiscal easing, together with a gradual normalisation of financial markets.

Inflation higher, on soaring food and commodity prices

In 2007 inflation remained contained at an estimated average of 2.3% in the EU and 2.1% in the euro area, but it picked up in the last quarter. By January 2008 it had risen to an estimated 3.2% on an annual basis. The recent increase has been driven by food and energy prices, together with unfavourable base-effects. Core inflation also increased to 2.3%, which can be attributed to services, non-energy industrial goods and processed food. Price pressures at the producer level have also started to increase. Based on the futures market, the average price for Brent crude oil is estimated at $90 per barrel in 2008, 15% more in USD-terms than assumed in the autumn forecast.

In view of this, the projections for consumer price inflation have been revised upwards by 0.5 pp. for 2008 in both areas: to 2.9% in the EU and 2.6% in the euro area. This upward revision is broad-based across most of the seven largest EU economies on account of higher oil prices. By the end of 2008 though, inflation should be back to just above 2½% in the EU (just above 2% in the euro area), as foreseen in autumn, if, as assumed, food and commodity price inflation taper off.

Risk assessment

The risks to the growth outlook stay on the downside. The US downturn is more marked and the impact of the fiscal and monetary easing remains uncertain. The distress in the financial markets is still ongoing. Lastly, high commodity prices are taking their toll on both European growth and inflation. The risks to the inflation outlook now appear more balanced, but are still on the upside, with the increase in inflation expectations being a particular source of concern.