Key issues facing the global economy outlook for the European economy: regaining prominence in the global economy?
Presentation by Jürgen Stark
Member of the Executive Board of the ECB
2006 Annual Membership Meeting of the IIF
Singapore, 17 September 2006
To start with, for me the answer to the question put forward in the headline is a clear “Yes”: the euro area will in my view indeed gain prominence. In the next few minutes I will explain why.
My first slide presents the latest macroeconomic projections prepared by ECB staff.
Regarding economic activity, it is projected that real GDP in the euro area will stabilise at growth rates which are largely in line with potential growth over the projection horizon. This view is shared by other international institutions, such as the IMF.
More specifically, real GDP growth is projected to be in a range between 2.2% and 2.8% this year, which is a significant improvement compared to the growth rate of 1.5% observed in 2005. According to Eurostat, the official statistical institute for the EU, on a quarter-on-quarter basis, real GDP grew by 0.9% in the euro area in the second quarter of 2006, following strong growth also in the first quarter (0.8%) – thus leading to an annualised growth rate of 3½% in the first half of 2006, which is the fastest pace in more than 5 years. In particular, domestic demand has contributed strongly (by 0.7 percentage points) to this favourable development. This confirms the view that euro area economic growth has been now more broadly based and also self-sustained.
Survey-based indicators of consumer and business confidence in both the industrial and services sectors – suggest an ongoing, but possibly less vibrant, real GDP growth in the second half of this year, more in line with estimates of potential growth, i.e. of around ½ % quarter on quarter.
Regarding 2007, staff projections suggest real GDP growth between 1.6% and 2.6%. The expected moderation between 2006 and 2007 largely reflects the impact of fiscal measures adopted by the German government. These measures include most importantly an increase in the standard VAT rate from 16% to 19% as of January 2007, but entail also cuts to social security contributions and some additional expenditures. The fiscal package is expected to have a direct positive effect on the German fiscal balance of about 0.7% of nominal GDP in 2007.
Looking at the driving factors of euro area growth, exports should continue to benefit from robust global economic activity. This, together with favourable financing conditions, high profits and still high levels of business confidence, should also support investment growth. In addition, growth in private consumption should be sustained by improvements in employment and increases in real disposable income. Overall, conditions remain in place for a solid, self-sustained growth path over the short to medium term.
Risks to the economic growth projection are broadly balanced over the shorter term, while longer-term downside risks relate mainly to persistant high oil price increases, to disorderly unwinding of global imbalances and protectionist pressure, especially after the suspension of the Doha round of trade talk.
Let me here briefly refer to the euro area’s current account balances.
In June 2006, the 12-month cumulated current account of the euro area shifted to a deficit of around 0.5% of GDP from a surplus of 0.3% of GDP a year earlier.
This shift resulted mainly from a decline in the goods surplus reflecting the significant rise in the cost of oil imports and the associated deterioration in the oil trade deficit in particular vis-à-vis oil exporting countries such as OPEC and Russia.
Let me also tackle briefly the developments in the euro area labour market. All available data point to an ongoing improvement. For example, the unemployment rate has fallen continuously since mid-2004 from 8.9% to 7.8% in July this year. The number of unemployed persons has declined by 1.5 million over the same period to stand in July below 11.5 million.
We have seen also a strengthening in euro area employment over the past year. More recently, employment grew by 0.4 % quarter-on-quarter in the second quarter of this year, following increases of 0.3% in the previous two quarters. Employment is expected to continue growing at this pace for some time. From a longer term perspective, since the start of the European Monetary Union in January 1999, the euro area economy has created about 11 millions of new jobs (on a net basis). It is worth mentioning that this is more than in the US over the same period of time.
Labour productivity growth continued to rise in the second quarter of the year, to 1.4% in annual terms, on account of growing employment and activity in the last few quarters, particularly in the industrial sector. Notwithstanding these recent increases, there has been a slowdown in labour productivity growth in the euro area since the mid-1990 which contrasts with gains in productivity in the US. However, on the basis of comparable measures for both economies the gap in productivity growth between the euro area and the US seems to have narrowed recently, most probably due to a recent slowdown in the US productivity growth rate. This gap is expected to narrow further in the coming years, reflecting different cyclical developments.
Turning to the outlook for price developments, the slide shows that HICP inflation is projected to be at an elevated level of 2.4% in both 2006 and 2007. Headline inflation has been at or just above 2% over the last few years and at 2.2% in August 2006.
The current and expected elevated levels of inflation reflect to a large extent the impact of the strong increase in commodity prices. These developments have put direct upward pressure on the energy component of the HICP and to upward price pressure along the production chain. This becomes evident from recent high growth rate in producer prices, which are just below 6%, and gradually rising non-energy goods prices at the producer and consumer level. Moreover, survey indicators suggest that companies are more and more able to pass higher input costs on to customers, indicating increased pricing power in the light of capacity constraints and buoyant demand. These indirect effects are expected to have a significant upward effect on inflation in the course of next year, together with the impact of the VAT increase in Germany.
At the same time inflation measured by the HICP excluding unprocessed food and energy – an indicator of underlying inflationary pressures – has remained more moderate, at levels just above 1.5%.
In particular, moderate wage growth contributed to this development. In the first quarter of 2006, the annual rate of growth in euro area compensation per employee stood at 2.0%. In particular, two factors helped to contain inflationary pressure emanating from the labour market:
First, strong international competition, particularly in the manufacturing sector, and a still high, albeit declining, unemployment rate in the euro area contributed to moderate wage growth.
And second, increases in labour productivity growth kept unit labour cost growth at very subdued levels (of below 1%).
Turning to inflation expectations, short-term inflation expectations have drifted somewhat upwards recently.
However, as the slide shows, longer-term inflation expectations have remained solidly anchored at levels consistent with a high degree of credibility of the ECB’s monetary policy as regards the maintenance of price stability in the medium-term. All available measures of long-term inflation expectations consistently point to expectations of continued low and stable inflation.
Overall, inflation is expected to remain at elevated levels in the remainder of 2006 and on average in 2007.
Risks to this outlook are clearly on the upside. In particular, the following upside risks prevail:
higher than currently expected increases in energy and non-energy commodity prices,
a potentially stronger pass-through of past oil price increases into consumer prices than currently anticipated,
further increases in indirect taxes and administered prices,
and – more fundamentally – potential second round effects due to stronger than expected wage developments.
Regarding prospects for inflation over medium to longer horizons, the monetary analysis continues to confirm that upside risks to price stability prevail.
The rates of monetary and credit expansion remain rapid, reflecting the still low level of interest rates in the euro area.
In particular, loans to the private sector continue to grow at double-digit rates on an annual basis, with this rapid growth remaining broadly based across the household and corporate sectors.
The moderation of annual M3 growth observed in the past two months – to 8.5% in June and 7.8% in July – may possibly reflect the impact of previous increases in interest rates. However, it also needs to be viewed against the high growth rate witnessed in May, which represented one of the highest annual rates of M3 growth seen since the introduction of the euro.
However, recent monetary developments should be assessed with the appropriate medium-term perspective, and thus against the background of the persistent upward trend in the underlying rate of monetary expansion observed since mid-2004.
On this basis, liquidity in the euro area remains ample by all reasonable measures.
Continued strong monetary and credit growth in the context of still ample liquidity points to upside risks to price stability over the medium to longer term.
Monetary developments therefore require careful monitoring, especially against the background of improved economic conditions and strong property market developments in many parts of the euro area.
What are the consequences for monetary policy?
The economic analysis underlying the ECB’s Governing Council assessment suggests that inflation in the euro area is likely to remain elevated, at rates above 2%. Moreover, as I mentioned, risks to the outlook for price developments remain clearly on the upside over the medium to longer term.
In its meeting on 31 August, the Governing Council stated that if its assumptions and baseline scenario continue to be confirmed, a progressive withdrawal of monetary accommodation will remain warranted so as to adjust the still accommodative stance of the ECB’s monetary policy and to address the risks to price stability identified in the economic and monetary analyses.
Regarding fiscal policy, all euro area Member States are committed to fiscal discipline and to complying with the fiscal rules enshrined in the Maastricht Treaty and the Stability and Growth Pact. Over recent years in particular the three largest euro area countries had difficulties in complying with the rules. As a consequence the euro area general government deficit rose to 3% of GDP and the debt-to-GDP ratio increased to above 70% of GDP.
At least as far as nominal budget balances are concerned, the situation in the euro area is now starting to improve.
In 2005, the euro area general government deficit was reduced from 2.8% to 2.4% of GDP. But this improving fiscal outlook owes primarily to the favourable economic environment and, in a number of countries, especially from buoyant revenues boosted by profit-related taxes. The contribution to the improving fiscal outlook from structural consolidation has been much more limited.
It is therefore worth recalling that at the time of the EU’s fiscal rule book revision just a year and a half ago, the commitment to undertake greater fiscal consolidation in "good times" was seen as an important new element. Euro area governments now have to translate their good words into action and seize the opportunity provided by the current favourable economic environment to make rapid progress towards sound budgetary positions.
Finally, let me stay a moment with structural reforms, a key domain for euro area policy makers, not least in view of the global challenges.
The benefits of structural reforms for the smooth functioning of the euro area are clear:
First of all, they raise the pace at which economies can grow and create jobs without creating inflationary pressures;
Second, they help workers and firms to respond in a flexible way to the key challenges from rapid technological progress, globalisation and ageing populations.
Finally, they help the euro area economy to increase its resilience to shocks.
My last slide shows some indicators covering structural policy areas such as labour market and product market regulation, for the euro area and the US. The figures on regulation show that the euro area has made quite some progress in both the labour and the product market over the last couple of years. Although they still lag behind the US. However, as the table shows, only 1.9% of euro area GDP was pent on R&D in 2003, against the 2.7% recorded in the US.
However, a closer look at the same indicators at a country level and the comparison to the US “benchmark” suggest that much more should be done. Indeed, continuous effort and determination in pursuing structural reforms is needed in several euro area countries, in order to foster growth and employment and to close the still significant gap with the targets set by the Lisbon strategy.
The priority areas for reform in Europe are:
getting more people into work;
unlocking business potential;
Structural reforms focussing on these areas will increase potential growth and will help Europe to fully exploit the benefits of the EU Internal Market.
All in all, I am confident about the economic prospects of the euro area and its contribution to a rebalancing of global growth. However, the preconditions that have to be met are obvious:
not to losing momentum in ongoing structural reform efforts,
structural improvement of fiscal positions,
last but not least maintaining price stability.