Economic Outlook and Policy Challenges for the Euro Area
Speech by Gertrude Tumpel-Gugerell, Member of the Executive Board of the ECBSwedbank’s “Economic Outlook Conference” Stockholm , 18 September 2006
Ladies and gentlemen,
I would like to start by thanking the Swedbank for inviting me to speak today at their Economic Outlook Conference.
There is a nice quote by Sweden’s Queen Christina (1626-1689) that says: "One can neither predict nor escape one's destiny; but one can accept it."
While my speech on economic outlook and policy challenges for the euro area will, to some extent, be an attempt to prove Queen Christina wrong, I do find her quote a healthy reminder of the limitations that we, especially as economists, face in predicting or even changing the future.
I will address two issues today. First, I will present the economic outlook in the euro area. I am happy to say that many of my remarks in this section refer to good news, as economic growth has recently surprised on the upside. However, inflation is higher than we would like, and this is a concern for the ECB.
Second, I will briefly discuss the challenges that population ageing, globalisation and technological change pose to policy-makers. I will make special reference to labour productivity growth, where interesting comparisons can be made between the performance of the euro area, the United States and the Nordic countries. Here, despite some recent progress, the news for the euro area economy is less encouraging. I will finish by arguing that the current economic situation provides a key opportunity to turn the “bad news” into more “good news”.
Economic outlook in the euro area
[Slide 1] Over the last few years, the euro area has witnessed a gradual recovery in economic activity. Data for the first half of 2006 point to a significant further improvement in economic activity that goes beyond earlier projections. According to Eurostat, 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 (0.8%) also in the first quarter. These data confirm the view that euro area economic growth is broadening and becoming more sustained. This is most evident in the strong contribution of domestic demand to real GDP growth (0.7 percentage point) in the first half of 2006. Among the components of domestic demand, investment has contributed most to this broadening, benefiting from an extended period of very favourable financing conditions, balance sheet restructuring, accumulated and ongoing strong earnings, and gains in business efficiency. At the same time, consumption growth has been supported by gradually improving labour market conditions.
[Slide 2] However, looking ahead, we expect some normalisation of growth, as indicated by the recent trends in survey data. Indeed, data on euro area economic activity in the third quarter of 2006 – such as survey-based indicators of consumer confidence and business confidence indicators in both the industrial and services sectors – support the assessment that real GDP is growing again at rates around potential (i.e. around 0.5% quarter on quarter).
[Slide 3] Focussing on the industrial sector, industrial confidence and the Purchasing Managers’ Index in the manufacturing sector have decreased recently. Thus the survey data in the industrial sectors appear to have lost their momentum somewhat. However, the current levels are still in line with ongoing robust growth in the industrial sector in the second half of 2006. The overall assessment of growth rates around potential looking forward is also supported by short-term forecasts that combine information from a number of data sources – such as the latest European Commission real GDP growth indicator, which projects euro area real GDP growth in the range of 0.5% to 0.9% (quarter on quarter) for the third quarter of 2006 and 0.4% to 0.9% for the fourth quarter.
[Slide 4] As you know, the ECB’s mandate is to maintain price stability. To achieve this, the ECB has announced that it will aim to maintain annual inflation rates for the euro area at below but close to 2% over the medium term. Regrettably, HICP inflation rates have remained elevated over the last few years at rates just above 2%. At the same time, inflation measured by the HICP excluding unprocessed food and energy – an indicator of underlying inflationary pressures – has remained more moderate. Most recently, in August 2006, annual HICP inflation was recorded at 2.3%. During the second half of 2006 inflation rates are likely to remain above 2%, the precise levels depending mainly on future energy price developments. Two underlying cost factors have strongly influenced the recent evolution of inflation: price pressures stemming from increases in oil and non-energy commodity prices and moderate labour cost trends.
[Slide 5] First, the strong increase in oil and non-energy commodity prices has contributed to keeping headline HICP inflation rates at levels above 2%. Since early 2004, oil prices have more than doubled (in US dollar terms), with the price of a barrel of Brent crude exceeding USD 70 in August 2006. Seen from an historical perspective, the relatively moderate impact of these oil price increases on underlying domestic inflationary trends and, in particular, on wage developments thus far reflects a notable achievement by the euro area economy during the recent period. However, the latest industrial producer price developments suggest incipient upward pressure on non-energy consumer prices. The annual rate of change in industrial producer prices (excluding construction) stood at 5.9% in July 2006. Growth in producer prices has been strong, even when excluding the dynamic energy component, pointing to underlying price pressure stemming from the domestic manufacturing sector.
[Slide 6] However, second, recent trends in euro area labour costs have been moderate. Strong international competition, particularly in the manufacturing sector, and high unemployment rates in euro area countries are likely to have mitigated increases in labour costs. In the first quarter of 2006, the annual rate of growth in euro area compensation per employee stood at 2.0% and the growth rate of unit labour costs remained below 1%.
[Slide 7] The quarterly macroeconomic projection exercises conducted by ECB and Eurosystem staff provide key inputs into the ECB Governing Council’s regular forward-looking assessment of the scenario for economic developments. Focusing first on the projections for economic activity, the September 2006 ECB staff macroeconomic projections foresee average annual real GDP growth in a range between 2.2% and 2.8% in 2006, and between 1.6% and 2.6% in 2007. Compared with the real GDP growth rate observed in 2005 (1.5%), these ranges reflect a scenario of a significant improvement in euro area economic activity. In comparison with the June 2006 Eurosystem staff projections, the ranges projected for real GDP growth in 2006 and 2007 have been revised upwards, mainly reflecting stronger growth recorded in the first half of this year and further positive signals from a number of other indicators. The outlook for euro area domestic demand, in particular, has become more favourable. Risks to these projections for economic growth are broadly balanced over the shorter term. However, there are downside risks over the longer term, relating mainly to potential further oil price rises, global imbalances and protectionist pressures.
Turning to the scenario for price developments in the euro area, annual HICP inflation is projected to lie between 2.3% and 2.5% in 2006, and between 1.9% and 2.9% in 2007. Compared with the June 2006 Eurosystem staff projections, the range projected by ECB staff for 2006 lies within the upper part of the previous range, while the range for 2007 has shifted slightly upwards, largely reflecting the assumption of higher oil prices. Furthermore, lagged indirect effects of past oil price increases and announced increases in indirect taxes are expected to exert a significant upward effect on inflation in the course of next year. Risks to this outlook for price developments remain on the upside. As has been the case for the past year, the risks include further increases in oil prices, a stronger pass-through of past oil price rises into consumer prices, additional increases in administered prices and indirect taxes, and – more fundamentally – stronger than expected wage developments.
[Slide 8] Let me also say a few words about monetary analysis, which is regularly used by the ECB’s Governing Council to cross-check the risks to price stability stemming from the economic analysis. Overall, the monetary analysis suggests that monetary and credit expansion remains 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. The recent moderation of annual M3 growth should be assessed against the background of the persistent upward trend in the underlying rate of monetary expansion observed since mid-2004. Monetary developments thus continue to require careful monitoring, especially against the background of improved economic conditions and strong property market developments in many parts of the euro area.
[Slide 9] The overview of the euro area economic outlook that I have just presented illustrates some of the regular analyses and data that the Governing Council of the ECB continuously examines to assess risks to price stability over the medium term. According to this analysis, upside risks to medium-term price stability were assessed to be increasing progressively in the course of 2005. By the end of 2005, the regular cross-checking of the economic and monetary analyses indicated that an adjustment of the very accommodative stance of the ECB’s monetary policy was warranted to address these risks. Therefore, on 1 December 2005, the Governing Council decided to increase the key ECB interest rates by 25 basis points, after two and a half years of maintaining these rates at historically low levels. This decision has been followed by three increases of the same size, the latest increase on 3 August 2006 bringing the minimum bid rate of the Eurosystem refinancing operations to 3%. It is important to note that, despite these policy actions, ECB interest rates are still low in both nominal and real terms. Short-term real interest rates have just recently turned positive and remain close to their lowest levels in decades. In an environment where money and credit growth remains dynamic and liquidity ample, the ECB’s monetary policy thus continues to be accommodative.
[Slide 10] Looking back at the more than seven years of single monetary policy, the ECB’s monetary policy decisions have contributed to longer‑term inflation expectations that have remained relatively well-anchored at levels consistent with the ECB’s definition of price stability. All available measures of long-term inflation expectations consistently point to expectations of continued low, stable inflation. For example, in the context of the ECB Survey of Professional Forecasters, since the first quarter of 1999 a group of more than 40 economists from institutions that forecast developments in the euro area, has regularly been asked the question “what do you expect the HICP inflation in the euro area to be five years from now?”. The average derived from the answers has remained remarkably stable at 1.8%-1.9% for more than six years. Inflation expectations based on other surveys, such as that conducted by Consensus Economics, and information derived from financial market assets broadly coincide with the responses to the ECB survey. Indeed, the effective anchoring of inflation expectations at levels consistent with price stability, despite inflationary shocks, has been one of the key successes of the single monetary policy. Through this achievement, the single monetary policy makes its best possible contribution to supporting sustained growth in economic activity and employment creation.
In the meeting of the ECB’s Governing Council at the end of August 2006, we left key ECB interest rates unchanged and concluded that the analysis and the latest available information further underpinned the reasoning behind the decision of 3 August to increase interest rates. Looking forward, it is essential that inflation expectations remain firmly anchored at levels consistent with price stability. Accordingly, strong vigilance is warranted in order to ensure that risks to price stability are contained. Euro area citizens can be assured that the ECB will continue to act promptly, where necessary, to contain risks to price stability over the medium term.
Let me now turn to some of the policy challenges that the euro area economy faces. I would like to focus on the main issues originating from the challenges of ageing, technological change and globalisation, which are common to most European countries.
Many of these challenges appear to have been tackled very effectively in the Nordic EU Member States. In Sweden, for example, innovation, technological and organisational improvements in recent years have contributed to very strong economic activity and to low inflationary pressures. In addition, public finances are in a good shape. Indeed, this is a very admirable economic situation. Lately, it has been popular to discuss socio-economic and institutional differences between EU countries, or so-called “social models”, in search of a recipe for coping with the changes brought about by these common challenges. Many positive things have, for instance, been said about the so-called “Nordic model”, which seems to combine successfully elements of efficiency and equity. While these discussions are very relevant, there may also be limits to the possibilities of applying and transferring social models to other countries – not least because of cultural differences and specific historical traditions. Instead, it may be useful to focus on the types of reforms that are most relevant and successful.
[Slide 11] In relation to the challenge of preparing for population ageing and assuring sustainable public finances, reducing government deficits and debt remains a top priority in the euro area. While significant progress was made in the run-up to EMU, fiscal consolidation has lost momentum in recent years, with the debt-to-GDP ratio for the euro area as a whole increasing to above 70% last year. Further fiscal consolidation, while being crucial in view of the challenge of population ageing, would not only provide a more stable and sound macroeconomic environment in EMU, but also consolidate credibility in the revised Stability and Growth Pact.
As regards the challenges of promoting competitiveness, raising economic efficiency and creating a flexible and resilient economy in the context of rapid technological change and globalisation, an important tool for policy makers is structural reform. Indeed, euro area markets still remain relatively rigid in many respects. In areas such as goods and wholesale financial markets, much progress has been achieved, partly due to the policy of opening up markets for international competition. In other fields, such as the non-financial services sectors and retail financial markets, progress has been much slower.
A top priority for reform in the euro area are labour markets, given that unemployment rates in euro area countries are still too high. Not only are unemployment levels in Europe unacceptably high, but technological change and the new global environment for production pose increasing demands on workers’ skills and adaptability. Policy‑makers consequently need to review the institutional features of labour markets, adjusting them as necessary in order to avoid or mitigate the worst forms of exclusion from the labour markets, such as long-term unemployment. While institutional reforms need to be carefully designed to fit local conditions, economic research has identified some general principals that characterise good labour market policies. Today’s policy recommendations target, in particular, first, the incentive structures induced by the tax and benefit systems in place, second, support for skills, retraining and adaptability of the work force, and, third, wage flexibility.
[Slide 12] Where does the euro area stand today in terms of labour and product market efficiency? As can be seen from this slide, the euro area as a whole is unfortunately trailing many of the most successful countries. However, it is important to remember that euro area averages hide large differences across euro area countries. The differences are most obvious in the case of labour markets. Despite solid performance in terms of employment growth in the past five years, partly a result of previous structural reforms, the euro area employment rate remains low by international standards, especially among older age groups. The euro area also scores relatively high in terms of employment protection legislation, which contributes to reducing labour market flexibility. In terms of the business climate, it appears that the institutional environment in the euro area is still not sufficiently encouraging for business start-ups.
[Slide 13] Recent developments in euro area labour productivity growth further underline the need for economic reform. Productivity gains are a key factor driving long-term economic growth and increases in living standards. Euro area labour productivity growth declined from above 2% on average until the early 1990s to below 1% on average in the period 2001-05. At the same time, productivity growth in the United States increased strongly, while it remained relatively strong in the Nordic EU Member States. In terms of its immediate determinants, the sustained decline in euro area labour productivity growth has resulted from both a smaller increase in the share of capital to labour used in euro area production (capital deepening) and lower total factor productivity growth. Lower rates of capital deepening can, in part, be associated with the robust pace of job creation in the euro area since the mid-1990s, in itself a positive development,
[Slide 14] The recent recovery in euro area economic activity has also resulted in a modest improvement in euro area labour productivity growth over the last few quarters. In the second quarter of 2006, euro area labour productivity growth is estimated to have grown by 1.4% in annual terms. While this recent improvement is encouraging, it should be noted that it largely reflects cyclical factors and does not detract from the need for structural reforms to strengthen trend labour productivity growth.
[Slide 15] Another positive development in the euro area is that labour participation rates have increased, mainly thanks to rising employment rates. This appears largely to have been a sustained improvement. Since 1999, the participation rate has increased by 2.6 percentage points while it has been broadly stable in many other countries.
What is driving these differences in trend labour productivity growth? The main storyline is, by now, familiar. The key difference in productivity growth between the euro area, on the one hand, and the United States and some of the Nordic countries, on the other, appears to lie in the use of productivity-enhancing technologies. The acceleration of US productivity in recent years is generally associated with the production and use of information and communication technology (ICT). The United States appears to have been more successful in terms of innovation and the diffusion of ICT technologies, in particular in some services sectors where retail and wholesale business, as well as financial services, have greatly benefited from technological improvements. The euro area economy seems to have benefited much less from these factors, reflecting barriers to competition in the services sector, lower investment in ICT compared with the United States and restrictions to the diffusion or appropriate use of new technologies.
The economic literature offers a number of explanations why innovation and technological progress is higher in some countries than in others. Normally, these include factors such as education, the presence of advanced financial markets and investment in R&D. While our understanding of the interactions between factors that drive productivity growth and economic policies remains incomplete, let me recall three factors that I believe are particularly important.
[Slide 16] First, human capital is of key importance for keeping up with technological advances and innovation. The educational attainment in the euro area is, in general, lower than in the United States, especially when it comes to university studies, where only 20.8% of those aged between 25 and 64 years old have received a university education. This naturally affects our ability to compete in new and cutting-edge technologies.
[Slide 17] Second, promoting research and development is crucial in order to adapt and promote innovation and technological change. Also in terms of R&D expenditures, the euro area, on average, spends less than the best performers: Sweden and Finland.
[Slide 18] Third, the availability of risk capital can be crucial in stimulating innovation and developing new businesses. In general, well-functioning financial markets are important for allowing available resources to be allocated to the most beneficial investment opportunities at the lowest possible costs. Not surprisingly, empirical research has established a strong connection between financial development, productivity and economic growth. In terms of venture capital for new and expanding companies, less financing is being provided in the euro area than in the United States. It is clear that further financial integration in Europe can play a key role in strengthening financial markets and fostering financial development.
There is general consensus that these factors play a role in explaining differences in labour productivity growth. In this context, a number of important policy recommendations have been put forward. Given the speed of structural change, there is no room for complacency. The urgency to act upon the existing policy recommendations cannot be stressed enough.
In conclusion, in the euro area, real GDP growth is projected to grow at rates close to potential. At the same time, headline HICP inflation rates are likely to remain elevated at above 2% and, overall, risks to price stability remain on the upside. As the ECB’s Governing Council has emphasised, strong vigilance is needed in order to ensure that risks to price stability are contained. If our assumptions and baseline scenario continue to be confirmed, a progressive withdrawal of monetary accommodation will remain warranted.
The main policy challenge for the euro area, however, is for it to raise its rate of potential growth. The current economic situation provides a good environment for pushing forward with both economic reforms and fiscal consolidation. In this respect, I believe we can learn a considerable amount from the successes of the Nordic countries.
Let me therefore conclude with another quote by Christina of Sweden, which is more encouraging than one that I mentioned at the beginning: “It is necessary to try to surpass oneself always; this occupation ought to last as long as life.”
Thank you for your attention.
 The ECB’s Survey of Professional Forecasters is a quarterly survey of private sector forecasters that provides information about expectations for the rates of inflation in the euro area for several horizons, together with a quantitative assessment of the uncertainty surrounding these expectations. Additional information can be found in J. A. Garcia “An introduction to the ECB’s Survey of Professional Forecasters”, ECB Occasional Paper No 8, 2003.
 Sapir, A. (2005): “Globalisation and the reform of European social models”, also recently discussed in Brown, G and Nuder, P. (2006): “Social bridges: meeting the challenges of globalisation”.
 For a recent review of the research on European unemployment, see Blanchard, O. (2006): “European unemployment”, Economic Policy.
 For a detailed discussion of labour productivity see Annenkov, A. and Madaschi, C. (2005): “Labour productivity in the Nordic EU countries: a comparative overview and explanatory factors 1980-2004”, ECB Occasional Paper No 39, and Gomez-Salvador, R., Musso, A., Stocker, M. and Turunen, J. (2006): “Labour productivity developments in the euro area”, to be published shortly as an ECB Occasional Paper.
 See Guiso, L., Jappelli, T., Padula M. and Pagano, M. (2005): “Financial market integration and economic growth in the EU”, Economic Policy, 19(40).
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