Euro area

OECD Economic Outlook, Dec, 2008

The euro area economy has slipped into recession this year, with tighter financial conditions, negative wealth effects, weaker housing market activity and greater uncertainty all reducing domestic demand. Growth is expected to remain below potential until the middle of 2010, before picking-up as the effects of monetary policy easing and the dissipation of stress in global financial markets emerge. Lower commodity prices and the emergence of a sizable negative output gap will dampen inflationary pressures, with headline inflation projected to fall to around 1 1/2 per cent during 2009.

With inflationary pressures already easing, there is scope for additional monetary stimulus, which should be prompt to minimise the downside risks to activity. The loss of tax revenues from financial and housing markets and the costs of emergency actions to alleviate financial turmoil will add to budgetary pressures. Any additional discretionary fiscal measures should be well-targetted and, reflecting the need for medium-term fiscal consolidation, temporary. Growth prospects would be enhanced by implementing measures to strengthen the regulatory and supervisory frameworks in European financial markets.

Economic activity has begun to contract

The euro area economy has slipped into recession, with GDP declining in both the second and third quarters of 2008. In the second quarter, drops in private consumption and business fixed investment reinforced downward pressures from the slump in housing investment. Exports also declined, affected by weaker world demand and the strength of the euro. With heightened turmoil in global financial markets, the near-term outlook for economic growth has weakened considerably, and a protracted slowdown appears increasingly likely. Area-wide industrial production and retail sales both declined in the summer months. Survey data point to further declines in activity, with business sentiment and consumer confidence falling well below their long-term average levels.

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Financial conditions have tightened

Even before recent events, international financial market turmoil had tightened financial conditions. Widening interest rate spreads, more stringent bank lending standards and declining equity prices all raised the cost of financing and generated negative wealth effects on household spending. Credit growth has remained positive this year, but has dearly slowed, especially for households. The euro has depreciated in effective terms by close to 10% since early 2008, but remains above its average over the past decade. More recently, financial pressures on banks, households and companies have intensified, with further increases in spreads and additional falls in equity prices. As a result the household wealth-to income ratio has declined considerably. Interbank markets have effectively been frozen since mid-September.

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Housing markets have turned down

Housing investment peaked in the first quarter of 2007, and has declined by just under half a per cent of GDP since then. House prices have fallen markedly in some countries, and area-wide house price inflation is now around zero, with prices declining in real terms. This will reinforce negative financial wealth effects on private spending, although housing is less widely used as collateral for borrowing in the euro area than in other economies.

Labour market improvements have ended

Unemployment is rising, with the unemployment rate edging up to 7 1/2 per cent in August, from a cyclical trough of 7.2%, close to the structural unemployment rate. Employment has continued to increase, although the growth rate has steadily slowed.

Inflationary pressures are beginning to recede

Headline inflation fell to 3.2% in October, from a peak of 4% in July, reflecting the decline in global commodity prices. Further sharp declines are likely in late 2008 and the first half of 2009, and headline inflation may well drop below core inflation for some time. Estimates of longer-term inflation expectations in financial markets have also turned down. Core inflation (excluding food, drink, tobacco and energy) has remained under 2% this year although cost growth picked-up in the first half of 2008, pushed by wage indexation clauses in some countries and weakening productivity growth. Nevertheless, the prospect of marked second-round wage and price effects from high headline inflation appears limited. The projected emergence of a sizable negative output gap, rising unemployment and weaker import prices will all moderate wage and price pressures in 2009 and 2010. Both headline and core inflation are projected to be below the medium-term objective of the European Central Bank from mid-2009 onwards.

Monetary policy can ease further

The European Central Bank has already begun to ease its monetary stance, although current financial market tensions have slowed the speed of pass-through into money market and retail interest rates. Policy rates were reduced by S0 basis points in the coordinated cut on 8 October and by a further SO basis points on 6 November. Additional changes have been made to the refinancing operations of the ECB to alleviate liquidity shortages in financial markets. The prospective dampening of inflationary pressures over the next two years will provide scope for further reductions in policy rates in the coming months. Policy rates are projected to decline to 2% by next spring, and remain at that level for a year. If financial conditions were to deteriorate further, or activity to drop more rapidly than projected, deeper interest rate reductions could prove necessary in the near term. Thereafter, with financial turmoil dissipating and economic activity turning up, modest increases in the policy rate appear appropriate to ensure inflation remains below 2% in the years ahead.