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Economics Weekly: Why eurozone economic growth will be solid in 2007; Weekly economic data preview: ECB to raise rates to 3.75%, MPC has never moved in a Budget monthEconomics Weekly:
Why eurozone economic growth will be solid in 2007
The recent sharp correction in global equity markets is a timely reminder that financial markets and economies do not move in a straight line. But a look at chart a for eurozone equity markets would suggest that it has been in a straight line recovery since the equity market crash of 2000 hit its floor in 2003. The current global equity market correction has barely impacted the EU - the reason appears to be that economic growth is robust by the standards of the last six years. The first 2 months of 2007 have shown a very positive start to the year for the eurozone economies, with investment strong and consumer spending holding up despite the VAT rise in Germany. We look at the factors driving eurozone economic growth, the prospects for this year and next and why this means that ECB interest rates are likely to rise by 0.25% this week to 3.75% and by a further 0.25% to 4% by June, supporting the euro in the near term.
Economic growth in the eurozone ended 2006 on a high, at 3%, above that of the US for the first time in four years, see chart b. The main drivers have been export growth, see chart c, which is up very sharply since 2005, particularly by German firms. Net trade (exports minus imports) is adding to eurozone economic growth. In turn, this has fed through to a rise in business investment spending, see chart d. But, as the chart also shows, consumer spending has also held up well in the eurozone, despite the prospect, and now the reality, of the VAT rise in Germany from January this year. Part of the reason is that unemployment continues to fall and employment to rise, see chart e. With economic growth in the US, emerging markets and UK set to be at trend or above, we look for eurozone exports to remain solid and so help to support investment spending, which we see as positive for the eurozone economy this year and next (chart d). The Purchasing Managersâ€™ Surveys (PMI) for manufacturing and services, see chart f, are suggesting robust industrial activity in the months ahead, as are business and consumer sentiment, chart g.
Buoyant credit conditions, as exemplified by fast growth in money supply, see chart h, are likely supporting above trend economic activity. This means that the take up of credit by firms should be expanding and this is indeed the case, with a rise in borrowing by non-financial companies of 12.9% in the year to October 2006. Investment spending should rise by above 3% this year and next, boosting employment and leading to further falls in unemployment, from 8% last year to just over 7% in 2007. This fall in unemployment is one of the key reasons why we feel that consumer spending will remain solid in the eurozone, as well as buoyant credit conditions and faster earnings growth that are helping boost housing markets and creating positive wealth effects. The bond market yield curve, 10 year benchmark bond minus three month interbank offer rate, suggests that bond market participants view the outlook for eurozone growth as positive, see chart i. But with sustained faster economic growth has come higher inflation and hence higher interest rates as the European Central Bank (ECB) moves to keep price inflation in check as the output gap (actual output relative to potential) turns positive, leading to inflation pressure.
Chart j shows that the ECB is successful in its current tightening phase ( we see repo rates at 3.75% this week and 4% by June), as our forecast shows euro economic growth slowing in 2008 and the output gap narrowing, so that price inflation remains low and stable in 2008. This rise in ECB interest rates and a better economic performance should support the euro in the first half of this year, perhaps rising to US$1.35, but then it should fall back towards US$1.30 in the second half of 2007 as the prospects for US economic growth brighten.
Trevor Williams, Chief Economist
Weekly economic data preview
ECB to raise rates to 3.75%, MPC has never moved in a Budget month
â€˘ Bank rate could increase to 5.50% this week, but we believe that with the UK Budget due on 21st March - the Monetary Policy Committee (MPC) has never changed base rates in March during the last ten years - and given the slightly dovish undertone to the February MPC meeting minutes, the likelihood is that the next hike may be postponed to April, or more likely May.
â€˘ In contrast, we expect the ECB to raise interest rates to 3.75% on Thursday, reflecting the clear hint from ECB president Trichet at last month's press conference. Euro zone economic data have been strong in the first two months of 2007 and supportive of further monetary tightening. We look for interest rates to reach 4% by end-Q2, but they could then remain on hold for the rest of the year.
â€˘ Interest rate decisions in Australia, Canada and New Zealand this week are not expected to result in any changes, but accompanying statements may be important for assessing the outlook ahead. We believe recent equity market shifts reflect a correction rather than anything more serious.
â€˘ Key economic releases this week are dominated by the US, but services PMIs in the UK and EU- 13 will also be closely watched. If the UK services PMI, on Monday, bounced back above 60 in February, the BoE decision could be a lot tighter. The US payrolls report is released at the same time as the US trade balance on Friday, promising a nervy close to the week. We look for 120,000 new jobs to be added in February, with a continuing firm undertone to the other key aspects of the labour market report. However, the trade balance may have widened again slightly in January.
Recent UK data have re-ignited talk and speculation of another hike in Bank rate in the coming months. However, the chances of a hike this week appear reduced by the timing of the next UK Budget on 21st March. The MPC has never changed Bank rate in March in its 10 year history. The slightly dovish tone to the minutes of the February MPC meeting, despite two members voting for an immediate hike, also suggests some members of the committee feel that further confirmation from upcoming data is required before hiking rates again so soon. Recent data releases may not have been enough to change their minds. However, it is worth noting that the February BoE Inflation Report showed CPI inflation only returns to target in two years' time if Bank rate follows market rates which indicated a further hike to 5.50%. With growing signs that economic growth is likely to remain above its long-run trend pace in Q1 and January CPI inflation well above the 2% target, at 2.7%, the main uncertainty appears to be the path of wage growth. We forecast a rise to 5.50% in Bank rate by May, with an evens chance that it happens in April and 30% probability for March.
UK economic data this week could be significant to the BoE rate decision. The services PMI, on Monday, has a good correlation with changes in Bank rate and a reading above 60 in February would raise the possibility of a surprise on Thursday. The manufacturing PMI last week was well above market expectations and also highlighted escalating price pressures. Official industrial production data for January are published on Thursday. We look for a modest 0.2% rise, with manufacturing up by 0.3%, based on continuing solid EU economic growth and robust domestic demand.
ECB president Trichet gave a strong hint at the February interest rate press conference that rates would rise to 3.75% in March. By using the key phrase 'strongly vigilant' he effectively prepared listeners for a hike but was more reserved about the medium-term outlook. Euro zone data have been firm in the first two months of this year and support likely further monetary tightening ahead (see our main article). Looking at this week's data, services PMIs, on Monday, are expected to show activity remained buoyant in February, but higher taxes may have dented retail sales in January.
US data this week are unlikely to support the growing market view of rate cuts later this year. The stock market falls are a correction in what has been a strong upward trend and not a signal of imminent recession. Friday's NFP report may show a further 120,000 new jobs were added in February, but perhaps more significantly should confirm that both earnings growth and the unemployment rate remained far off the levels generally associated with interest rate cuts. The non-manufacturing ISM, on Monday, is forecast to show activity remained brisk in February, if at a slightly slower pace than in January. We look for an outturn near 58, down from 59 last month. The survey may elicit strong market reaction given its employment and prices sub-components. The US January trade deficit is out on Friday and may be overshadowed by a solid NFP report. US treasury secretary Paulson is in China later this week.
Lloyds TSB Bank,
London EC3R 8BQ
0207 283 - 1000
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