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Brussels, 26 March 2008

Quarterly report on the euro area: headwinds gather strength

The economy has to contend with strengthening external headwinds but the euro area is showing resilience helped by strong growth in emerging markets, shows the latest Quarterly Report on the Euro Area (QREA). The most recent hard and soft data are consistent with the growth forecast announced on 21 February. The Report also looks at why growth and inflation have become more stable in industrialised countries in recent decades, a phenomenon economists refer to as the 'Great Moderation'. It shows that labour market reforms have succeeded in increasing employment levels but that there is a growing divide on the labour market, with the burden of reform falling on those not subject to standard labour contracts. It also shows that the economies of the Member States are reacting differently to the ongoing inflationary pressures. Finally, in its focus section, the QREA argues that East Asia could take inspiration from the European economic and monetary experience to the benefit of the region and indeed the whole world.

"The euro-area economy continues to face strong headwinds, including persistent uncertainties about the duration and the ultimate cost of the financial turmoil, a weakening US economy and surging commodity prices. And, in spite of its sound economic fundamentals the euro area is starting to feel the pinch ," said Joaquín Almunia, European Economic Affairs Commissioner.

Euro area GDP growth decelerated from 2.6% year-on-year in the third quarter of 2007 to 2.2% in the fourth quarter. This deceleration owes much to a weakening of private consumption on the back of surging consumer prices. In February, inflation was running at 3.3%, up from 1.7% in the summer of last year. However, continued strong growth in investment supported by high capacity utilisation and the high profitability of the non-financial corporate sector is encouraging. According to the Commission’s interim forecast of February 2008, economic growth in the euro area is expected to slow down to 1.8% for 2008. This is borne out by the hard and soft data released since. Confidence indicators in the manufacturing sector have generally held up relatively well in recent months and the latest reading of industrial production was stronger than expected.

The recent increase in inflation differentials among euro-area Member States is analysed in this QREA. It shows that the economies of Member States have reacted somewhat differently to the increase in energy and food prices since summer 2007, as a result for example of differences in the weight of food and energy in the national HICP[1] basket, the degree of competition in retail markets and the position in the economic cycle. How far the appreciation of the euro has moderated inflation also depends on the pattern of international trade, cyclical conditions and degree of competition in the domestic retail markets.

The report also examines the more stable inflation and growth rates experienced by the euro area, like most industrialised countries, over the past two to three decades. This 'Great Moderation' is not just due to luck in the form of milder shocks, but also improvements in economic policies, in particular better monetary policy and, to a lesser extent, more powerful automatic fiscal stabilisers. Changes in economic policies have been a particularly important driver of moderation in countries where policy mistakes were particularly acute before.

The QREA also looks at recent labour market reforms in the euro area. The reforms have mainly aimed at increasing labour utilisation, especially in groups with low participation rates, such as the low-skilled, women and older workers. Evidence shows that reforms have paid off, raising employment rates and enabling employment to respond more effectively to cyclical shocks. However, additional measures may be required to tackle the growing divide in the euro-area labour market with reforms concentrated in the margins of the labour market while standard labour contracts are spared.

Finally, the focus section looks at the possible lessons of European economic and monetary integration for Asia. The Asian financial crisis of the late 1990s gave regional integration in East Asia a boost but progress has been uneven. Trade integration has increased rapidly, financial and monetary cooperation considerably less so. Greater monetary and exchange rate cooperation would be beneficial not only to the region but also to the euro area and the global financial system particularly if it could help support a more orderly unwinding of global imbalances.

Although Europe’s integration cannot be replicated step by step in East Asia, it provides some useful pointers. It suggests exchange rate and monetary integration require important structural changes, including, for instance, stronger intra-regional labour mobility and higher diversification in production and consumption patterns. Monetary integration also necessitates stronger political commitment and adequate governance. Asia currently lacks the effective surveillance mechanisms which are a necessary condition for successful exchange rate and monetary coordination.
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[1] Harmonised Index of Consumer Prices

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