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Joint Economic Forecast Project Group: Upswing Interrupted
Autumn 2007 Joint Economic Forecast, Summary
18 October 2007
The world economy is still expanding strongly in autumn 2007, but the cyclical risks have increased. The problems in the financial markets caused by the real-estate crisis in the United States
led to a new appraisal of credit risks. Many fear that this could increase the financing costs for enterprises and could burden activity in the real economy. An optimistic perspective is correct, however, since the dynamics of world economic growth have been high for some time. In the newly
industrialised countries, the already very strong expansion sped up even more during 2007, particularly in Asia and more specifically in China. On the other hand, for some time output in the industrialised countries has only been expanding at a moderate pace. In the US economic activity clearly
slowed down already in mid 2006, starting with a decline in construction activity. In the euro area
and in Japan, where the real gross domestic product had been expanding strongly into the current
year, the underlying economic trend has weakened.
The turbulence in the financial markets was touched off by a sharpening of the real-estate crisis in
the US. This led to a perceptible increase in volatility in the financial markets. The result was a
“flight into security” that led to gains in government bonds and also in high-grade bonds in the private sector. For many other assets the risk premiums have increased although to varying extents.
This, along with banks’ higher costs for liquidity safeguarding, led to a worsening of the financing
conditions for enterprises.
The US Federal Reserve and the European Central Bank initially reacted to the acute malfunctioning of the interbank market by provisionally providing additional liquidity. Then the ECB decided
not to carry through with its announced increase in interest rates, and the Federal Reserve lowered
its key rate. In light of the problems in the real-estate market, the Federal Reserve will continue to
lower interest rates further up to spring 2008. Presumably the ECB will leave rates unchanged initially and only raise them after mid 2008.
The world economic activity will lose momentum noticeably in the forecast period. The reason is
not as much the current problems in the financial markets, which the institutes expect will dissipate
in the coming weeks and months. More important is that the correction in the real-estate market in
the US is more pronounced than has been previously forecast. An additional factor in the euro area
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is that the upward valuation of the euro will have a dampening effect and that monetary policy will
no longer be expansive. Also in Britain, as in Japan, the pace of expansion will slow down in the
coming year, without indication of a downturn. With weaker economic activity in the industrial
countries, a slow-down in the increase in output in the newly industrialised countries could occur.
The worldwide increase in output will amount to 2.9% in 2007 and 2.7% in 2008. Approximately
0.6 percentage points are due to growth in China alone. World trade will increase this year and the
coming year at only a moderate pace, with growth rates of 5.3% and 5.8%, respectively.
Presumably the greatest risk for economic activity in the world economy will come from the realestate crisis in the United States. It could drag out longer and weaken US economic activity more
noticeably than is assumed in this forecast. The impact of recessive tendencies in the US for the
euro area could be intensified if the euro increases more in value over the dollar. In light of such a
crisis scenario, other risks have currently slipped into the background. It is indeed by no means
certain that the world economy will be able to cope with an oil price shock in a phase of weaker
economic dynamics. There are also risks that the forecast is too pessimistic. If the situation on the
US real-estate market were to stabilise soon or if the corrections remained limited to home construction spending, the US economy could quickly recover again.
The German economy is still experiencing a strong upswing. However, economic activity is burdened this year by several factors. Restrictive fiscal policy is dampening domestic demand, in particular private consumption, to a considerable extent. Additional factors are the further rise in the
oil price and the upward valuation of the euro. Furthermore, the recent turbulence in the financial
markets will probably have a further dampening effect on economic activity. All this is not impacting an unprepared German economy. Instead, the fundamentals have improved perceptibly. Tensions, which in previous cycles could have caused a downturn or even a recession, are not yet evident, either in terms of wages or inflation. For this reason a markedly restrictive monetary policy is
unlikely. Against this background, although the expansion will slow down in the forecast period,
the upswing will not come to an end but will only be interrupted.
In the first half of 2007 economic activity decreased vis-à-vis the previous year. The reason was the
increase in the value-added tax, which dampened domestic demand, in particular private consumption to a considerable extent, especially because of purchases made before the end of 2006. Only in
the second quarter did consumers begin to expand their spending somewhat. Also investments in
housing construction fell considerably after the tax increase. Simultaneously, exports hardly expanded anymore because industry production abroad increased at a weaker pace. All in all, in the
first half of 2007, real GDP grew at an average annual rate of just 2½%. The situation on the labour
market has improved up to the present, albeit no longer as rapidly as in the winter half year. Regis-
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tered unemployment has declined more slowly since spring; nevertheless, the seasonally adjusted
unemployment rate is currently 8.8%, about one percentage point lower than at the end of the previous year. Price increases have slowed down after the boost caused by the raised VAT rate. Recently, however, prices for energy and for food have increased so markedly that the rate of inflation
reached the 2.4% mark in September.
In spite of the economic weakening, the buoyant forces are still intact. A number of indicators, such
as the strongly augmented purchases of machinery and equipment, the still increasing demand for
industrial products and the high level of order stocks indicate that the economy is expanding again.
This should not be affected for the time being by the turbulence in the financial markets. Domestic
demand, in particular equipment investment, will expand robustly in the further course of this year.
This will be boosted in particular by an advanced completion of projects due to a worsening in depreciation allowances as of January 2008. Furthermore, private consumption will be more strongly
expansive since the labour market situation will continue to improve and since disposable income
will clearly increase. Impulses from foreign demand should strengthen somewhat since domestic
demand in the rest of the euro area will accelerate. All in all, real GDP should increase in 2007 by
2.6%.
In the coming year, aggregate output will increase at a moderate pace. A weaker contribution to
growth will come from foreign trade, since the world economy is expanding at a slower pace than
in previous years and the stronger euro is retarding an increase in exports. Domestic demand will
be the main pillar of economic activity. In particular, private consumer spending will expand perceptibly since disposable income will increase clearly and since fiscal policy will no longer have a
dampening effect. However, corporate investments will lose momentum. On the one hand, this is a
reflex in light of the advanced purchases in 2007; on the other hand, financing conditions have
worsened somewhat. In addition to the past hikes in interest rates by the ECB, the main reason for
this is that the markets, as a result of the recent turbulences, will demand a higher risk premium in
future. The financing conditions will also be affected by more rapidly rising labour costs. For 2008,
an increase in real GDP of 2.2% is expected. The rate of increase will decrease to 1.5%, after 2.3%
this year.
Unemployment will fall in 2008 at a slower pace than in 2007; on average for 2008 it will amount
to 3.4 million, after 3.8 million this year. Inflation at 2.0% will be just as high as in 2007. Although
the inflation rate has been pushed downwards due to the fact that the hike in VAT has been completely passed on, the continuingly strong economy will enlarge the scope for price increases and
the oil price will be higher, on average for the year, than it was in 2007.
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The risk that the forecast assumptions may be too optimistic results particularly from the realestate crisis in the US and the turbulence they set off in the financial markets. This forecast assumes
a favourable outcome, which is also indicated by the fact that the situation on the financial and foreign-exchange markets has calmed. New surprises, such as additional losses of private households
and enterprises and the resultant negative reactions on the financial markets, cannot be excluded,
however. These would clearly dampen the economic expansion in Germany.
Although the domestic growth conditions improved in recent years, economic policy still has a job
to do. Although it cannot prevent a cyclical slowing, it is able to moderate trend growth.
We advise that fiscal policy continues its consolidation course with a special emphasis on qualitative consolidation, that is the strengthening of investment spending. It can succeed at this if it continues to limit the increase in expenditures. The institutes propose that cyclically independent government expenditures increase by 2% per year and thus at a lower pace than the growth of nominal
GDP, whose annual increase they estimate to be 3%. This would lead to a budget surplus of
roughly 10 billion euros per year. This could be employed for a reduction of the still remaining
structural deficit but also for more investment spending or tax reductions. The budgetary scope
could be expanded if the reduction of subsidies continues. The cyclically independent expenditures,
especially for labour market policies, could fluctuate around the long-term expenditure path, so that
the automatic stabilisers take their effect. However, there are currently no clear indications that the
necessary consolidation course will be continued. Instead, consumption expenditure will grow
more strongly in the coming year. The forecast improvement in the budget situation of 0.1% in relation to GDP this year and 0.3% in 2008 will largely come about because of the favourable economic situation.
In the labour market, a continuation of the reform policies of recent years is not taking place, although structural unemployment is still high. Instead, turning back some of the reforms is currently
being discussed. What is required, however, are measures that increase incentives to work, especially in the low-wage sector, and that contribute to a lasting integration into the labour market.
This would contribute to a continuation of employment-enhancing wage restraints.
Monetary policy has the difficult task of weighing up the existing inflation risks and the still lasting
uncertainty on the financial markets with the higher risks for economic growth. The former concerns speak for a more restrictive monetary policy; the latter for a wait-and-see policy. The institutes expect that the ECB will initially keep its key rate where it is. But in order to counter increasing inflation expectations, it might implement the rate interest it had announced for September
2007 in the second half of the coming year.
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Joint Economic Forecast Autumn 2007 (18 Oct 2007)
Federal Republic of Germany
Key Forecast Figures
2005
Percentage change over previous year
Private consumption
Government consumption
Gross fixed capital formation
Machinery and equipment,
Buildings
Other investment
Domestic demand
Exports of goods and services
Imports of goods and services
Gross domestic product (GDP)
Employment (1.000 persons)
West Germany
East Germany and Berlin
Unemployment (1.000 persons)
West Germany
East Germany and Berlin
Unemployment ratec) (in %)
West Germany
East Germany and Berlin
2006
2007
2008
(a)
(a)
b)
-0,1
0,5
1,0
6,0
-3,1
4,8
0,3
7,1
6,7
0,8
1,0
0,9
6,1
8,3
4,3
6,7
1,9
12,5
11,2
2,9
-0,1
1,8
5,5
10,1
2,0
4,7
1,5
7,8
6,0
2,6
1,9
2,0
3,2
5,0
1,5
5,5
2,1
6,5
6,9
2,2
38749
31317
7432
4861
3247
1614
39006
31531
7475
4487
3007
1480
39690
32045
7645
3780
2489
1291
40000
32315
7685
3450
2227
1223
11,1
9,4
17,8
10,3
8,7
16,5
8,7
7,2
14,4
7,9
6,4
13,7
2,0
1,7
2,1
2,0
-1,0
-1,1
0,7
1,3
-75,6
-37,3
2,2
8,4
-3,4
-1,6
0,1
0,3
3,1
2,9
1,9
2,1
1,9
2,2
2,0
1,7
1,5
2,8
2,6
2,1
2,2
2,2
2,0
2,1
Consumer pricesd)
(% change on the previous year)
Unit wage costs)
e)
(% change on the previous year)
f)
General government financial balance
- EUR billion
- in % of GDP
memo item:
USA: Real GDP
(% change on the previous year)
Japan: Real GDP
(% change on the previous year)
Real GDP in the EMU
(% change on the previous year)
Consumer prices in the EMU
(% change on the previous year)
g)
a) Forecast by the Institutes.- a) Price-adjusted.c) Unemployment as a % of labour force (employed and unemployed).d) Consumer price index.- e) Gross wages and salary income
created in the domestic economy per employee as a % of GDP (price-adjusted) per employed
person.- f) On national accounts definition (ESA 1995).- g) Harmonized index of consumer prices (HICP-EMU).
Quelle: BEA, ESRI, Eurostat, Federal Statistical Office, AK VGR der Länder, Federal Agency of Labor,
Forecast by the Institutes.