Euroland: Strong upswing, risks to price level stability

The Euroland economy is in a strong upswing. Last year, real GDP increased at a rate roughly equal to that of potential output in spite of the export losses in the wake of the crises in various countries of the world. There have been considerable impulses from monetary policy. Because of the strength of the economy, the ECB has started to tighten its policy. Nevertheless, monetary conditions in the euro area are still favorable. In 2000, real GDP is likely to increase by 3.2 percent; this is the highest rate in the past ten years. After a weak start, the economy gained considerable momentum in the course of 1999. While the strong export performance was responsible for the turnaround, domestic demand growth also accelerated somewhat. In the second half of 1999, real GDP increased at an annual rate of 3.5 percent, and capacity utilization should have reached its normal level by now. Inflation picked up in the course of 1999 with rates between 1.5 and 2.0 percent, thus coming close to the upper limit of the target range tolerated by the ECB. The driving force so far were higher import prices. Since November, the ECB has raised key interest rates by 100 basis points to 3.50 percent. This is the first tightening of monetary policy since the fall of 1997. The expansion of M3, however, indicates that monetary policy continues to be expansionary. Last year, the reference value for money growth was exceeded considerably. The interest rate hikes must be seen against this background. They were the logical consequence in the concept which is based on money growth. In the present situation, rules for monetary policy also suggest a tightening. The McCallum Rule pertains to the growth rate of the money stock M3 that is compatible with the inflation target and the trend changes in output and velocity. Since early 1999, money growth has been higher than the rate implied by the rule. If this tendency continued, inflation would exceed 2 percent. In order to avoid this, interest rates have to go up. Similarly, the Taylor Rule suggests that interest rates need to be higher because capacity utilization is at its normal level and will rise further. The countries in the euro area have come closer to the target of the Stability and Growth Pact as budget deficits have declined. Next year, fiscal policy will be characterized by tax cuts in a number of countries. The strongest impulse will come from the tax reform in Germany. For Euroland as a whole, the stance of fiscal policy will thus become expansionary. In general, there appears to be a shift in the strategy of fiscal policy: While deficits were reduced on the road to EMU also by increases in taxes and contributions, the revenue/GDP ratio will decline in the coming three years according to the plans of governments. Spending is supposed to decline even more so that deficits will shrink. Such a strategy can be highly recommended. According to empirical estimates, fiscal policy has contributed to the decline in the potential growth rate in the past 30 years by expanding the share of government spending in GDP. While leading indicators point to a strong expansion of economic activity in the near future, several factors will lead to a moderate slowdown of the upswing later this year and in 2001. The recovery in the world economy will lose some momentum and the effect of the weaker euro will gradually fade. Furthermore, the ECB will raise interest rates again. An impulse for the upswing, however, will result from the turnaround of fiscal policy. All in all, real GDP growth will amount to 3.2 percent this year and will go down to 2.8 percent in 2001. The unemployment rate will continue to fall; next year, it'will drop to below 9 percent for the first time since 1992. Consumer prices will rise a lot faster than in 1999. Although the inflation rate will decline somewhat in the course of this year because import prices will moderate, the core rate of inflation will go up due to the marked rise in capacity utilization. The Harmonized Index of Consumer Prices will increase by 1.9 percent this year and by 1.8 percent next year. The weakness of the euro has a stimulating effect on output in the euro area which is equivalent to roughly half a percentage point of GDP. If the trade links of the individual EMU countries with the dollar area are taken into account, it can be shown that the effects are spread more or less symmetrically across the economies.