...weaker economic activity this year. Private consumption however expected to grow more strongly than last year thanks to higher pay rises. Consumer price inflation is projected to rise on the back of higher energy prices. In the fourth quarter of 2007, with oil prices reaching above $90 per barrel, yearly harmonised consumer price inflation jumped to 2.9 per cent. As a consequence, annual consumer price inflation is expected to remain relatively high in the first three quarters of this year, at around 2 3/4 per cent. Year-on-year, it should fall markedly by the fourth quarter of 2008, partly because of the projected fall in oil prices and partly because of the base effect from the fourth quarter of 2007. Although non-energy domestic inflation remains around 2 1/4 per cent, persistent financial uncertainties and higher market volatility may prompt the European Central Bank to tighten monetary policy rather than to loosen it.

On 1 January 2008, Cyprus and Malta joined the Euro Area, raising the number of member states to fifteen. The two new members account together for less than 0.5 per cent of the Euro Area GDP and population.

Household consumption in the Euro Area is forecast to expand by 2 per cent this year, supported by higher nominal pay rises. Nominal earnings are expected to rise by 3.5 per cent on average this year, nearly 1 percentage point more than last year. Despite a continued decline in the unemployment rate since 2006, nominal earnings growth has indeed remained subdued, hardly exceeding consumer price inflation, perhaps because wages tend to lag labour market development. The further decline in the unemployment rate expected this year could lead to higher nominal pay rises. Nevertheless, under the current projections, around half of the projected rise in nominal wages will probably be absorbed by higher consumer price inflation. On the downside, if uncertainties bearing on the international economic and financial environment persist or even increase, employment could rise by less than the projected 1 per cent and nominal wage growth could be more moderate than expected.

On the side of financial risks, uncertainties remain high in 2008. Nevertheless, if the financial outlook were to worsen further, the direct impact on private consumption of an equity price slump or of persistent market volatility would probably be smaller in the Euro Area than in the US, UK or Japan, due to the smaller equity market base, especially in Germany and Italy, as discussed on pp. 8-14 of this Review. As a consequence, the negative impact of a fall in equity prices on present and expected future income flows, and therefore on consumption, is smaller in the Euro Area than in the other major economies. The impact on investment is also smaller, as Euro Area firms tend to favour bank finance over equity finance, and are therefore less sensitive to restricted access to equity financing than firms in the US or the UK. However, despite a lower direct exposure to share prices, the Euro Area would not be immune to a worsening in financial conditions, and within the Euro Area Spain would feel the impact of a global rise in equity risk premia more acutely than other economies (see table 6) because it has higher levels of equity finance than do most other Euro Area economies. Continued financial turmoil and high market volatility would lead to additional tightening of credit standards on loans to enterprises and to households, and firms are relatively more sensitive to bank borrowing costs than are their counterparts in the other major economies. In early January, the ECB bank lending survey was already indicating that banks thought that credit availability over the next three months would be restrained by financial uncertainties. At the end of 2007, access to loans to enterprises was especially affected but continued uncertainties might also lead eventually to more restricted access to loans for households as well. Germany is more sensitive to firm borrowing costs than other Euro Area economies, while the Netherlands is more sensitive to household borrowing costs, as shown in table 6.

[FIGURE 7 OMITTED]

Under the current projections, the turnaround in net trade will be the main drag on GDP growth in the Euro Area this year, while investment growth is also expected to slow down. In 2008, net exports are forecast to reduce real GDP growth by 0.2 percentage points, in particular due to the effects of the strong euro on competitiveness and hence net trade as well as weak external demand. Most of the weakness in demand is expected to come from the UK and the US which are the Euro Area's main export markets. In 2007 they accounted for 15 and 13 per cent respectively of extra-Euro Area exports. Demand both from the UK and from the US is projected to slacken this year. In addition to weaker domestic demand in these economies, the continued weakening of the US dollar and sterling and the relative strength of the euro will restrain the Euro Area's net external trade performance. Expressed in national currency, the Euro Area's non-commodity export prices are forecast to rise only moderately this year, by around 1 1/2 per cent after 1.1 per cent in 2007 (see figure 7). By comparison, in US dollar terms, world...

NOTE: All illustrations and photos have been removed from this article.



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