Euro-Zone Economy Slowed Sharply In 2Q 2007

The euro-zone economy slowed sharply in the second quarter of this year, growing at its weakest pace since the first three months of 2005.

Although surveys of business sentiment and measures of new orders suggest the economy may rebound in the third quarter, signs that the upswing that took hold last year may be running out of steam will increase the likelihood that the European Central Bank is nearing the end of a series of interest rate hikes that began in December 2005. According to figures published Tuesday by the European Union's statistics agency Eurostat, gross domestic product in the 13 countries that comprise the euro zone expanded 0.3% from the first quarter and 2.5% from the second quarter of 2006. That marked a significant slowdown from the 0.7% rate of growth recorded in the first quarter. It was also weaker than expected. Economists surveyed by Dow Jones Newswires last week estimated that GDP grew 0.5% on the quarter and 2.8% on the year. The slowdown was felt across the euro zone. With nine of the 13 euro-zone members having reported gross domestic product figures for the second quarter, only one - Austria - recorded a pickup in growth. The sharpest slowdown occurred in Greece, where GDP contracted 0.8% over the quarter, having risen 3.2% in the first three months of the year. Although Eurostat didn't give a breakdown of the contributions made by the various sectors during the second quarter, it appears that industrial production was weak, while consumer demand made only a small positive contribution, if any at all.

Germany Continues Growth Despite Strong Euro

"The demand situation appears mixed across the region, with robust equipment investment in Germany and softer in France as well as a positive contribution from net trade in Germany and a negative one in France," said Silvia Pepino, economist at JP Morgan. "Private consumption appears to have recovered somewhat. Germany construction investment was a huge drag." Despite the strong euro, exports continued to fuel growth in Germany during the second quarter. But, a drop in construction spending after a strong first quarter led to a slowdown in growth for the economy as a whole, to 0.3% on the quarter from 0.5% in the first quarter. "Germany's upswing is not over yet. But it is taking quite a breather," said Holger Schmieding, an economist at Bank of America. "While the outlook for 2008 remains quite positive, the current market jitters and the strong euro exacerbate the risk that growth could disappoint this autumn as well." By contrast, in France net trade was a drag on growth in the second quarter, with the euro zone's second largest economy also growing 0.3% on the quarter. Italy last week reported disappointing quarterly growth of just 0.1%, compared with 0.4% forecast. Spain reported 0.8% growth Tuesday, in line with expectations, but weaker than the 1.1% rate of growth recorded in the first quarter. For the first time in over a year, the U.S. economy outpaced the euro zone during the second quarter, growing 0.8%.

Possibility of Upcoming Rate Hikes Dimmed

Economists said with business sentiment remaining strong and new order flows robust, growth should pick up in the third quarter. "The surveys and orders data have remained much more robust, reinforcing the case for a bounce back in GDP in the third quarter," said Pepino. The International Monetary Fund in late July forecast that growth would slow to 2.6% this year and 2.5% next from 2.8% in 2006 as exports grew less rapidly. The ECB, Aug. 2, signaled that it would raise interest rates for a ninth time Sept. 6. Since then, however, there have been high levels of volatility in global financial markets. Against that background, a sharper-than-expected slowdown in the second quarter could lead the ECB to rethink. "A GDP figure easing down toward potential bodes well with expectations of an ECB on hold in the near term to prevent risks of a credit crunch, and to let markets settle down on a new less risk-friendly equilibrium," said Aurelio Maccario, an economist at UniCredit in Milan. "However, it is too early to say and we would be careful in dismissing the possibility of a rate hike in September." And for some economists, the second-quarter slowdown suggests the ECB should have been more cautious in signaling future interest rate hikes. "At a minimum, the ECB should have taken the less buoyant pace of growth in the second quarter as a reason to slow down the pace of its rate increases, in our view," said Bank of America's Schmieding.