Despite a bigger sales tax bite, Germany has overtaken France as the engine of euro zone growth
German confidence data indicate that the economy has largely shrugged off the impact of a 3% hike in value-added tax imposed at the start of this year. Data confirm that the expected slowdown in German gross-domestic-product growth at the beginning of 2007 will be temporary, with the economy set for robust growth of up to 2% this year. Germany has taken over from France as the engine of euro zone growth and continues to benefit from brisk export demand and surprisingly resilient domestic growth. These developments support the European Central Bank's current hawkish stance.
Germany's quarterly growth rate accelerated to 0.9% in the fourth quarter of 2006, helped by the prospect of the imminent VAT increase, which lifted demand for consumer durables and construction. A slowdown at the start of this year was always expected, and data available so far confirm this. German manufacturing orders dropped –1.0% month-to-month in January. January production data still benefited from strong order inflow at the end of 2006, but there is likely to be a correction with the February figures. The marked declines in the ZEW and Ifo surveys, as well as the dip in consumer confidence around the turn of the year, also support this view.
However, the latest confidence data have been surprisingly vibrant, indicating that the economy has shrugged off the VAT boost quicker than experts feared. The March Ifo index came in much better than expected, rising to 107.7 from 107.0 a month earlier.
Optimists Have the Upper Hand
The breakdown of the numbers showed not only an improvement in the future expectation reading, but also a stronger current conditions number. The diffusion index showed that optimists outnumber pessimists by a relatively large margin, with only the readings for the construction and retail sectors in negative territory.
These two sectors will have been hit hardest by the VAT increase. However, retail sentiment has already started to improve again and was less pessimistic in March than in February. This suggests that consumers have shrugged off the VAT hike relatively quickly.
Indeed, a look at GfK's consumer confidence data supports this. As our numbers show, the GfK reading rose to 4.4 in April, up from 4.3 in March. This was the first improvement since the peak in December of last year. The breakdown, which is only available until March, showed a rebound in the willingness to buy, which also supports the view that the VAT hike has had only a temporary impact.
Improved Employment Environment
Indeed, the tax hike seems to have been counterbalanced by the very strong economic growth and improvements in the labor market. Business cycle expectations have improved remarkably in recent months, reaching levels last seen in 2001. The same holds for income expectations.
The latter is likely due to the marked decline in unemployment and the successive rise in full-time employment over the past year. March data, released this morning, showed unemployment down by 65,000 over the month, after a drop of 79,000 in February. The seasonally adjusted jobless rate has come down to 9.2% from 9.3% a month earlier, compared to a peak of 11.9% in 2005. Employment has also risen markedly over the past year. Looking ahead, employment readings in the PMI surveys have also been robust, and it seems companies are still sufficiently optimistic to take on more staff.
It also appears that growth will pick up again in the second quarter. The ZEW, the most forward-looking of all indicators, suggested a further dip in second-quarter growth. However, this is a survey of institutional investors rather than producers, and the marked decline in previous readings was partly due to concerns about the VAT impact. The Ifo, which is less forward-looking but more reliable, actually rebounded in the first quarter, to a reading of 107.5, up from 107.0 in the fourth quarter of last year. This suggests that annual GDP growth will accelerate in the second quarter. The rebound in the ZEW in the first quarter also points to further acceleration in the third quarter.
Inflation Overshoots Its Target
Surveys also suggest that growth is broadly balanced, with domestic demand helped by falling unemployment and robust investment, while net exports continue to benefit from still-strong world growth. All in all, we continue to see full-year GDP growth at 2.0%, down from 2.7% in 2006, but still above trend growth, which has fallen over the past decade. With growth above trend and unemployment falling, there is even the risk of a buildup of underlying inflation pressures.
Preliminary March consumer price inflation data showed acceleration in the national CPI rate to 1.9% from 1.6% year-over-year in February, as well as a rise in the EU-harmonized HICP to 2.1% year over year, up from 1.8% in the previous months. The latter is above the ECB's upper limit for price stability. True, numbers are boosted by the VAT hike, which in theory is a temporary factor. Yet, oil prices are also rising again and, more important, the inflation overshoot will add to the arguments of trade unions in the ongoing wage round. Unemployment may still look high by international standards, but structural unemployment is also high, and the labor market is tightening.
IG Metall, Germany's most powerful union, is calling for a pay raise of 6.5% this year. Employers have offered just 2.5%, and the final deal is likely to be somewhere in the middle. The metal industry is benefiting from high world prices and robust world demand, but the risk is that the deal could serve as a model for other sectors and even other euro zone countries. So there is a distinct risk of second-round effects, adding to pressure on underlying inflation.
All in all, Germany looks set to remain the engine of euro zone growth this year, with domestic GDP growth of around 2%. At the same time inflation pressures are rising, and the fact that the German economy has shrugged off the VAT hike much sooner than anticipated adds to arguments for more rate hikes from the ECB this year. We continue to see the next 25-basis-point hike in the refi rate in June at the latest. This would bring the refi rate to 4%, a level widely considered to be around neutral for the euro zone. With growth exceeding potential, there is room for further hikes beyond that in the first half.