Economic prospects June, 2005

• Dutch economy expected to grow by 0.5% in 2005, and by 2% in 2006. This implies a downward adjustment of former forecasts from the Central Economic Plan 2005 by 0.5 and 0.25%-points, respectively.The main cause of lower international and national growth prospects: higher oil prices.
• Private consumption and investment recover slightly in 2006, due to the increasing household purchasing power and the recovery of profitability.
• This year, the number of unemployed will reach its zenith (6.75% of labour population), and is expected to decrease slightly in 2006.
• Despite the high price of oil, inflation will be moderate: 1.5% in 2005 and 0.5% in 2006.
• The EMU deficit will probably come out just over 2% of GDP in both years.

These are the lead headlines of today's short-term forecast by CPB Netherlands Bureau for Economic Policy Analysis (CPB). The economic prospects are published today in the CPB Newsletter 2005/2.

THE WORLD ECONOMY

Economic growth continues in the United States
The favourable economic development in the US is expected to continue this year and in 2006. For both years, the increase of the Gross Domestic Product (GDP) is forecast at 3.25%. In order to avoid high inflation, the US Federal Reserve Bank will be forced to further raise its official interest rates. The deficit on the US current account remains staggeringly large.

Euro area continues to disappoint
Economic growth in the euro area has thus far this year been moderate. Besides the more expensive euro and the high price of oil, also the gloomy and worsened mood of consumers and producers will put pressure on growth in the euro area. Consequently, economic growth is expected to fall back from 2% in 2004 to 1.25% this year. Next year, growth will probably rebound to 2.25%, due to the improved profits and balance positions of European business, expansive monetary policy, the projected fall of the oil price, and the end of the euro's further appreciation.

High oil price
In recent years, the crude oil price has increased strongly. In December 2001, the price of one barrel of Brent crude oil averaged 18.5 dollars. By mid-June 2005, this price increased to 52 dollars per barrel-almost a threefold increase. Current oil prices reflect the uncertainty and tightness that have characterised the world oil market for years. This tightness is reflected not only in the high oil price, but also in the relatively limited spare capacity of OPEC countries. This year and next, however, the high oil price will probably lead to greater oil production, but this will only absorb the demand increase, so that the oil market remains tight. In the projection, only a moderate price fall, to an average of 45 dollars per barrel in 2006, is expected.

Oil price and exchange rate uncertain
Because demand and supply do not react very firmly in the short run to the oil price, even minor changes in demand and supply can lead to relatively firm decreases or increases in the price of oil, and thereby to substantial positive or negative effects on the world economy. In addition, the euro exchange rate could (either temporarily or not) come out lower, due to the uncertain political situation in Europe- after the French and Dutch 'no' to the European Constitution. On the other hand, the hefty deficit on the US current account balance might lead to further depreciation of the dollar, and consequently to a higher euro exchange rate.

THE DUTCH ECONOMY

Economic growth drops back…
Also in the Netherlands, economic growth fell in the first quarter of 2005. According to provisional figures of Statistics Netherlands, the economy even shrank by 0.1% in the first three months of this year compared to the previous quarter, so that the Dutch economy has essentially not moved for four quarters in a row. Compared to the same quarter in 2004, production decreased by 0.3%. Export growth strongly levelled off, and private consumption decreased. From the second half of this year, the economy is expected to rebound once more. But in 2005, growth will probably come out not higher than 0.5%-the second lowest growth projection in Europe after Italy.

… but light shines at the end of the tunnel
During the past five years, the Dutch economy has performed sluggishly, but next year, growth is expected to come out at 2%. That's close to potential growth, and almost as high as the average growth in other European countries. The main reason is the expected recovery of world trade. Moreover, the wage moderation put into effect will begin to pay off in improved business profitability and somewhat less of a loss in market share. The economy has been under pressure in recent years as a consequence of cutbacks, financial burden increases, and rising pension premiums. For next year, the Cabinet foresees room for extra expenditure and some financial burden relief. The financial position of pension funds also seems solid, so that pension premiums do not necessarily have to increase further next year.

Temporary slowdown of exports
Growth of exports will probably slacken strongly this year. The disappointing economic development in Europe has greatly hindered Dutch exporting companies, since about 85% of Dutch exports are destined for other European countries. Moreover, the steep euro increase makes Dutch products more expensive in countries outside of the euro area. Next year, trade and industry can benefit from rebounding growth in surrounding countries. Especially re-exports, imported products that are exported after some further manufacturing, will benefit. 'Made in Holland' products will still be losing market share in 2006, but less than this year. The competitive position of trade and industry has been under strain for some time. Last year, however, the possibilities for change were created. In the period 2004-2006, labour costs in the Netherlands are expected to grow less than those in competing countries in the euro area, although they will grow more strongly than labour costs of our non-euro competitors, due to the robust euro. At the projected euro exchange rate of 1.30 dollars or less, however, this will probably no longer be the case in 2006, when business will have the opportunity to improve its competitive position somewhat.

Private consumption falls
Consumer confidence is still floundering, and even had to take a step back last May- mainly because households consider the economic climate as less favourable. The other component of consumer confidence, willingness-to-buy, has been stable at a low level since 2003, showing up in falling sales of durable consumer goods. The volume of private consumption will probably shrink this year. Household purchasing power will strongly decrease, due to real-wage reductions and increases in the burden of taxes and social security contributions. Employment is also expected to decline in 2005. Next year, private consumption (adjusted for statistical effects due to the implementation of the new healthcare system) will increase slightly, by 0.5%. Household income should develop somewhat more favourably because of real-wage increases, growth in the number of jobs and some burden relief.

Revival of investment and profitability in 2006
Private non-residential investment will grow hardly at all by no more than 0.5%. Since the summer of 2004, the capacity utilisation rate has again been falling, making new investments less necessary. Moreover, a recovery of profitability is not projected for 2005 (mainly due to the strong rises in the price of oil), and producer confidence remains at a moderate level (due to disappointing orders in hand). Next year, private non-residential investment, following the higher production growth, will probably revive. Profitability, moreover, is expected to recover in a wide range.

Labour market in smooth waters
The labour market deteriorating is petering out. For four quarters in a row, unemployment has increased less, fewer jobs have been lost, and the number of vacancies has risen. Still, employment is expected to fall further this year. Production growth remains substandard, and low profitability persists, causing companies to cut the number of their employees on average. Next year, recovery of production growth and higher profits will probably lead to increases in the number of jobs. Employment growth will even be somewhat higher than the increase of the labour population, reducing unemployment slightly- from 6.75% in 2005 to 6.5% in 2006.

Low inflation
Inflation remains low, due to declining unit-labour costs and a strong euro making foreign products cheaper. As a consequence of the strongly inflated oil price and higher prices for fruit and vegetables, inflation increased to 1.8% in March 2005. From that moment on, however, inflation declined to 1.3% in May. For the entire year 2005, the expected consumer price index amounts to 1.5%. For next year, inflation is forecast even lower (at 0.5%) due, among other things, to the abolition of the users' part of property taxes. Low inflation and strong increases in unemployment will cause moderate wage demands. The contractual wage increase is expected to decline further, to 0.75% this year. For 2005, contractual wages will probably come out at 1%, so that wages (also adjusted for inflation) can increase somewhat.

General government financial balance comes to a standstill
Last year, the general government deficit ended up at 2.3% of GDP, well under the 3% ceiling of the Stability and Growth Pact. The budget deficit will broadly stabilise this year and next. In 2005, large cutbacks will still take place, countered by lower tax receipts and higher unemployment expenditures due to disappointing economic growth. Next year, the Cabinet is intending to begin financial burden reductions and increase expenditures, including extra expenditures for education, knowledge and innovation, in accordance with the so-called 'Easter agreement'.

Further in CPB Newsletter 2005/2
Apart from the table Main Economic Indicators with the economic prospects for 2005 and 2006, this issue of the CPB Newsletter contains a Starter about the knowledge economy, an article about the Dutch defence against floods, and a review of recent CPB publications.