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Euro Zone Economy Heads for Sharp Slowdown

Euro zone economic growth looks set for a sharp slowdown in the second quarter after a strong performance at the start of the year, data showed on Friday, but rocketing inflation will keep interest rates on hold.

A closely-watched index of the euro zone services economy showed a steep slide in May as a strong euro and surging oil prices tore into companies' margins and hinted at weaker growth round the corner.

The RBS/NTC Flash Eurozone Purchasing Managers Index for services companies, ranging from hotels to banks, fell to 50.6 in May from 52.0 in April, matching a 4-1/2 year low reached in January, and well below the 51.7 forecast by economists.

The index is now only just above the 50.0 mark that separates growth from contraction.

At the same time, growth in prices charged by services companies accelerated.

Separate data showed the Italian economy grew by 0.4 percent in the first quarter, better than the 0.2 percent expected by economists, after contracting in the previous three months. But it remained way behind the strong 1.5 percent seen in Germany.

Yet a strong start to the year despite the restrictions of the global credit crunch does not look like it held on, and there are now significant differences in the pace of growth among the top four euro zone economies.

"The numbers are suggesting that the second quarter will be pretty weak. We are looking at growth pretty close to stagnation if this continues," said Dario Perkins at ABN Amro.

French consumer spending fell 0.8 percent last month as shoppers shunned car purchases and new clothes, underscoring the view that growth has slowed down sharply from the first quarter. Economists had expected a 0.7 percent rise in spending.

"The second quarter isn't looking good at all," said Societe Generale economist Olivier Gasnier.

Inflation Worries

But with oil close to a record high of $135 dollar a barrel inflation will probably remain high through the summer, preventing the European Central Bank from even contemplating an interest rate cut.

Economists are gradually scratching out the cuts they had forecast from the ECB since the start of the year and coming round to the idea that rates on hold at 4.0 percent seems likely for now.

"The dilemma for the ECB is that inflation is getting worse certainly in the near-term," said Mark Wall at Deutsche Bank.

Euro zone inflation is set to climb back towards its recent record high this month, likely to hit 3.5 percent when figures are released next week, compared with the current 3.3 percent. This is well above the ECB's 2.0 percent ceiling.

The other major concern is diverging growth.

Flash data for Germany released earlier on Friday also showed a slowdown across both its manufacturing and services sectors, though holding at robust levels, while corresponding French data showed levels closer to contraction.

Italy's better than expected performance in the first three months of this year followed a 0.4 percent contraction in the fourth quarter of 2007 and recent business surveys there are pointing to stagnation or contraction.

"The Q1 result is a little bit better than expected but it comes after a big contraction, so it doesn't significantly change the picture," said Deutsche Bank economist Susana Garcia.

Contact Europe: Economy

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