The euro zone economy will slow more sharply than previously expected this year and inflation will jump higher, but Europe will avoid stagflation, the European Commission said on Thursday.
The Commission cut its forecast for 2008 growth in the 15 countries using the euro to 1.8 percent, from 2.2 percent projected in November and against a 2.7 percent expansion in 2007. The risk was that growth would be slower, it said.
The interim forecast is an indication of the downward revision to growth that the European Central Bank is likely to make in early March, and which will affect its interest rate decisions, economists said.
Growth will be weaker because of turmoil on financial markets, which has lasted longer than previously expected and raised borrowing costs, EU Economic and Monetary Affairs Commissioner Joaquin Almunia told a news conference.
A growth slowdown in the United States has also proven more pronounced than earlier estimated and high commodity prices, especially oil, have added to the problems.
"We are not in a stagflation situation, we are living in an environment of less growth and more inflation," Almunia said.
But the Commission growth forecast is more optimistic than the 1.6 percent seen by economists in a Reuters poll on Feb. 19, and several expressed further caution.
"Given the evolution of leading indicators, this looks very optimistic still -- we expect 1.3 percent growth this year," said Ken Wattret, economist at BNP Paribas.
"We expect the growth forecast for 2008 will have to be revised further downwards in May," he said.
Inflation above ECB Target
Inflation, which the ECB wants to be just below 2 percent, would be 2.6 percent on average this year against 2.1 percent in 2007, driven by food and energy prices, the Commission said. Economists on average saw inflation of 2.5 percent for 2008.
But the Commission said that by the end of the year, inflation should fall back to just above 2 percent in the euro zone if food and commodity price growth tapered off.
Yet Almunia said that while risks to the inflation outlook appeared more balanced, they remained on the upside, and he expressed concern about inflation expectations.
"More worryingly, inflation expectations have also increased lately," Almunia said. "For example, consumer price expectations currently stand close to high levels reached in 2001. Their levels could suggest they are no longer as well anchored as we believed earlier."
Markets have interpreted the latest ECB statements as meaning the bank moved its monetary policy stance from a tightening bias to neutral earlier this month amid growing signs that the economy was slowing rapidly.
But record-high inflation in the euro zone of 3.2 percent in January makes it difficult for the bank to reduce rates in support of growth like the U.S. Federal Reserve.
Nevertheless, economists expect the ECB to start cutting rates in the second quarter of this year from the current 4.0 percent to 3.5 percent by year-end.
The Commission cut its growth forecast for the euro zone's biggest economy, Germany, to 1.6 percent this year from 2.1 percent seen in November and for the second-biggest, France, to 1.7 percent from 2.0 percent.
The French government, which expects growth of about 2 percent this year, said it was sticking to its forecast despite the Commission projection.
The growth outlook for Italy, the euro zone's third-biggest economy, was halved to 0.7 percent.
Britain, which is not in the euro zone, was seen growing at 1.7 percent against the previous prediction of 2.2 percent.