Outlook for the euro area: Sentiment better than the hard facts?

by Joachim Scheide,

Kiel Institute for the World Economy
on March 4th, 2014

The outlook for the euro area economy has continued to improve in recent months. Real GDP started to increase in the second quarter of last year, and this upturn should continue in the first half of this year. According to the March estimate of the Eurogrowth indicator, we can expect increases of 0.5 and 0.3 percent in the current quarter and the second quarter of 2014, respectively.

 The improvement comes mainly from the sentiment indicators which have shown some strength in recent months. Firms in manufacturing are still confident about the future although the optimism has lost some momentum, leading to the small deceleration of growth in the second quarter as predicted by the estimation results.  Another positive factor is the decline of pessimism in the household survey; the confidence has again a smaller negative contribution to the growth estimate. One reason is probably that the situation on the labor market has stabilized, although the recovery seems to be too weak to expect already a considerable decline of unemployment rates. But there are some signs of hope in some of the countries in a crisis. Other factors such as the results of the construction survey only showed minor changes with some volatility. A small negative contribution can be expected from the recent strengthening of the euro against the dollar.

All in all, the forecast looks a little more optimistic than the consensus forecast for this year. But some caution is warranted. The indicator is a little bit too positive compared to the actual outcome of the first GDP estimate for the final quarter of last year by Eurostat. Also, there are some indications that sentiment indicators have lost some of their power of explaining or predicting actual growth. A case in point is Germany where sentiment indicators are near their record levels, but growth has remained rather subdued recently.

Needless to say, risks remain for the outlook, also because of the crisis in the euro area. A new factor is the possible slowdown in some emerging economies as indicated by the turbulences on financial markets. Finally, nobody can predict the outcome of the crisis in Ukraine.

Indicator methodology

The Euro Growth indicator forecasts the euro area GDP quarterly growth rate two quarters ahead of official statistics using a bridge regression. Regressors are chosen among survey data and financial data, i.e. series which are rapidly available and not revised. The monthly series are converted to a quarterly basis by averaging their monthly values. Series selection is conducted on an econometric basis starting from the set of monthly business and consumer survey results released by the European Commission: industry, construction, retail trade, services and consumers. From this large dataset, a few series are significant stemming from industry (production trend and expectation), construction (confidence indicator) and households surveys (major purchases). Two financial series are also significant, i.e. the growth rates of the real euro/dollar exchange rate and of a Euro area stock market index.

Some of these regressors are leading by at least two quarters, and may be used as such to forecast GDP growth. Some others are not leading or are leading with a lead which does not suit a two-quarter-ahead forecast horizon. These series have to be forecast, but over a short time-horizon which never exceeds four months. All these forecasts are implemented using monthly autoregressive equations.

The Euro Growth indicator is run each month, soon after the release of business and consumer survey results.

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