Global Economic Research

Europe
Erik Nilsson
1 (416) 866-4205
erik_nilsson@scotiacapital.com

Weekly Outlook January 26, 2007

• European interest rate expectations unaltered by surging money supply growth

• UK reports solid growth in fourth quarter of 2006
• European business sentiment still intact; producer price pressures ease
• France expected to remain on a moderate, sustainable expansion path

European interest rate expectations unaltered by surging money supply growth

Financial markets have been fully reconciled to another 25 basis point rate increase by the
European Central Bank (ECB) in March. As a result, they reacted indifferently to the end-
2006 money supply data showing a 9.7% y/y jump in M3 in December – more than double
the ECB’s growth target of 4½%. The euro briefly fell back through the US$1.290 threshold
before recovering to US$1.291 at the time of writing; both equity security and fixed income
markets have weakened slightly from Thursday’s close. Interest rate futures for both the first
and second quarters were essentially unmoved by the M3 figures, with a rate hike by the
ECB fully factored into the former, and pricing for the latter indicating that investors are as-
signing a relatively high probability to another upward adjustment by mid-year but are not
fully convinced that the monetary authorities will push the benchmark rate to 4.0%.

UK reports solid growth in fourth quarter of 2006

The UK economy entered the new year with considerable momentum. According to prelimi-
nary data, gross domestic product rose a solid 0.8% q/q in the final quarter of 2006, the big-
gest advance since mid-2004; this pushed output up 3.0% y/y. The national accounts data
will serve to reinforce the Bank of England’s (BoE) monetary policy tightening bias. The min-
utes of the Monetary Policy Committee’s January meeting reveal that the members voted 5-4
to nudge the benchmark rate up another 25 basis points to 5.25% in reaction to the advance
notification of the December CPI release. The stronger-than-anticipated GDP gain, with the
attendant further narrowing of spare capacity in the economy, provides some additional evi-
dence in support of the rate increase and further possible upward adjustments. The minutes
indicate that those dissenting did not necessarily challenge the wisdom of additional tighten-
ing; rather, some saw no need to accelerate the measured pace of rate increases, and pre-
ferred to frame any such move in the context of the quarterly Inflation Report, which will be
released in February.

The UK housing market may be characterized by increased volatility in the months ahead, as
the effect of rising interest rates clashes with the impact of still-positive gains in household
incomes. Major home financiers had previously reported a weakening in housing prices in
December, and just-released industry data show a marked decline in mortgage approvals
last month. However, early data for January indicate a renewed bump-up in housing prices,
suggesting that a consolidation phase has not yet taken hold.

Europe Weekly Outlook is available on www.scotiabank.com, Bloomberg at SCOE and Reuters at SM1C
Europe Weekly Outlook
European business sentiment still intact; pro-
ducer price pressures ease
Germany’s closely-followed Ifo index and other in-
dicators of sentiment suggest that European busi-
nesses remain comparatively hopeful about the
outlook. Admittedly, the headline Ifo index declined
in January. This setback in Germany was to be ex-
pected. While the three percentage point increase
in the value added tax that took effect at the outset
of the year had been fully anticipated, it neverthe-
less weighed on Ifo survey responses; thus, the
index’s current conditions component fell back
sharply. However, the business expectations com-
ponent rebounded to an 8-month high. Unsurpris-
ingly, there was also a dramatic decline in German
consumer willingness to buy in January even as
respondents’ views regarding the general eco-
nomic outlook and their own income prospects
strengthened from late-2006 levels. A roughly simi-
lar trend to the Ifo results was evident in France,
where manufacturers reported some easing in ac-
tivity, but were more optimistic regarding the pro-
duction outlook for their own firms (although a
separate survey of the retail sector showed a third
consecutive monthly deterioration in sales expecta-
tions). In Italy, consumers were more negative than
their German compatriots, and were considerably
more downbeat regarding both the country’s over-
all economic outlook and their own financial pros-
pects than was the case in December.
Underlying price pressures at the industrial level
remain moderate, with oscillations in the overall
producer price index continuing to reflect the ebb
and flow of energy costs. In Germany, the PPI was
Global Economic Research
January 26, 2007
unchanged for a second consecutive month in De-
cember, pulling the annual rate of increase down
to a 19-month low of 4.4%; the sub-index excluding
energy rose a somewhat more subdued 2.9% y/y,
matching the increase of the previous month.
In Switzerland, too, producer price inflation is abat-
ing despite the potentially adverse impact of Swiss
franc depreciation vis-à-vis the euro. The PPI was
unchanged for the third time in four months in De-
cember; as a result the annual rate of increase
held steady at 2.0% for a fourth consecutive
month. While inflationary pressures remain muted
at the consumer level and further up the distribu-
tion chain, we expect the Swiss National Bank
(SNB) to undertake further monetary policy tighten-
ing at least through the first half of 2007. Indeed,
the SNB president this week flatly asserted: “The
normalization of interest rates must continue”.
France expected to remain on a moderate, sus-
tainable expansion path
France appears well-positioned on a moderate
growth trajectory, led by private sector spending.
Consumer expenditures on manufactured goods
were up a robust 1.3% m/m (6.8% y/y) in Decem-
ber, the third consecutive monthly gain. Moreover,
French firms reported a solid 2.7% m/m increase in
industrial orders in November, pushing the cumula-
tive 3-month rise to almost 6.0%. As a result, we
expect that business investment will continue to
provide some impetus for growth in France, de-
spite the constraining impact of rising interest
rates.
2
Europe Weekly Outlook

INTERNATIONAL RESEARCH GROUP

Pablo F.G. Bréard, Head

1 (416) 862-3876
pablo_breard@scotiacapital.com

Tuuli McCully
1 (416) 863-2859
tuuli_mccully@scotiacapital.com

Erik Nilsson
1 (416) 866-4205
erik_nilsson@scotiacapital.com

Estela Ramírez
1 (416) 862-3199
estela_ramirez@scotiacapital.com

Scotia Economics
40 King Street West, 63rd Floor Scotia Plaza
Toronto, Ontario Canada M5H 1H1
Tel: (416) 866-6253 Fax: (416) 866-2829
Website: www.scotiabank.com
Email: scotia_economics@scotiacapital.com

This Report is prepared by Scotia Economics as a resource for the clients of Scotiabank and Scotia Capital. While the
information is from sources believed reliable, neither the information nor the forecast shall be taken as a representation for which
The Bank of Nova Scotia or Scotia Capital Inc. or any of their employees incur any responsibility.

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