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Euro area inflation increases with higher commodity prices

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Euro area inflation increases with main reason higher pricesThis Quarterly Report on the euro area concludes that the main reason for the acceleration of inflation in recent months is higher commodity prices, whereas domestically-generated inflation pressures remain subdued. The Report also welcomes the recent milestones in strengthening the economic governance in the euro area as decisive steps to safeguard the financial stability and restore confidence among market participants.

The comprehensive response to the crisis agreed at the European Council on 24 March represents a systemic overhaul of European economic policy, with the creation of the European Stability Mechanism (ESM) and the Euro Plus Pact at its heart.

The report shows that raising the capital requirements for banks would be associated with a significant reduction in GDP volatility, but may come at the expense of slightly lower GDP growth in the medium term. Secondly, business survey data reveal that the current recovery remains on track but is nonetheless associated with comparatively weak and unbalanced GDP growth, and shows features on both the consumer and the corporate sides which may weigh on growth over the medium term.

The Commission and the Member States have taken swift action to safeguard financial stability and deal with a deep recession. The Report reviews all economic and financial policy responses to the crisis since 2008. In particular, the comprehensive package of measures adopted by the European Council on 24 March represents a decisive reinforcement of the EU’s economic policy framework. The future permanent crisis resolution mechanism, the European Stability Mechanism (ESM), and the “Euro Plus Pact” for growth and convergence will set the euro area back on course towards stability, growth and employment.

As inflation in the euro area has risen in recent months to its highest level since October 2008, it is important to separate globally-driven short-term price volatility from more persistent underlying wage and price pressures. To this end, an analysis of recent inflation dynamics confirms that mainly non-core items such as commodity and fuel prices are responsible for the recent pick-up in inflation, driven by cyclical, structural and geopolitical factors.

The considerable amount of spare productive capacity in the euro area means that the prospects for core inflation have not picked up significantly. Inflation divergences within the euro area has widened with the outbreak of the economic and financial crisis. The analysis shows that current inflation differences between the Member States are partly due to country differences in the transmission of fluctuations in oil prices, but also reflect a process of correction of macroeconomic imbalances.

A special section is dedicated to the assessment of higher capital requirements for banks under a move to Basel III regulations. Higher capital buffers would help to strengthen the banking sector and make it more resilient to shocks, and the analysis presented sheds light on the macroeconomic impact of higher capital requirements. According to simulation results, higher capital requirements may entail some GDP losses over time because of higher lending costs; however, these are likely to remain small and would be associated with a significant reduction in GDP volatility.

The euro area’s current recovery in economic sentiment remains on track with order books still rising and inventories at record lows. It is nonetheless associated with comparatively weak and unbalanced GDP growth. Furthermore, surveys also point to a number of factors in the household and corporate sector that may act as a drag on medium-term growth.

Estonia has become the 17th Member of the euro area on 1 January 2011. In recent years, the country has undergone a highly dynamic convergence process. But it also had to contend with some side effects of rapid catch-up, particularly in the form of significant macro-economic imbalances driven by excessive credit growth. But following an impressive consolidation and the structural reforms undertaken in recent years, ambitious economic and financial policies are contributing to a fast recovery and sectoral rebalancing. Overall, the recent Estonian experience shows that sound public finances, structural reforms and financial resilience strengthen adjustment capacity and boost employment.

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