The European Central Bank has flagged an interest rate increase for this week, but a sharper than expected slowdown in the United States and budget austerity ahead for Europe raise new questions over future hikes.
In 2007 both fiscal and monetary tightening will squeeze eurozone growth, denting the buoyant economic performance the region is currently enjoying.
An abrupt slowing in second quarter US GDP growth to half the rate seen at the start of this year, reported on Friday, also may presage a broader softening of the global economy later this year, analysts said.
This would send the euro spiralling upward against the US dollar and undermine European business sentiment, stalling the slow, painful eurozone recovery that has at last taken hold. Some analysts predict a tough year in 2007.
"A stronger euro, higher interest rates and a significant fiscal tightening will inflict a triple whammy on the euro area recovery next year, not to mention elevated energy prices," said Eric Chaney, European economist at Morgan Stanley.
For now though, the path is clear for the ECB Governing Council to raise its benchmark rate by 25 basis points to 3 percent on Thursday, marking its fourth hike in nine months. Retail sales are perking up, industrial orders are strong, unemployment falling and economic confidence the best in over five years.
"If numbers continue to come in on the high side, the ECB might be tempted to pursue a faster pace in the rate of normalisation," said Audrey Childe-Freeman, economist at CIBC.
Moreover, there probably is sufficient economic momentum for the ECB to tighten two more times this year to curb inflation, at 2.5 percent for the third month in a row in July, uncomfortably above the ECB's goal of annual inflation just below 2 percent.
"The ECB's inflation hackles are already up with the headline rate stuck at 2.5 percent and with high oil prices and strong liquidity growth persisting," said David Brown, chief European economist at Bear Stearns.
Analysts surveyed last week in a Reuters poll unanimously expected an ECB hike on Thursday. A slim majority of 34 out of 59 expected a 3.5 percent policy rate by year end, with a good chance the ECB would quicken its tightening pace from the once every three months seen until now.
But a sizeable camp said the central bank will pause at 3.25 percent, given uncertainties over the 2007 growth outlook. Budgetary restraint is a key reason for that uncertainty.
Morgan Stanley estimates that higher taxes in Germany, plus major budget cuts in Italy, will shave 0.9-1.3 percent off eurozone growth next year, reducing growth to 1.4 percent from 2.3 percent now.
"By next year I think the ECB will turn more cautious," Chaney said. UBS European economist Stephane Deo sees a smaller fiscal hit of 0.5 percent to GDP, but is still concerned. "Fiscal tightening is our main worry for the eurozone," he said.
"You move from a situation where fiscal policy was easy and monetary policy was very easy at the beginning of this year to 2007, where monetary policy is neutral and fiscal policy is restrictive."
What's more, the central bank could well find by November or December that it is raising rates just as a broader economic weakening takes hold. Economic survey data already suggest the business cycle in the eurozone may have peaked, as it appears to have done in the US
If that happens Erik Nielsen, European economist at Goldman Sachs, said he would look for the ECB to pause around December until the picture clears by the spring of 2007. "It would send an unfortunate political signal if they kept pounding on rates when budgets are being tightened," he said.
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