• One would be excused for thinking that a VAT rise from 16% to 19% would hardly have any large impact on the German economy. After all, the price of a washing machine will only rise from 500 euro to 515 euro. However, experience shows that a VAT rise of this size could have a strong impact on economic data - especially in the short run.

    •  Most of the VAT rise is likely to be passed through to prices implying a rise in German CPI by about 1- 1.25% and a rise in Euroland CPI of around 0.3%. A price rise of this magnitude would normally only dampen consumer demand by some 1% in Germany and some 0.25% in Euroland. However, the experience with VAT hikes is that it often generates powerful dynamics. While we are likely to see a boom in demand in the coming months, demand is likely to implode in early 2007, as consumer demand fall back sharply.

    • This implies that even Euroland GDP will be hit hard. On the back of the VAT rise we expect Euroland GDP to growth by about 0.75-1.0%q/q in Q4, but to stall in Q1 next year.

    •  Some effects of the VAT hike are already showing in the economy. One is consumer willingness to buy, which is surging dramatically. We also estimate that the VAT rise has a significant say in forcing a historical large wedge between surveys of expectations and current conditions in the German economy. This divergence is likely to reverse strongly during H1-2007, as current conditions will worsen, while expectations could start to rise.

    •  In general we expect the German VAT rise to support the tendency towards slower German growth, which is being fuelled by a global industry that is heading down. However, we do not expect the German recovery to end. The strong recovery in the construction sector, in business investments, and in the labour market is robust enough to carry on. After a weak first quarter next year, we therefore believe the economy will re-accelerate, as underlying consumer demand is robust and as global industry picks up speed again. This will be supported by the falling oil price, which, if stable, will neutralise most of the VAT rise.

    •  To ECB the VAT rise creates a dilemma. On top of slowing sentiment and upside risks to inflation, the VAT hike could bust demand but boost wages. Uncertainty about the precise impact may be the best argument for the ECB to take a “wait-and-see approach” before deciding what to do in 2007. The VAT rise poses a clear risk that the ECB will not pause its tightening campaign in H1-2007 as we currently expect. We continue to expect the ECB refi rate at 4.0% by yearend 2007.