In contrast, core inflation remains at around 1.5%, just slightly higher than at the beginning of the year (1.3%), which seems to indicate that energy prices have not yet been passed through to core inflation. Other price indicators (import and production prices, and players' inflation expectations) are showing rather more negative signs, although wages seem to be held in check. Current forecasts for 2006 and 2007 put annual average inflation at 2.2% and 2.1% respectively.

In this context, the ECB seems determined to speed up the rising interest rate cycle. The increases are mainly justified by the need to gradually reduce the high degree of monetary laxity, not so much because any strong inflationary pressures are perceived. Inflation expectations seem to be well-anchored and the upward deviations are basically attributed to energy. However, the pass-through risk persists, particularly in a context of faster growth. Thus, in the central scenario of growth of above 2% in 2006 and 2007, the ECB can be expected to raise interest rates to 3.5% in 2006 and by another 50 basis points at the beginning of

2007.

Spain

A gradual adjustment which is taking its time

Despite renewed dynamism in the first half of 2006, the current growth cycle, the longest and most intense of the last 35 years, will gradually become more moderate in the coming quarters in response to the weaker spirit of the factors supporting company and household spending. Although the increase in employment will continue to hold up real household income and wealth, there are factors pointing to their becoming more moderate. Firstly, although financial conditions will continue to be accommodating, they are gradually becoming tougher. Moreover, the economy's greater sensitivity to changes in interest rates in view of the higher level of indebtedness, will limit the growth of household demand. Moreover, the deceleration of housing prices and the sustained increase in inflation at rates of between 3.5% and 4% are holding back the increase in household wealth and real income. The moderation of household spending will be more intense than the boost already coming from the improvement in foreign demand. This boost to goods and services exports will offset the deterioration in the price-competitiveness of foreign sales. However, the continual increase in prices in the domestic market in comparison with imports will favour the growth of foreign goods and services. With all of this, in 2006 the GDP is expected to grow above the 3.4% of 2005, and to slow to 3.0% in

2007.

Improvement in the economic situation: employment, indebtedness and foreign demand

With annual GDP growth of 3.5% in the first quarter of the year, the Spanish economy was as dynamic as it had been in previous periods, underpinned by a 5.0% contribution from domestic demand, partially offset by the foreign sector detracting 1.5 points. In the first half of 2006, different activity indicators, especially the real estate sector, employment and indebtedness, outstripped the expectations in force at the end of 2005, which were consistent with a scenario of gradual slowing as from

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