The European Union's executive commission trimmed back its 2005 euro zone growth forecast to 1.6 percent in spring estimates released on Monday, blaming high oil prices, the strength of the euro and continuing economic weakness in Germany.

However, the European Commission remained optimistic that the clouds would clear over the course of the year as domestic demand, benefiting from historically low interest rates, picked up.

The commission's spring estimate marks a slowdown from the 2.0 percent growth it was previously forecasting and from the 2.0 percent chalked up last year.

But the estimate brings the commission's forecasts into line with those of private economists as well as the International Monetary Fund and the European Central Bank, which are both counting on 1.6 percent growth this year.

Germany under scrutiny

Germany, the biggest economy in Europe, weighed heavily on euro-zone growth with only 0.8 percent forecast for this year, half the 1.6 percent registered in 2004.

The German government is sticking to its forecast for economic growth this year of 1.6 percent -- until new updated forecasts are published at the end of April -- and insists it will still be able to bring down its deficit this year as promised, despite the doubts expressed by the European Commission, the German finance ministry said.

Berlin aims to bring down its public deficit this year to less than 3.0 percent of gross domestic product (GDP) as required by the Stability and Growth Pact, a ministry spokesman said, after the European Commission forecast the German 2005 deficit ratio at 3.3 percent.

EU Commissioner for Economic Affairs Joaquin Almunia said the commission would continue to keep close tabs on the German deficit -- as well as those of France and Italy -- warning that "in the coming months it is possible that we will need to adopt some decisions" regarding the euro zone heavyweights.

Full membership growth at 2.0 percent

The commission also forecast that growth in the full, 25-nation EU would be 2.0 percent this year, slowing from the 2.4 percent chalked up last year. It said in a statement that "although world trade growth is estimated to have peaked in 2004, soaring oil prices and the strength of the euro dampened economic activity in the euro area in the second half of 2004 with carry over effects in the beginning of 2005."

Almunia warned that growth could be lower if oil prices were higher than an estimated average $50.90 a barrel this year and if the euro's average exchange rate were above $1.32 per euro the commission expected.

Despite the lower forecasts for growth this year, Almunia was upbeat about signs that the driver of European momentum was shifting from external demand to domestic demand.

"In 2005, we think that even if the growth rate is smaller at 1.6 percent, the composition of growth is much more favorable than the previous year," Almunia said, predicting: "Internal demand will take the lead in the composition of growth."

Although private consumption was seen improving only gradually, the commission expected low interest rates to fuel higher investment spending. Those factors would help lift the euro zone's growth rate to 2.1 percent next year and that of the EU to 2.3 percent.

Employment set to rise across the bloc

The commission also predicted that employment would pick up this year and next, with three million new jobs created in the EU over the period. But the euro zone's stubbornly high unemployment rate would remain unchanged this year at 8.8 percent before falling to 8.5 percent in 2006. The EU would also see its unemployment rate steady at 9.0 percent this year before falling to 8.7 percent in 2006.

Despite its lower growth forecasts, the commission said that the deficits of EU states was improving, forecasting an EU-wide deficit of 2.6 percent of output this year falling to 2.5 percent in 2006.

The euro zone deficit, which stood at 2.7 percent in 2004, was expected to fall to 2.6 percent this year and then nudge up again to 2.7 percent in 2006.

EU states are supposed to keep their deficits to less than three percent of gross domestic product, but the fiscal rule book was broadly rewritten last month giving member countries much greater leeway to overshoot the limit.

Italy's condition a cause for concern

Italy's deficit, which stood at 3.0 percent in 2004, was seen widening sharply from 3.6 percent this year to 4.6 percent in 2006, which Almunia described as " worrying."

"We will need to adopt measures in the case of Italy. When? As soon as possible," he said. Almunia (photo) said the commission "is more pessimistic than the Italian government" over the impact of some of its 2005 budget measures. "It's a very worrying situation."