Recent Economic and Monetary Trends

This review covers the period from mid-December 2007 to the beginning of March 2008

There are now clear indications that the turmoil in the financial markets has real economic consequences. Growth in the West is expected to slow down. The same applies in the emerging markets economies, including China and India, but growth will remain strong. Inflation is high in most parts of the world, driven by higher food and energy prices.

Growth in the Danish economy is also declining. Both private consumption and investments saw lower growth in 2007 than previously. In spite of a sluggish housing market and falling share prices, the wealth of the Danish households remains sound, however, and employment is high.

Although demand is more subdued, there is a pronounced shortage of labour, which has led to a higher rate of wage and price increases. The Finance Act 2008 implies a continuation of the expansionary fiscal policies seen in recent years. This entails a risk that Denmark's competitiveness will be further undermined, which can lead to an unnecessarily high and protracted rise in unemployment, particularly if the strong global economic growth slows down.

THE GLOBAL ECONOMY

The global economy is expected to dampen in 2008 following several years of very high growth. Expectations have thus been adjusted downwards in line with an increasing awareness that the subprime turmoil will have real economic implications. The International Monetary Fund, IMF, estimates that global growth will fall to 4.1 per cent in 2008, from 4.9 per cent in 2007, cf. Table 1. The slowdown will be most pronounced in the West, while growth is expected to remain high in the emerging markets, despite a small decline.

Tightening of liquidity in the wake of the subprime turmoil meant that the spread between collateralised and uncollateralised money-market interest rates widened considerably. Central banks worldwide have gradually smoothed the functioning of the money markets, e.g. by providing liquidity, and by increasing access to dollar funding. The spreads between collateralised and uncollateralised interest rates in both the USA and the euro area have narrowed by around 0.50 percentage point since their peaks, but remain above the very low level seen before the problems emerged in the late summer of 2007.

Risk premiums, i.e. the additional interest required for taking risk, have risen. Since the beginning of November 2007, the spread between government bonds and bonds rated BBB or higher has widened by 0.8 percentage point in the USA and 1 percentage point in the euro area, to approximately 2.3 percentage points in both economies.

Known subprime-related losses in the financial sector total around 120 billion dollars, but estimates indicate total losses could be as high as 400 billion dollars, cf. the statement by the German Minister of Finance after the G7 meeting in February. The subprime crisis and the mounting losses have had a negative impact on the price of bank shares worldwide, cf. Chart 1. Subprime-related losses, the calling of guarantees and the downgrading of a number of assets have reduced the solvency of several US and European banks. Since October 2007, banks in the USA and Europe have reported tightening of their credit terms.

In recent months monoline bond insurance companies have also come into focus. These companies provide insurance against credit risk on bonds, including securities linked to the subprime market. The financial turmoil has considerably increased the value of the policies, and thus the commitments of the insurance companies. The shares of two of the largest bond insurance companies have dropped by more than 80 per cent since the summer of 2007, and the companies potentially face downgrading. In that case, securities insured by the monoline companies will also be downgraded, which in turn will increase market uncertainty and entail further bank losses. Recent developments, however, indicate that for the time being these companies will not generally be downgraded. At the end of February, Standard & Poor's and Moody's retained their credit ratings for the largest US monoline bond insurance company. Moreover, the authorities and a number of financial enterprises are working on a restructuring plan, as well as a plan for raising further capital.

The prospect of lower growth means that US long-term yields have declined steadily since the summer of 2007, to 3.5 per cent at the beginning of March, cf. Chart 2. During this period, the Federal Reserve has lowered the fed funds target rate by 2.25 per cent. The US 10-year yield is now just over 0.35 percentage point below its German equivalent.

The stock markets have also reacted to the weaker growth prospects, cf. Chart 3. The price falls on Monday, 21 January 2008 were among the largest in recent times. The Germany DAX30 index declined by more than 7 per cent and the MSCI^[1] emerging-market index by almost 6 per cent. For both indices, this is the most pronounced drop since 2001. The Danish OMXC20 index fell by more than 5 per cent. In early March, share prices the USA, the euro area and Denmark were 5-10 per cent below their level one year earlier.

Oil prices remain very high. The strong economic growth in non-OECD countries has boosted the demand for oil. Combined with geopolitical tensions and only marginal increases in oil production, this has for short intervals pushed up oil prices to a level of more than 100 dollars per barrel, cf. Chart 4 on p. 7. The higher oil prices, together with higher food prices, have led to rising inflation in most countries worldwide, cf. Box 1. Inflation excluding energy and food has been relatively stable.

FOOD PRICES	Box 1
Food prices have risen steeply throughout most of the world in the last couple of years, cf. Chart 5. This is not a new phenomenon, but the current increases have received much attention and have been linked to e.g. higher production of biofuel derived from grain, sugar and maize.
FOOD PRICE INFLATION	Chart 5
Source: EcoWin.
Food price inflation is particularly pronounced in the developing countries. The reason is that higher prices for unprocessed food have a more significant impact on the prices of processed food in these countries. Commodity costs constitute a larger share of total manufacturing costs for processed food; for example, wage costs are lower in the developing countries than in the industrialised countries. This means that overall food prices are more severely affected by rising commodity prices, and consequently food price inflation is higher. In November 2007, food prices in China were thus 17.1 per cent higher than in November 2006, while food prices in the euro area rose by just under 5 per cent in the same period. The elevated food prices are attributable to several factors. High energy prices have pushed up the cost of fertilisers and transport. Moreover, the supply of e.g. grain has been limited, one of the reasons being poor harvests in Australia, which has been hit by draughts for several years. Wheat production in Australia dropped by more than 60 per cent from 2005 to 2006, while global wheat production fell by approximately 4.5 per cent. The low harvest in 2006 meant that by the end of the year global grain inventories had reached the lowest level since 1983. This inflated prices further in 2007. While global production has shrunk, demand has been growing. Greater affluence, particularly in Asia, has boosted the demand for meat and dairy products. Producing 1 kg meat requires around 8 kg of grain, and hence the demand for grain is rising. The strong focus on biofuel in the USA and the EU has also increased the demand for grain and maize. Higher prices have induced farmers to switch to these crops, which has kept price rises at bay, but has pushed up the prices of other crops. The decline in production in 2006 was four times higher than the consumption of grain for biofuel. "Normalisation" of weather conditions should therefore lead to a substantial rise in production and thereby to lower prices. In the slightly longer term it is expected that residue such as straw and wood chips can be substituted for grain, maize and other food in biofuel production. In addition, it should be possible to enhance agricultural productivity in developing countries significantly. In Asia and South America the average yield per hectare is only one third of the yield in Europe. The immediate consequence of rising foods prices is higher inflation and thus an undermining of purchasing power. Households in the developing countries are most severely affected since they spend a larger proportion of their income on food, cf. Chart 6.
FOOD WEIGHTS AND INCOMES	Chart 6
Note: Food weights indicate the weighting of food in the consumer price index. Ln is the natural logarithm. Source: IMF, World Economic Outlook, October 2007.

After having been steady for some months, the euro in February appreciated against the US dollar and the pound sterling, cf. Chart 7. The Chinese renminbi depreciated in line with the US dollar. Conversely, the euro has weakened vis-à-vis the Japanese yen and the Swiss franc during the last quarter.

The strengthening of the latter two currencies is attributable to the development in the stock markets, and in risk appetite in general. "Carry trades" – i.e. speculation in the spread between interest rates by borrowing in low-yield currencies such as the yen and the Swiss franc and investing in high-yield currencies – have had a major impact on the exchange rates of these currencies. In recent months, risk appetite has waned in the financial markets. This has led to the settlement of speculative positions, which in turn has strengthened the Japanese yen and the Swiss franc.

USA

The USA is at the centre of the financial turmoil and the global slowdown. GDP rose by a mere 0.2 per cent in the 4th quarter of 2007, compared with 1.2 per cent in the 3rd quarter. The low growth was primarily related to residential investments falling by 25 per cent from the 3rd to the 4th quarter, which reduced overall investments by 0.9 per cent on the previous quarter. Private consumption, on the other hand, continued to show robust growth. US exports are still buoyed up by the weak dollar. The trade deficit was stable in 2007.

The labour market is also showing signs of weakness. In January, non-agricultural employment fell for the first time since 2003. Unemployment rose from 4.7 per cent in November 2007 to 4.9 per cent in January 2008. The ISM index, which is a confidence indicator for non-manufacturing enterprises, i.e. primarily the service, agriculture and construction sectors, rose again in February, having reached its lowest level since 2002 in January.

The signs of weakness in the US economy have triggered reactions from both the Bush administration and the Federal Reserve. Fiscal policy has been eased by 150 billion dollars, equivalent to just over 1.0 per cent of GDP, primarily by way of cash tax discounts, increased unemployment benefits, food assistance for the destitute and more lenient depreciation rules for the business sector. The administration is also working on a solution whereby more than 300,000 homeowners at risk can have the interest rates on their mortgages frozen at a fixed, low level for a certain period.

The Fed has lowered the fed funds target rate by a total of 2.25 percentage points over the last six months, cf. Chart 8, and expects inflation to fall in the coming months. In addition, the Fed, in collaboration with other central banks, has sought to smooth the functioning of the money markets. Access to dollar funding has been eased and a new lending facility has been introduced, whereby a broader range of assets may be pledged as collateral in connection with normal market operations.

EMERGING MARKET ECONOMIES

China's GDP rose by 11.2 per cent in the 4th quarter compared with the 4th quarter of 2006. This is only slightly below the growth rate observed in the previous two quarters. Output growth was mainly driven by domestic investments. Export growth remains high, albeit declining on account of weaker demand in the USA and the strengthening of the renminbi.

In December 2007, annual inflation in China was 6.5 per cent, primarily reflecting rising food prices. The risk of overheating led the People's Bank of China to raise its interest rates by some 0.25 per cent in December 2007. In an attempt to curb lending growth, the central bank in January 2008 raised the reserve requirement imposed on banks to 15 per cent.

In India growth is high, but slowing down. Economic growth was 8.7 per cent from March 2007 to March 2008. Although the Indian rupee has appreciated against the US dollar over the last year, the Reserve Bank of India has kept its interest rate unchanged, citing a risk of higher inflation due to rising energy and food prices.

EUROPE

Retail turnover in the euro area was down by 1.2 per cent year-on-year in November and by a full 2 per cent in December, a rate of decline not seen for a decade. Industrial production also fell in both November and December.

The labour market has seen a favourable development with unemployment reaching 7.1 per cent in January, an all-time low for the euro area. Forward-looking confidence indicators have fallen somewhat in recent months, but remain at a sound level. The Purchasing Managers Index, PMI, is still above 50, which indicates expansion.

Consumer prices rose by 3.2 per cent in January. The high rate of inflation is primarily attributable to higher food and energy prices.

The ECB has maintained its key interest rate at 4.0 per cent since 13 June 2007. Money-market interest rates in the euro area (Eonia swap rates) indicate that market participants expect the minimum bid rate to fall by up to 0.75 per cent over the next year.

In the UK, GDP rose by 0.6 per cent in the 4th quarter, which was only slightly below the growth seen in the preceding quarters. There are, however, indications that growth in private consumption is declining, partly on account of steadily falling housing prices throughout the autumn and further tightening of credit conditions.

Inflation has been stable at around 2 per cent for the last six months after having exceeded 3 per cent in the spring of 2007. On 7 February, the Bank of England, BoE, lowered the bank rate by 0.25 percentage point to 5.25 per cent. In the assessment of the BoE there is a medium-term risk that inflation may fall below the target of 2 per cent as a result of declining activity.

In Sweden, Sveriges Riksbank raised the repo rate by 0.25 percentage point to 4.25 per cent in February, citing expectations of high inflation in a still favourable cyclical environment. Inflation was 3.2 per cent in January 2008.

THE DANISH ECONOMY: MONETARY AND EXCHANGE-RATE CONDITIONS

The Danish krone has been stable around its central rate in ERM II. Tensions in the euro area money market meant that the short-term yield spread to the euro area was narrow in December, while there was a forward discount for trading euro against kroner, as opposed to the forward premium usually applicable to such trading. This caused the krone to weaken somewhat up until Christmas. The weakening coincided with considerable net capital outflows, primarily purchase of foreign bonds by Danish residents and sale of Danish bonds by non-residents. Danmarks Nationalbank intervened in the foreign-exchange market to purchase kroner against foreign exchange for around kr. 12 billion. The krone strengthened slightly from the end of December when forward rates in the foreign-exchange market normalised. In January, Danmarks Nationalbank purchased foreign exchange for just under kr. 8 billion in order to stabilise the krone. The foreign-exchange reserve was kr. 180.3 billion at end-February.

The yield on 10-year Danish government bonds has declined by 0.2 percentage point since December, to 4.0 per cent at the beginning of March. In the same period, the maturity-adjusted yield spread between 10-year Danish and German government bonds widened to around 0.15 percentage point.

During the international financial turmoil in the 2nd half of 2007, the longer-term uncollateralised money-market interest rates in both Denmark and the euro area rose considerably in relation to the collateralised money-market interest rates, cf. Chart 9. Since the turn of the year, money-market tensions have subsided, and the spread between the collateralised and uncollateralised money-market interest rates has narrowed.

The spread between uncollateralised money-market interest rates in Denmark and the euro area for various maturities has been highly volatile in the period since August 2007, cf. Chart 10. As in many previous years, the spread narrowed significantly over year-end. Money-market interest rates in the euro area usually rise around New Year. Subsequently spreads between uncollateralised money-market interest rates in Denmark and the euro area have returned to a level of 0.25 percentage point, corresponding to the difference between monetary-policy interest rates.^[2]

The banks' interest rates on corporate lending increased by 0.2 percentage point in the 2nd half of 2007. The reason was that part of the banks' lending is linked to the uncollateralised money-market interest rates, which soared in connection with the international financial turmoil. In early 2008 several banks announced that they were raising lending rates by 0.25 percentage point, referring to higher financing costs in the money and capital markets. Higher financing costs have also intensified competition for deposits. A few banks have raised their deposit rates, while others have introduced new deposit types.

Overall growth in lending by banks and mortgage-credit institutes, which was 12.6 per cent year-on-year at the end of January, cf. Chart 11, has been declining since the beginning of 2007. The moderation has been most pronounced for lending to households, mirroring the slightly lower growth in private consumption.

THE DANISH ECONOMY: REAL ECONOMY

Economic activity and the housing market
Growth in the Danish economy is declining, cf. Chart 12. There are indications of a dampening of demand pressure, but nevertheless the economy remains at its capacity limit with resultant pressure on the labour market. The shortage of labour is expected to peak in 2008 and then to ease in step with falling demand. Growth will continue to be determined by supply-side factors, i.e. the development in the labour force and in productivity. This entails a slowdown in economic growth in the coming years, cf. Table 1 on p.2.

The pressure on the economy has resulted in a strong increase in the propensity to import and a rapidly decreasing current-account surplus in the last few years. In recent quarters the rate of wage increase and domestic price pressures have risen, reflecting the normal pattern whereby prices and wages react with a considerable lag to cyclical developments. This also applies in connection with downturns, which may be deep and long if the level of costs has become too high in relation to that of Denmark's foreign competitors.

GDP at constant prices grew by 0.4 per cent in the 4th quarter, while full-year growth was 1.8 per cent. Consumption and investments rose at a faster rate than GDP in the 4th quarter. The reason why overall growth was nevertheless modest was that demand was to a large extent aimed at foreign products. Imports of goods and services increased by 3.3 per cent, while inventory investments declined substantially.

The confidence indicator for building and construction showed a downward trend in the 2nd half of 2007, cf. Chart 13. The share of construction enterprises reporting labour shortages has declined, but still exceeded 25 per cent at the turn of the year. Building and construction is one of the most cyclically sensitive sectors of the economy and thus one of the first to feel the impact of a slowdown.

Residential investments have been stable since 2006. This marks the end of a period of virtually uninterrupted growth since 1993, combined with rising real cash prices for owner-occupied housing, which trebled over the period.

Against the backdrop of strong economic growth with robust earnings and mounting capacity pressure, business enterprises have increased their investments substantially since 2004, but the rate of growth subsided in 2007. Particularly investments in machinery and software have been high. The elevated investment level in relation to output entails a higher capital-to-worker ratio. This development has been accelerated by the shortage of labour, but is also important if the Danish wage level, which is high in an international context, is to be maintained. That is only possible if productivity is high in Denmark.

Private consumption grew by 2.5 per cent in the 4th quarter of 2007 and by 2.7 per cent for the full year, i.e. at a lower rate than in the preceding years. The slowdown is accentuated by factors such as consumer confidence, which fell towards the end of the year and was negative in January for the first time since the upswing started in 2003. The primary reason is increased concern about Denmark's economic prospects, presumably partly on account of the financial turmoil.

From the peak in October 2007 until the end of February the households have lost an estimated kr. 250 billion on share portfolios, equivalent to approximately 7 per cent of their total wealth. The price drop follows a period of considerable growth in wealth. The estimated consumption effect of the declining share portfolios is sizeable, but not dramatic. Calculations using Danmarks Nationalbank's macroeconomic model show that, viewed in isolation, losses of this magnitude can dampen the development in private consumption by 1 per cent over a 2-year horizon. The GDP impact is more modest, approximately 0.25 per cent over a 2-year horizon, since imports account for a large share of the adjustment. If the level of interest rates, which has fallen by approximately 0.25 percentage point over the same period, is taken into account, the effect of the lower share prices on private consumption is less pronounced, and the decline in GDP growth is virtually zero.

Apart from share prices, the primary factor affecting household wealth is the price of housing. According to the statistics of the Association of Danish Mortgage Banks, single-family houses have risen only slightly in recent quarters, while owner-occupied flats have fallen by almost 10 per cent over the last year, cf. Chart 14. Price developments are subject to considerable regional differences. The dampening of the housing market is also reflected in sales of owner-occupied homes, which were lower in the 4th quarter of 2007 than previously. At the same time, the number of homes for sale is high.

In general, the finances of the households are sound, and combined with good employment opportunities this means that the households are resilient to the slowdown in the housing market and the global decrease in share prices. This is underlined by the fact that  the number of foreclosures remains low. The propensity to consume has risen only slightly in recent years. To the extent that home equity has been mortgaged, the proceeds have in many cases been used to reduce other debt, boost pension savings or improve the home.

Foreign trade and balance of payments
A shortage of domestic production capacity means that an increasing share of demand must be met by foreign production, which has reduced the trade and current-account surpluses. In 2007, the current-account surplus was down to kr. 17 billion, from almost kr. 70 billion in 2005, cf. Chart 15. Particularly the balance of goods, which includes bunker costs for the large Danish merchant fleet, has deteriorated. Bunker costs rose from kr. 19 billion in 2005 to kr. 33 billion in 2007.

The sustained external surplus in the current cyclical phase is primarily attributable to North Sea oil and gas production, as well as a considerable expansion of the merchant fleet. Viewed in isolation, both contribute to the current-account surplus with relatively limited input of Danish production resources.

Labour market and wages
According to the national accounts, seasonally adjusted employment grew by 11,000 from the 3rd to the 4th quarter of 2007, to an all-time high of more than 2.8 million persons. Growth in employment has exceeded the decline in unemployment, which means that the labour force has increased, despite a decline in the age groups from which the labour force is mainly recruited. A major reason has been an influx of foreign labour.

Statistics Denmark has changed its method for compilation of unemployment figures, which has reduced unemployment by 0.5 percentage points in relation to the previously published figures. The labour statistics have been revised backwards to April 2000 using the new method. The overall picture remains the same: unemployment has been steadily declining, to 2.1 per cent of the labour force in January. This is the lowest rate of unemployment in Denmark since the early 1970s, cf. Chart 16. Unemployment is now well below the structural level that is compatible with a balanced economy, cf. Box 2, which means that a certain increase in unemployment is necessary to ease the capacity pressure and prevent wages and prices from accelerating.

STRUCTURAL UNEMPLOYMENT	Box 2
Structural unemployment reflects the level of unemployment that is compatible with stable wage and price developments a few years ahead. When actual unemployment is equal to structural unemployment, the labour market is thus in balance, entailing a stable development in wages at a level corresponding to growth in productivity plus the 2-per-cent inflation which signals price stability. Structural unemployment is closely related to the concepts of natural unemployment and NAIRU (Non-Accelerating Inflation Rate of Unemployment). When unemployment falls below structural unemployment this will, all other things being equal, lead to accelerating wage increases, whereas unemployment above the structural level leads to lower wage increases. The wage response is, however, normally lagged, one reason being that many wages are only adjusted in connection with collective bargaining. If low unemployment leads to wage increases that are not matched by higher productivity, manufacturers will at some point have to raise their output prices, whereby price developments are affected by labour-market imbalances. The wage response to fluctuations in unemployment around its structural level is asymmetrical since wage acceleration in periods of lower actual unemployment typically exceeds wage moderation in periods of higher actual unemployment. In other words, the more unemployment falls below its structural level, the greater the risk that a protracted period of high unemployment is required in order to restore competitiveness. Structural unemployment is determined by institutional conditions, mainly in the labour market, and experience from the 1990s shows that it is possible to reduce structural unemployment through reforms, e.g. by reducing the period of entitlement to cash benefits and speeding up activation. Structural unemployment is not directly observable, but is regularly estimated by the Ministry of Finance1, the European Commission and the OECD, among others. Such calculations are naturally subject to considerable uncertainty and the estimates are revised from time to time. The difference between actual and structural unemployment – the unemployment gap – is important in relation to the planning of economic policy, but is not the only factor to be taken into account. In a situation when unemployment is falling it is difficult to say whether structural unemployment has also fallen or whether the unemployment gap has changed. In theory it is possible to distinguish between the two situations by examining whether or not wage increases have accelerated, but in practice this is not possible due to the lagged wage response. Consequently, there is a risk that economic policy is not tightened in time if a decline in unemployment is initially misinterpreted as an expression of falling structural unemployment. In the current situation there is consensus that actual unemployment is lower than structural unemployment, although the estimates of e.g. the Ministry of Finance and the European Commission are far apart, cf. Chart 17. According to the Ministry, the pressure on the labour market is the strongest for 25 years, and the Ministry does not expect the unemployment gap to narrow in 2008 compared with 2007.
UNEMPLOYMENT GAP	Chart 17
Note: The unemployment gap is actual unemployment less structural unemployment. It has been taken into account that the data from the Ministry of Finance refers to registered unemployment according to Statistics Denmark, while the data of the European Commission refers to the EU-harmonised compilation of unemployment. Estimates for 2007 from the European Commission. Data for 2008 are estimates. Calculations are made on unemployment data from before the restructuring of statistics in February 2008. Source: Ministry of Finance, Economic Survey, February 2008, and European Commission, Autumn Forecast, November 2007.
1     The Ministry's calculation of structural unemployment is described in Appendix 2.2 of the Financial Report 2004 (Finansredegørelse – in Danish only).

Confidence indicators show that a pronounced shortage of labour still exists in the construction sector and in industry, although the situation has improved a little in recent months. Other parts of the economy also have problems filling vacant positions, e.g. the public sector. The number of jobs advertised on the Internet is high, so even if the economy is set to cool down, the labour market will remain tight.

The squeezed labour market has triggered a wage response. In recent quarters the rate of wage increase has risen, to 4.3 per cent year-on-year in the 4th quarter of 2007, from 4.0 per cent in the preceding quarter according to Statistics Denmark. At 5.2 per cent, the rate of wage increase in building and construction was among the highest. The new collective agreements for employees in central government and parts of local government and in the financial sector, which have now been concluded, but not yet adopted, entail wage increases in the range of 13 per cent over three years. For the public sector, a large part of the increase is in the early part of the agreement period.

Competitiveness
Denmark's competitiveness has weakened substantially since 2000 on accountofseveralfactors:strengtheningofthekrone vis-à-vis a number of currencies; higher wage increases in Denmark than in competitor countries; and weaker productivity development in Denmark than abroad.

Firstly, the Danish krone has strengthened, particularly against the US dollar, the Japanese yen and the pound sterling. Its appreciation against these currencies far exceeds its depreciation against a number of Eastern European currencies, cf. Table 2.

The effective krone rate is calculated using weights determined on the basis of trade in goods. If trade in services is included, the krone has strengthened even more over this period, since the dollar has a greater weighting in the index including services^[3].

Secondly, Danish industrial wages have increased at a faster pace than those of Denmark's competitors every year since the mid-1990s. An index of wage developments abroad and in Denmark, expressed in the same currency, has thus fallen more than the strengthening of the krone would warrant, cf. Chart 18.

Thirdly, industrial productivity has improved less in Denmark than in competitor countries in recent years, which means that Denmark's competitiveness in terms of unit labour costs has deteriorated even further.

The trend is particularly strong in a broader perspective, but less pronounced in relation to the euro area member states. In the same period, the price of Danish industrial production grew more rapidly than that of the euro area, but slightly slower than unit labour costs, indicating a small increase in labour costs as a share of value added. Calculations of productivity development, and thus of unit labour costs, are subject to considerable uncertainty.

In spite of the deterioration in competitiveness, strong growth in Denmark's export markets has boosted exports in terms of both current prices and volumes. This applies even if energy is disregarded. Wage competitiveness is not the only factor determining the degree of success in export markets. Denmark has to some extent lost market shares, but that is natural during a strong domestic boom with good sales opportunities in the domestic market. The undermining of Denmark's competitiveness will really be felt when the international boom subsides. In that situation it may be difficult for business enterprises to find foreign alternatives to the domestic market if Danish products are too highly priced. Consequently, it may be necessary – in order to restore competitiveness – for unemployment to rise to a level above that which is necessary to ensure a balanced economy in the long term.

Prices
The Harmonised Index of Consumer Prices, HICP, rose by 3.0 per cent in January. That is quite a leap compared with the development in the autumn, and the highest increase since the beginning of 2003. The acceleration is mainly attributable to higher energy and food prices. The latter rose by 5.9 per cent year-on-year, and since they account for almost 20 per cent of HICP, such an increase is clearly reflected in the overall index, as is also the case abroad. The year-on-year increase in energy prices was 8.3 per cent in January.

Domestic market-determined inflation, IMI, has been rising from a low level since the end of 2004, to 1.3 per cent in January. The IMI index is more sensitive to the cyclical situation in Denmark than the HICP index, and the rise in IMI reflects factors such as the tighter labour market. The existence of underlying inflationary pressures is also reflected in large price increases for Danish wholesale goods, industrial products and building materials during 2007.

The higher prices have not gone unnoticed by consumers. There is widespread sentiment that prices have risen, and moreover they are increasingly expected to continue their upward trend in the coming year, cf. Chart 19.

Economic policy
Government finances have a strong automatic stabilising impact on the Danish economy. For example, expenditure for unemployment benefits increases with the rate of unemployment. This is one of the reasons why active fiscal policy in the form of economic intervention is seldom required. Nevertheless, it is an advantage if fiscal policy contributes to dampening output when the latter exceeds the potential of the economy, i.e. the maximum output that is compatible with stable wage and price developments over a few years.

In recent years, the fiscal-policy stance has changed. While in the 1980s and 1990s fiscal policy was counter-cyclical, i.e. aimed at smoothing fluctuations in GDP, it has for some years been pro-cyclical, cf. Box 3. Fiscal policy affects GDP not only within the current year, but also several years into the future. A compilation based on data from the Ministry of Finance shows that the fiscal policy conducted since 2002 has contributed substantially to the strong capacity pressure on the economy in recent years. Fiscal policy has thus been an underlying factor of the current labour-market squeeze.

FISCAL POLICY AND ECONOMIC CYCLES	Box 3
Capacity pressure on the economy can be quantified by determining actual GDP in relation to potential GDP, i.e. an estimate of the maximum output volume that will not lead to pressure on the labour market. In the most recent Economic Survey, this GDP gap is calculated at 2.5 per cent in 2008. An aggregation of the multi-annual fiscal effects shows that fiscal policy since 2002 has increased GDP by 1.7 per cent. A substantial part of the current GDP gap is thus attributable to an expansionary fiscal policy in this period.
ACTUAL AND POLICY-ADJUSTED GDP GAPS	Chart 20
Note: GDP gaps with and without an active fiscal policy for the period 1981-2000 are derived from the Financial Report 2000 (in Danish only), the actual GDP gap being represented by the OECD's current calculation, while the assessment of fiscal policy in the years 2001-08 has been based on various volumes of the Economic Survey. Source: Ministry of Finance, OECD and own calculations.
The stabilising effect of fiscal policy can be illustrated by eliminating the fiscal effect from the GDP level and relating the resulting "policy-purged" GDP to potential GDP. The outcome is the GDP gap, had fiscal policy been neutral. Chart 20 shows that actual GDP gaps in recent years have been wider than the GDP gap without an active fiscal policy, 2004 being an exception. This means that fiscal policy has amplified the upswing. In the period 1980-2000 it was the other way round. Fiscal policy helped to smooth GDP developments, as reflected in the fact that in this period the blue bars are closer to zero than the orange ones.

Because of the general election in the autumn of 2007 the Danish government did not present its Finance Bill 2008 until the beginning of February. The fiscal stance whereby government finances have an expansionary impact on the economy will be upheld in 2008, amidst pronounced labour shortages and clear signs of overheating of the Danish economy, e.g. high rates of wage increase.