Recent Economic and Monetary Trends

This review covers the period from the middle of May 2006 to the beginning of September 2006

Growth in the global economy is strong and broadly based, cf. Chart 1. In the USA, the economic upswing is dampening, while in Europe it has gained momentum. Japan has experienced strong growth in the past 12 months, and in non-Japan Asia – especially China – the economic expansion is still very strong. Despite the high growth rates and rising energy prices, inflationary pressures are moderate. The US fed funds target rate was held unchanged at the latest meeting of the Federal Reserve in August, following a good two years with interest-rate increases. In the euro area, the official interest rates have been increased on three occasions this year, and the Bank of Japan raised its official interest rate in July for the first time in several years. The near-term outlook for the global economy is still favourable. However, cyclical developments in the USA, including in the housing market, and oil-price trends still represent challenges to international growth.

INTERNATIONAL FINANCIAL AND COMMODITY MARKETS

The oil price rose over the summer to reach a new record of 78 dollars per barrel (Brent) at the beginning of August, cf. Chart 2. The increase could be attributed to generally rising demand for oil, as well as greater uncertainty concerning the future supply conditions due to such factors as unrest in the Middle East. The uncertainty diminished during August and the oil price fell back to 66 dollars per barrel at the end of August.

Most commodity prices – especially for industrial metals – have risen this year. Nickel and copper prices in particular have increased sharply. The gold price peaked in April, but has since receded slightly to reach 627 dollars per ounce in August.

International stock prices fell considerably in May and early June, cf. Chart 3, but during the summer they regained most of the lost ground. Stock markets in emerging economies accounted for the strongest price fluctuations in view of their sensitivity to global economic developments and higher risk profile. The principal factors behind the stock-price fluctuations were greater uncertainty of future economic growth, inflation and corporate earnings in the USA. The assessment of the risk associated with holding stocks thus shifted in favour of investments with a lower risk profile. Fears of rising inflation in the USA subsided during the summer months, which strengthened the stock markets.

Long-term yields increased up to May, but decreased slightly as the market participants moved away from stocks and other high-risk assets to safer securities. Mounting fears of inflation led to renewed interest-rate increases in the 2nd half of June, but towards the end of June the long-term US interest rates began to fall, in view of the prospects of lower economic growth in the USA. The course of US interest rates was mirrored by European interest rates, but with less fluctuation. The 10-year US government bond yield was 4.7 per cent at end-August, while the corresponding euro-area yield was 3.8 per cent. In contrast to long-term yields, the official interest rates – and thus the short-term market interest rates – rose during the summer. This resulted in a flattening of the yield curve, measured as the spread between 1-year and 10-year yields, in Europe and the USA. Since the middle of May, the slope of the US yield curve has even been negative, which can be taken to reflect a relatively tight monetary-policy stance. Previously, a negative slope of the yield curve often preceded an economic downturn. However, the current situation differs from previous cases in several key respects, and the current flattening is unlikely to be followed by a recession.^[1]

From March to May the dollar depreciated strongly vis-à-vis the other major currencies, and has since remained fairly stable against the euro and the pound sterling, but appreciated by approximately 5 per cent against the yen from mid-May to the end of August.

INTERNATIONAL ECONOMIC DEVELOPMENT

USA
There are signs that the upswing in the USA which started at the end of 2003 has begun to recede. GDP growth was 0.7 per cent in the 2nd quarter compared to the previous quarter, which is a slightly lower growth rate than earlier in the upswing. The lower growth is attributable to such factors as a slower increase in private consumption and a downturn in residential investments. Overall, the contribution to growth from foreign trade has been negative, but the 2nd quarter saw unchanged US imports and continued growth in exports.

House prices have barely risen since the turn of the year, cf. Chart 4. Furthermore, the number of homes sold has decreased, and home builders now have a markedly less optimistic view of the property market potential. The dampening of the housing market is one of the factors behind the development in consumption and residential investments. In addition, consumption was adversely affected by higher energy prices and a slight weakening of the labour market. Employment as measured by non-farm payrolls rose by 119,000 on average in the period April-August, compared to an average of 170,000 from the beginning of 2004 to March 2006, cf. Chart 5. The slower rate of employment growth coincided with a virtually unchanged unemployment rate, which was 4.7 per cent in August. However, the forward-looking ISM (Institute for Supply Management) indicators for the manufacturing sector and consumer confidence are still at a high level – despite a slight slowdown in recent months – and show no signs of any major downturn.

Business investments showed moderate growth from the 1st to the 2nd quarter, but the growth rate from the same period in 2005 was still considerable at 7.3 per cent. Recent years' strong increase in corporate profits has contributed to expanding the investment ratio, but nevertheless a smaller share of profits than normal was invested in real capital. Instead, business enterprises allocated their profits to the financial markets and consequently increased their savings.

Wage pressure has been remarkably moderate during the current upswing, although the exact wage development is uncertain due to the different trends shown by various wage indices. According to the Employment Cost Index, a relatively broad wage index comprising wages as well as bonus, pension and insurance, etc., the rate of increase has declined in the last few years. In the 2nd quarter of 2006 the index rose by 3.0 per cent on the same quarter of 2005.

Inflation was relatively high during the summer despite the moderate wage increases. In July, consumer prices were 4.1 per cent higher than a year before, primarily due to oil-price increases, but also to rent increases. Consumer prices excluding energy and food, which are of key significance to the Federal Reserve in its implementation of monetary policy, rose by 2.7 per cent year-on-year in July. This exceeded the relatively stable level of around 2 per cent that persisted during much of the upswing.

At its latest meeting on 8 August, the Federal Reserve held the fed funds target rate unchanged at 5.25 per cent. This was the first meeting for more than two years without a decision to raise the interest rate by 25 basis points. The reason given was the moderation of economic growth in the USA, reflecting a gradual cooling of the housing market. Another factor was the lagged effect of increases in interest rates, which, together with moderate inflation expectations, is expected to keep inflation relatively stable. The Federal Reserve also found a persistent risk of higher inflation in view of energy prices and capacity pressures. The market predominantly expects the Federal Reserve to hold the fed funds target rate unchanged for the next six months.

The 2006 fiscal year ends on 30 September. Although fiscal policy has not been tightened, the federal budget deficit in the fiscal year to date, i.e. 10 months, is approximately 60 billion dollars lower than in the same period of 2005. Against this background the Congressional Budget Office expects a budget deficit of 260 billion dollars, or 2.0 per cent of GDP, for 2006. The federal budget deficit was 318 billion dollars in 2005. The budget improvement can be attributed to higher tax revenue as a result of increasing tax payments from business enterprises and households.

Euro area
The euro area saw strong economic expansion in the 2nd quarter of 2006, with GDP growth of 0.9 per cent on the previous quarter. The growth rate has been 2.6 per cent for the past 12 months, so now the upswing is finally reflected in the real economy and not only in economic indicators such as business and consumer confidence, which have been favourable for some time.

The significant growth in the 2nd quarter was driven by both domestic demand and exports. Unemployment in the euro area, especially in Germany and France, is still high, but decreased towards the summer in view of the strong economic growth. In July, the unemployment rate was 7.8 per cent of the labour force.

In Germany, exports have been the main driver of economic growth in recent years. Growth has been moderate until this year, when it reached 0.9 per cent in the 2nd quarter compared to the 1st quarter of 2006. The export growth e.g. led to a higher investment ratio, and in the 2nd quarter investments rose strongly by 3.4 per cent quarter-on-quarter. For a long time rising energy prices and a weak labour market have burdened real disposable incomes and thereby private consumption, but in the 1st half-year consumption also made a contribution to the stronger activity. The real-economic development reflects the positive trends shown by confidence indicators for a relatively long period. The near-term outlook for the German economy is relatively favourable, even though the picture is not completely clear. However, business confidence, measured by the Ifo index, and consumer confidence are very high. The VAT increase in January 2007 is expected to induce consumers to move their purchases of consumer durables forward to the 2nd half of 2006 and constitutes a risk to the development in the German economy next year.

France's GDP rose by 1.1 per cent from the 1st to the 2nd quarter. In recent years the contributions to growth from both private consumption and exports have been considerable. In Italy, activity is still subdued, with moderate GDP growth of 0.5 per cent from the 1st to the 2nd quarter. In Spain, domestic demand was the main driver of growth, which stood at 0.9 per cent in the 2nd quarter.

The growth in consumption in France and particularly Spain can primarily be attributed to strong increases in asset prices, especially housing.

The euro area Harmonised Index of Consumer Prices, HICP, has risen slightly in recent months as a result of higher energy prices in particular. In July, consumer prices rose by 2.4 per cent on July 2005, while consumer prices excluding energy and unprocessed food increased by only 1.6 per cent.

In most euro area member states inflation is in the range of 2-3 per cent. In a few member states consumer prices are increasing at a higher rate, particularly Spain, where inflation was almost 4 per cent in July, cf. Chart 6. The Netherlands, on the other hand, posted an inflation rate of only 1.8 per cent. A measure of inflation dispersion across the euro area can be compiled as the numerical deviation of the member states' inflation rates from the average inflation rate in the euro area, weighted using the HICP weights. Based on this measure, inflation dispersion across the euro area member states has declined in recent years, cf. Chart 7. In the period 1998-2002 the dispersion was almost constant, but from the middle of 2002 it increased due among other things to lower inflation in Germany than in most other euro area member states. The inflation dispersion in the euro area has declined since 2003 and is now lower than before the introduction of the euro in 1999. Homogeneous development in inflation in the euro area is a preferred basis for the single monetary policy.

At its meetings on 6 June and 3 August, the ECB decided to raise the minimum bid rate by 25 basis points, bringing it to 3.0 per cent. The reason stated was upside risks to price stability based on economic forecasts for the euro area. Furthermore, it was pointed out that growth in money and credit is still high and that there is ample liquidity in the markets. The money-market interest rates signal that the market predominantly expects a further two increases by 25 basis points in the minimum bid rate this year.

On 1 January 2007, Slovenia, which meets all the economic criteria, will join the Economic and Monetary Union. This makes Slovenia the first of the new EU member states to adopt the single currency.

Japan and China
The upswing in Japan gained momentum in 2005, and this development has continued in 2006. However, a decrease in inventories contributed to growth in the 2nd quarter of only 0.2 per cent on the 1st quarter. While previously exports were the main driver of the Japanese economy, domestic demand now contributes more to GDP growth.

In July consumer prices rose by 0.3 per cent on the same period of 2005. The upswing and rising energy prices have contributed to the higher consumer prices. However, so far there are no certain indications that deflation has come to an end. Consumer prices excluding energy and fresh food have thus declined in every month of 2006, including by 0.3 per cent in July.

On 14 July 2006, the Bank of Japan raised the official interest rate (UOCR), by 25 basis points. This was the first increase in Japan's official interest rate since August 2000. A higher interest rate is the last step in the normalisation of the monetary-policy framework that was adopted in March 2006. The purpose of the tightening was to ensure sound development in activity and stable inflation in the medium term. It was assessed that continuation of the zero-interest-rate policy could entail the risk of excessive fluctuation in economic activity and prices. The market expects further interest-rate increases by approximately 50 basis points over the next 12 months.

China's GDP rose by approximately 11 per cent year-on-year in the 2nd quarter of 2006. The very strong growth, probably attributable primarily to high increases in investments end exports, surprised many market participants. The Chinese government has sought to dampen the upswing by tightening the restrictions on investment in certain sectors and by encouraging the local authorities to exercise restraint in public investment. Furthermore, monetary policy was recently tightened a little, e.g. in August when the People's Bank of China's deposit and lending rates were raised by 27 basis points, and by introducing higher reserve requirements for the banks. In addition, the renminbi has appreciated slightly against the dollar over the past year. However, these measures were not sufficient to dampen the higher growth.

UK
Following a period of moderate growth, GDP rose by 2.6 per cent in the 2nd quarter compared to one year before. Business investments and exports rose strongly, and private consumption also expanded, by 1.0 per cent quarter-on-quarter. Private consumption was previously kept down by rising expenses for electricity and heating, etc., a growing tax burden and increasing mortgage interest expenses. Residential investments declined in the 1st half of 2006 due to such factors as stagnating house prices from the middle of 2004 to the end of 2005. However, house prices have recently begun to rise again.

Over the last 12 months both unemployment and employment have risen, and in June 5.4 per cent of the labour force were unemployed. An influx to the labour market from abroad and a higher proportion of elderly people in employment have expanded the labour force, which is the reason why unemployment has not fallen.

HICP inflation was 2.4 per cent year-on-year in July, i.e. above the medium-term target of 2 per cent. However, a large part of the increase could be attributed to higher energy prices. Consumer prices excluding energy rose by only 1.1 per cent in June.

In August the Bank of England raised the base rate by 25 basis points to 4.75 per cent. The decision was based on the recent sound growth, limited capacity in the economy, strong growth in money and credit, and estimates of above-target inflation for some time.

Sweden and Norway
The upswing continues in Sweden and Norway with high growth, strong labour markets and low inflation.

Sweden's GDP grew by 1.4 per cent quarter-on-quarter in the 1st and 2nd quarters of 2006. In July 2006 consumer prices were 1.4 per cent higher than one year before, measured in terms of the UND1X index which excludes indirect taxes and price effects of interest-rate adjustments. Inflation was thus still within Sveriges Riksbank's target zone of 1-3 per cent. In June and August, Sveriges Riksbank raised the repo rate by 25 basis points to 2.50 per cent. The monetary-policy tightening reflects normalisation of the interest-rate level in view of the strong real-economic growth.

In Norway, consumer prices rose by 2.2 per cent year-on-year in July, while inflation measured by the KPI-JAE index, which excludes energy and indirect taxes, was only 0.6 per cent. This is significantly below Norges Bank's inflation target of 2.5 per cent. In May, Norges Bank raised the sight deposit rate by 25 basis points to 2.75 per cent, and again in August to 3.0 per cent. This was motivated especially by concerns about the Norwegian economy overheating. Norges Bank expects to raise the interest rate further later this year.

DANISH MONETARY AND FOREIGN-EXCHANGE CONDITIONS

In the period under review, the krone was close to its central rate in ERM II of kr. 7.46038 per euro, and Danmarks Nationalbank intervened in the foreign-exchange market on only one day. At end-August, the foreign-exchange reserve was kr. 180 billion.

In conjunction with the ECB's interest-rate decisions, Danmarks Nationalbank raised its interest rates by 25 basis points on 9 June and 4 August, cf. Chart 8. The most recent increase brought the lending rate to 3.25 per cent and the discount and current-account rates to 3.0 per cent.

The developments in international bond yields and in stock prices impacted on the Danish market. After fluctuating at around 4 per cent, the 10-year government bond yield was 3.8 per cent at end-August. Since at the same time short-term interest rates increased, the yield curve flattened. The Danish OMX stock index fell from approximately 416 in mid-May to approximately 350 in mid-June. It has subsequently rallied to approximately 391 at end-August. The Danish stock market fell more than most international markets, but the increase prior to the dive had also been more pronounced. To a great extent this reflects the price development in the A.P. Møller Mærsk A/S stock, which accounts for around 26 per cent of the total index.

Growth in lending by banks and mortgage-credit institutes to households and business enterprises has been very strong in recent months, reaching almost 15 per cent in July, cf. Chart 9. This growth is high compared to previous years. Growth in lending to business enterprises was particularly strong. The high lending growth can be attributed to the favourable economic climate.

THE DANISH ECONOMY

The Danish economy is in a significant upswing. Employment rose strongly in the 1st half of 2006. The building and construction sector accounted for the largest increase, and the labour shortage in this sector is increasing, cf. Chart 10. In addition, the Labour Market Councils report more and more bottlenecks elsewhere in the economy. Furthermore, in 2006 the shortage of labour has entailed a strong increase in the number of active work permits for citizens of the new EU member states, cf. Chart 11. However, they only account for 0.3 per cent of the labour force, to which should be added employees seconded to Denmark, for which no statistics are available.

In July, the number of unemployed was 122,100, corresponding to 4.4 per cent of the labour force – the lowest level for more than 30 years. The very low unemployment rate reflects the tight labour market. It is difficult to set a lower limit for unemployment, but any further reduction will probably require a targeted effort.

In the current employment situation there is considerable focus on initiatives that can contribute to meeting the demand for labour. The welfare agreement concluded in June 2006 between the government, the Danish People's Party, the Social Democrats and the Social Liberals sets out a number of initiatives primarily aimed at postponing the age of retirement in order to counter the demographically conditioned decline in the labour force, cf. Box 1. The agreement entails only a modest expansion of the labour force in the short term. However, the amendment of the Eastern Europe agreement in April 2006 has simplified the administrative procedures for granting permits for Eastern Europeans to work in Denmark, cf. above.

Overall, a significantly higher influx of qualified labour is hardly a realistic prospect in the short term.

Economic activity
Real GDP growth was high in the 1st half of 2006, and both domestic demand and exports contributed to the improvement in activity. However, output growth is restrained by the tight labour market.

The strong growth in domestic demand excluding changes in inventories continued in the 1st half of 2006. Compared to the previous quarter, private consumption rose by 3.0 per cent in the 1st quarter and by 1.6 per cent in the 2nd quarter, and was thereby the main driver of the increase in domestic demand. The increase in consumption can be attributed especially to a high number of car sales, while retail sales growth was more moderate.

Several factors contributed to the strong increase in consumption. Disposable real incomes have grown significantly, and consumer confidence is high due to such factors as the buoyant labour market. In addition, household wealth, especially housing wealth, has risen strongly in recent years, reflecting the price increases for owner-occupied homes, cf. Chart 12. The average price per square metre for one-family houses was thus approximately 25 per cent higher in the 1st and 2nd quarters of 2006 than one year before. The increases in house prices can be attributed to a number of positive factors, including employment growth and higher incomes, low interest rates, new loan products in the mortgage-credit market and the freezing of property value tax. The number of homes for sale through estate agents has risen strongly since February, however, cf. Chart 13. Combined with this year's interest-rate increases, this will dampen increases in house prices. The statistics in particular show a tendency for property prices to flatten out in the most expensive areas of Greater Copenhagen. The number of sold homes has declined in 2006.

Business investments are high, and business confidence in the service sectors, manufacturing industry and the building and construction sector is still favourable. The confidence indicator for building and construction is particularly high. Exports grew by 3.4 per cent quarter-on-quarter in the 1st quarter and by 6.6 per cent in the 2nd quarter, reflecting the favourable global economic environment.

Growing demand implies higher imports. Compared to the growth in demand for products for final use, import growth in the 1st half of 2006 was stronger than normal, however, cf. Chart 14. This reflects high capacity utilisation and shortage of labour in Denmark. Imports in relation to demand are likely to increase further in the next quarters if the pressure on the economy persists.

Despite the strong import growth, the seasonally adjusted trade balance continues to show a sound surplus due to oil revenue and rising manufactured exports.

Overall, the balance of payments showed a modest surplus of just over kr. 9 billion in the 1st half of 2006. Special factors, including the development in sea freight, reduced the balance of payments at the beginning of the year, while the income account, particularly interest and dividend income, was at a high level in May and June, which improved the balance of payments. The total income account over 12 months showed a surplus in June for the first time in many years. This reflects that net foreign assets are now positive.

Wages and prices
The rate of wage increase rose to 3.3 per cent year-on-year in the 2nd quarter, according to statistics from the Confederation of Danish Employers, cf. Chart 15. The higher wage-increase rate should be viewed in the light of the low unemployment. Particularly the building and construction sector is experiencing strong wage pressure, and blue-collar wages rose by 4.7 per cent in the 2nd quarter, excluding bonuses and other one-off payments. Wages in the manufacturing sector also edged upwards, although at a lower rate than for construction, which is traditionally a sector with considerable wage flexibility, which can also be in a downward direction. The rate of wage increase in the financial sector has recently gathered momentum.

This is the first pronounced acceleration of the wage-increase rate during the current upswing. Earlier in the upswing wage increases were moderate, despite the tighter labour market. The lag in wage pressure can probably be attributed to several factors. First and foremost, inflation expectations are anchored, e.g. due to low inflation for a prolonged period. Furthermore, Danish wages and salaries are affected by the moderated wage-increase rates abroad – directly via the highly competitive sectors and indirectly via opportunities to relocate jobs to abroad. Finally, since local wage agreements are typically concluded for one year, it takes time for the tight labour market to impact on wage increases.

More substantial wage increases that are not attributable to corresponding productivity growth will have an adverse impact on the economy in that competitiveness – and thereby corporate earnings – will be diminished and inflation will be subject to upward pressure. The result may be a weakening of exports and declining investments, causing unemployment to begin to rise. Such a situation would require several years of increasing unemployment for competitiveness to be restored. Cases in point are Denmark in the years after 1987 and the Netherlands in the early 2000s. Higher wage increases should therefore be regarded as a serious matter. Since the beginning of the 1990s, Danish employees have seen stable real-wage increases year after year, and Danish business enterprises have achieved sound earnings as a result of the moderate wage increases, in combination with even lower inflation.

Inflation has been almost unchanged for the last three months, and consumer prices in HICP terms rose by 2.0 per cent in July compared to July 2005. Inflation has fluctuated at a level of around 2 per cent over the last 12 months. Price increases are thus moderate in a cyclical perspective and reflect a combination of higher energy prices and so far low wage increases and moderate domestic inflation. Inflation in Denmark is still slightly below inflation in the euro area, which is 2.4 per cent.

Economic outlook and fiscal policy
There appears to be continued strong growth in demand. Favourable international cyclical factors are expected to drive exports, while considerable income growth, high housing prices and substantial wealth will contribute to sound growth in private consumption and residential investments in Denmark.

This autumn's economic-policy challenge is to manage the risk of the Danish economy overheating, a risk which has been increasing for some time. The probability of continued pressure from demand having a permanent effect on prices and wages of a magnitude that in the longer term will lead to rising unemployment is now so great that it is advisable that public finances have a marked dampening effect on the overall economy.

An alternative strategy is to wait and see if wage and price increases rise further. It is possible that the economy is now so flexible that continued strong pressure from demand will not cause wages and prices to react to any significant extent, or that the economy will be dampened of its own accord. However, the problem of a " wait-and-see" strategy is that the damage to the economy if things do go wrong will be more serious than the effects of taking measures to dampen the economy now, even if the measure may subsequently prove to be less necessary. A perceptible weakening of wage competitiveness will thus lead to a prolonged increase in unemployment.

For a number of years, growth in public consumption has exceeded government targets, cf. Chart 16. According to an estimate by the Ministry of Finance in August, this will also be the case in 2006.

The government's 2007 Finance Bill provides for expansion of public consumption by 1.1 per cent. This is higher than the government's previous target, due to increased expenditure by regional and local governments and to initiatives concerning the globalisation fund, cf. Box 1. An estimated large reduction of government investments implies that the government's proposal overall will entail a moderate fiscal tightening next year.

Experience from the preceding years shows that it is difficult to keep public consumption within the targets set. This challenge is by no means diminished by the forthcoming implementation of the structural reform.

In order to contain the risk of the upswing being derailed, public finances should in 2007 dampen domestic demand by around 0.5 per cent. This will perceptibly reduce the risk of general overheating.

The increase in short-term interest rates since December 2005 will contribute to dampening consumption and investments. In view of the persistently low long-term bond yields, this dampening effect will be limited. The interest-rate increases therefore have no major impact on the need for a fiscal-policy tightening.