Recent Economic and Monetary Trends

This review covers the period from mid-February 2007 to mid-May 2007.

Growth in the global economy is higher and more broadly based than before. US growth has slackened off, but the upswing in Europe and many other parts of the world has gained momentum. Global growth has been exceptionally high since 2004 and the strong development is set to continue. Stock prices have continued to rise after their sharp dive in late February, and long-term interest rates and commodity prices have risen in recent months. Despite the high global growth, consumer price inflation remains moderate.

The Danish economy is still booming. Employment has never been higher, and unemployment has fallen to the lowest level since the early 1970s. Many companies face difficulties in attracting the necessary labour. The capacity pressure has triggered a substantial expansion of the capital stock, imports are growing strongly, and the trade and current-account surpluses are diminishing rapidly. Variations in demand and its composition will be reflected in fluctuations in the current account of the balance of payments to a greater extent than is normally the case. The shortage of labour and high growth in imports indicate that for all practical purposes the economy has reached its capacity limit. The prospects of higher growth among Denmark's key trading partners are favourable for exports, so even though the rate of consumption growth has declined, the overall demand in the economy is high. The capacity pressure will thus be sustained.

INTERNATIONAL COMMODITY AND FINANCIAL MARKETS

Prices of oil and other commodities have begun to rise again, primarily because the global growth has augmented the demand for com modities. The oil price reached almost 70 dollars per barrel (Brent) in April, in the wake of announcements of falling production. In mid-May, the price was 66 dollars per barrel. The prices of most metals have con tinued to rise, but are extremely volatile. The price per tonne of nickel is just over 15,000 dollars higher than at the turn of the year, which is equivalent to an increase by almost 45 per cent. This is attributable to lower stocks.

International stock prices fell considerably at the end of February, cf. Chart 1. Prices in the higher-risk markets fell most, just as they did during the stock-market unrest in May 2006. The price drops began with a slump in the Chinese stock market, but since there were fears of a more pronounced dampening of US growth than previously expected, stocks fell on most exchanges. In the USA, there were concerns about the ability of homeowners with low credit standing to meet their payment obligations in the mortgage-credit market, cf. below. In step with the growing uncertainty, the implied volatility of the stock-option prices increased.

In the course of the spring, investor concerns about the future de vel op ment in stock prices diminished, and prices have more or less recovered the lost ground.

Long-term yields have generally mirrored the development in stock prices. In view of improved growth prospects in Germany, the yield on the German 10-year government bond in April reached the highest level since mid-2004, cf. Chart 2. Since the summer of 2006, the spread be tween long-term yields in the USA and Germany has narrowed by around 70 basis points to 0.4 per cent.

Since the turn of the year, the euro has strengthened further against the US dollar and the Japanese yen. On 15 May the exchange rate was 1.36 dollars per euro, which is a weakening of the dollar by 6 per cent from the level one year earlier. The spread between the official inter est rates in the euro area and the USA has narrowed further after the ECB raised its interest rates in March. The yen's weakening partly reflects unhedged speculation in interest-rate differences, i.e. "carry trades"^[1], whereby investors borrow in yen at a low rate of interest and invest in currencies that pay higher interest rates, among them the euro.

INTERNATIONAL ECONOMIC DEVELOPMENT

USA
Economic growth in the USA has abated since the summer of 2006 after several years of strong growth. According to preliminary national accounts data, real GDP grew by 0.3 per cent in the 1st quarter of 2007. This was an increase in GDP by 2.1 per cent from the same quarter of 2006. House prices have stagnated at a high level and were on average 0.3 per cent lower in March than one year before. Residential invest ments have declined substantially in the last four quarters. In mid-February, there was focus on the rising number of loans defaulted by less creditworthy homeowners in the "subprime" US mortgage-credit market, cf. Box 1. The situation in this market has stabilised since then, which supports the widespread expectations that the housing market's adjustment after the boom in previous years will be moderate and gradual. Analyses of the criteria for the banks' lending indicate that in recent months the banks have tightened their credit standards for approval of mortgage loans to the subprime market, but this has only affected loans to more creditworthy borrowers on a limited scale, and the standards for approval of credit card loans have generally been eased.

SUBPRIME US HOUSING LOANS1	Box 1
In mid-February, following the rise in interest rates and the slowdown in the US housing market, attention focused on the increase in loans defaulted by less credit worthy borrowers in the US mortgage-credit market, i.e. subprime loans. A number of credit institutions specialising in subprime loans have incurred financial problems. This has led to speculation as to whether the problems might spread to other markets and lead to a general credit tightening. The spread between variable-rate subprime bonds and the money-market interest rate widened considerably, cf. Chart 3. However, the influence on the yield spread to secure (prime) mortgage-credit bonds has been only limited.
US YIELD SPREADS	Chart 3
Note: The subprime yield spread is the spread between yields on variable-rate securities issued on the basis of home equity loans with BBB- rating and the money-market interest rate, expressed as the 1-month Libor. The prime spread is the yield spread between secure (prime) fixed-rate 30-year mortgage-credit bonds and 10-year government securities. Source: JPMorgan.
Subprime loans are issued to borrowers that are not considered eligible for normal (prime) mortgage-credit loans. A personal credit assessment is required in order to obtain a loan under the US mortgage-credit system, and the credit assessment is important in determining the yield to maturity of the housing loan. A low credit rating may be assigned if the borrower for example has limited or poor credit (defaulted loans), a relatively high debt-to-income ratio and/or the home is heavily mortgaged. These and other characteristics are included in the credit institutions' statistical models – known as credit score models – that apply historical links between these characteristics and loan defaults to assess the borrowers' creditworthiness. A certain minimum score is required to be eligible for a prime loan. Around 75 per cent of the outstanding mortgage-credit loans are prime loans, i.e. loans granted to borrowers with a high credit standing. The volume of subprime loans has increased in recent years, to around 14 per cent of all outstanding US mortgage-credit loans at the end of 2006. In addition, there is an intermediate loan category, Alt-A loans, granted to borrowers with a good credit history that do not qualify as prime borrowers due to lack of documentation and/or the size of the mortgage debt as a ratio of their income or the value of the home. Alt-A loans account for around 12 per cent of the outstanding mortgage-credit loans. The growth in subprime loans in the US mortgage-credit market in recent years is primarily attributable to the low level of interest rates and the buoyant housing market. These factors have considerably increased the demand for housing loans, as well as the interest in granting them. As a result, credit standards for borrowers have been weakened, loan limits raised, credit risk increased and new mortgage-credit products introduced. Much of the recent growth in subprime loans has concerned loans at variable interest rates, for which the interest rate is lowered in an introductory period and then raised. Borrowers with such loans are particularly severely hit by rising interest rates if the latter coincide with the expiry of the introductory period. Around 85 per cent of the subprime loans are at variable interest rates, compared with less than 20 per cent of the prime loans. This has made the subprime market vulnerable to rising interest rates and a housing market that is cooling off, since borrowers are more exposed and have fewer options to alleviate payment problems by raising supplementary mortgage-credit loans or selling the home. More than half of all subprime loans are financed by issuing asset-backed securities. These securities are split into segments, or tranches, that differ in terms of when a suspension of payments on the underlying loan is reflected in payments on the securities. Securities in the various risk tranches can then be sold to investors with different risk appetites. Calculations show that more than 90 per cent of the securities issued on the basis of subprime loans in 2006 will only incur losses if housing prices fall by 4 per cent annually over the next five years. The reason is that investors in these securities are protected against credit losses by one or more underlying tranches. Subprime loans also exist in e.g. the UK, Canada and Australia, but are virtually non-existent in other countries. In some countries this is due to consumer protection legislation that limits the interest rates on housing loans so that they cannot reach a level that is sufficiently high to compensate for the risk associated with granting subprime loans.
1 For a more detailed description, see e.g. Toger T. Cole, Mortgage markets, Testimony before the Committee on Banking, Housing, and Urban Affairs, U.S. Senate, 22 March 2007, BIS Committee on the Global Financial System (2006), Housing finance in the global financial market, CGFS working group report, IMF (2007), Global financial stability report, April and Elizabeth Laderman (2001), Subprime mortgage lending and the capital market, FRBSF Economic Letter, No. 38.

Even though the housing market has slowed down, private con sumption has shown only limited signs of weakness. On the other hand, the growth in corporate investments has been modest. The de velopment in consumption and corporate investments is reflected in the confidence indicators. Consumer confidence is riding high, while business confidence as measured by the Institute for Supply Manage ment (ISM) for the manufacturing sector is only just above the neutral level of 50.

The deficit on the US balance of goods and services was 181 billion dollars in the 1st quarter, equivalent to 5.3 per cent of GDP, compared to 6.0 per cent in the 3rd quarter of 2006. The improved balance of goods and services is due especially to lower imports as a result of declining economic growth and the dollar's depreciation.

Employment continued to grow in the first months of 2007, albeit at a lower rate than in the preceding years, cf. Chart 4. The influx to the labour force has matched the increase in employment, so that un employment has been stable at around 4.5 per cent of the labour force. The capacity pressure in the economy remains high, and wage increases have reached around 4 per cent on an annual basis. This is reflected in very high price pressure. In April, consumer prices rose by 2.6 per cent against the same month of 2006, and consumer prices excluding energy and food rose by 2.3 per cent, cf. Chart 5. Lower growth in the US economy is expected to gradually ease the pressure on prices.

Citing weaker growth but sustained high inflation as its grounds, at its meetings in March and May the Federal Reserve maintained the fed funds target rate at 5.25 per cent. Market participants now consider it most likely that the fed funds target rate will be lowered around the turn of the year.

Japan and China
The upswing in Japan continues, with a GDP increase by 0.6 per cent in the 1st quarter of 2007. Exports are the main driver of the upswing, but private consumption has also expanded strongly. House prices have begun to rise, while consumer prices are easing off. The Bank of Japan raised its official interest rate by 25 basis points to 0.5 per cent in February in the expectation that the upswing would stimulate inflation, and in an attempt to normalise its very expansionary monetary policy.

In China, GDP grew by more than 11 per cent in the 1st quarter of 2007 against the same quarter of 2006. Despite the substantial GDP growth, inflation has so far been low. In April, inflation was 3.0 per cent on an annual basis. The People's Bank of China raised its interest rates in March and again in May, bringing the lending rate to 6.57 per cent and the deposit rate to 3.06 per cent. The interest rates were raised in order to reduce liquidity in the economy and dampen the growth in investments. The current-account surplus was almost 10 per cent of GDP in 2006, which has contributed to substantial inflows of foreign exchange. In order to curb the renminbi's appreciation, the People's Bank of China has continued to purchase foreign exchange on a large scale. At the end of 2006, the foreign-exchange reserve had grown to just over 1,000 billion dollars, equivalent to 42 per cent of China's and 8 per cent of the USA's GDP.

Europe
The upswing in the euro area is strong. Although growth is expected to remain high, the interest-rate increases over the last 18 months, com bined with the euro's strengthening vis-à-vis the dollar and the yen, will curtail future growth. GDP in the 4th quarter of 2006 was 3.3 per cent above the same quarter of 2005, and preliminary national accounts data points to sustained growth in the 1st quarter of 2007. The upswing is broadly based and reflected in both exports and domestic demand. Fixed investments have increased in particular, and the growth in private consumption has accelerated.

The German economy looks stronger than it has done for a long time. The strong growth in employment has pushed down unemployment considerably, cf. Chart 6. Furthermore, consumer confidence has risen to the highest level in many years. The VAT increase at the turn of the year appears to have dampened retail sales in the 1st quarter, but consump tion is expected to pick up as the VAT effects subside.

In March, industrial production in the euro area was 3.7 per cent higher than one year before, and business optimism is high. Especially the German business confidence index, Ifo, is at a high level.

Employment has risen in the euro area, and in February unemploy ment had fallen to 7.3 per cent of the labour force. Wage increases remain moderate, but the current collective bargaining in Germany points to higher wage increases in 2007-08. The benchmark collective agreement for the German metal and electronics industry entails wage increases of 4.1 per cent as of 1 June 2007 and 2.4 per cent as of 1 June 2008. Measured by the HICP, euro area inflation was 1.9 per cent in April. Inflation has been below 2 per cent since the autumn of 2006. Core inflation, measured as HICP excluding energy and food, was likewise 1.9 per cent in April. The ECB raised the minimum bid rate by 25 basis points to 3.75 per cent in March, referring among other things to the risk of higher inflation in the euro area due to stronger economic growth. The ECB still considers its monetary policy to be expansionary, and the money market expects a further 1-2 interest-rate increases, each of 25 basis points, this year.

Growth in the UK was 0.7 per cent in the 4th quarter of 2006 against the preceding quarter. This indicates that the sound economic upswing is continuing. Inflation measured by the index of consumer prices was 3.1 per cent in March, thereby deviating by more than 1 percentage point from the inflation target of 2 per cent for the first time since the Bank of England acquired operational independence in 1997. The Governor of the Bank of England therefore had to publish an open letter to the Chancellor of the Exchequer to explain why inflation had risen above the target and what the Bank proposed to do about it. Against the background of such factors as the high inflation, the Bank of England raised the bank rate by 25 basis points to 5.5 per cent in May.

Sweden and Norway are still in a strong boom with high growth, low inflation and declining unemployment. In Sweden, collective bargaining in the private sector has now entered the final phase. The benchmark agreement for industry has been adopted and entails aggregate wage increases of 10.2 per cent over three years. This is somewhat higher than under the previous collective agreement, reflecting the tight Swedish labour market.

DANISH MONETARY AND FOREIGN-EXCHANGE CONDITIONS

Since February, the Danish krone has been stable vis-à-vis the euro at a level close to its central rate in ERM II of 7.46038 kroner per euro. Dan marks Nationalbank intervened in the foreign-exchange market for a small amount on one occasion in March, and at end-April the foreign-exchange reserve was kr. 170.7 billion.

In ERM II, the central rate for the Slovakian koruna was revalued by 8.5 per cent effective 19 March following a period of frequent intervention in the foreign-exchange market by the National Bank of Slovakia. The fluc tuation band remains +/- 15 per cent around the central rate. The condi tions for the rest of the ERM II currencies, including the Danish krone, remain unchanged.

On 3 May 2007, the maturity of Danmarks Nationalbank's monetary-policy loans and certificates of deposit was changed from 14 to 7 days, in order to reduce the inappropriate fluctuations in the day-to-day interest rate that may occur up to an expected adjustment of interest rates.^[2] The transition to 7 days' maturity was smooth.

In March, Danmarks Nationalbank followed the ECB by raising the lending rate and the rate of interest on certificates of deposit by 25 basis points to 4 per cent. The discount and current-account rates were also raised by 25 basis points, to 3.75 per cent. Viewed in isolation, the raising of interest rates over the last 18 months contributes to a damp ening of growth in consumption and investments in 2007. After interest rates have been increased, the monetary-policy stimulation of the real economy is fading out, cf. Box 2.

IS MONETARY POLICY STIMULATING ECONOMIC GROWTH IN 2007?	Box 2
Since monetary policy in Denmark is designed to keep the krone stable vis-à-vis the euro, Danmarks Nationalbank's interest-rate decisions do not take the potential cyclical impact into account. Danmarks Nationalbank normally adjusts its interest rates when the European Central Bank, ECB, adjusts the official interest rates in the euro area. However, this does not mean that the development in Danmarks Nationalbank's interest rates is of no significance to economic activity in Denmark. In the long term, monetary policy may not influence the real economy, but solely the price level and inflation rate. In the short term, monetary policy can stimulate or dampen the economy, and the degree of growth stimulation is often determined by the difference between the current official interest rate and the "natural short-term interest rate". The latter is the short-term interest rate that is consistent with both full utilisation of the factors of production and unchanged inflation. If the current official interest rate is lower than the natural short-term interest rate, monetary policy is expansionary. The natural short-term interest rate cannot be observed. It must therefore be cal culated, and various estimates and assumptions yield different results. The natural short-term interest rate is not constant over time, but varies in step with the economic fundamentals. The natural short-term interest rate comprises two elements: inflation and real interest rates. In view of Denmark's fixed-exchange-rate policy, the inflation element can be equated with the ECB's target of keeping inflation below, but close to, 2 per cent p.a. The real-interest-rate element can be approximated by the potential real growth rate of the economy, currently towards 2 per cent p.a.1 The sum of the inflation and real-interest-rate elements corresponds to the economy's nominal potential growth rate. Consequently, the natural short-term interest rate can currently be estimated at around 4 per cent p.a. In March 2007, Danmarks Nationalbank raised its lending rate and rate of interest on certificates of deposit to 4 per cent p.a., i.e. close to the level of the natural short-term interest rate. Monetary policy is thus close to being neutral, and the actual stimulation of the real economy via monetary policy is fading out.
NOMINAL GROWTH AND INTEREST RATES IN DENMARK, 1996-2007	Chart 7
Note: The official interest rate is the monthly average rate of interest on certificates of deposit. Growth in GDP is on a quarterly basis. Source: Danmarks Nationalbank.
Since the end of 2005, when the latest series of monetary-policy tightenings in the euro area began, the short-term interest rate in Denmark has risen by almost 2 percentage points, cf. Chart 7, while the long-term interest rate has risen by around 0.75 percentage points. Multiplier calculations on Danmarks Nationalbank macro economic model, Mona, indicate that on an isolated increase in the level of interest rates by 1 percentage point for all maturities the real GDP level will be around 0.5 per cent lower than in the baseline scenario after two years, and around 1 per cent lower after 4-6 years.2 Viewed in this context, the interest-rate increases over the past 18 months are thus in isolated terms assessed to have reduced real GDP growth by around 0.25 per cent in 2007. In Mona, the real economic impact of an increase in interest rates is via con sumption and investments.3 When interest rates rise, it becomes more expensive to finance consumption, leading to a current tendency to save up rather than consume. In addition, the cash price of real property is reduced, which pushes down housing investments and curtails the households' wealth and consumption. The higher interest rates also reduce corporate investments since loans become more expensive and passive investments yield higher returns. In Mona, housing investments initially react most strongly to the increase in interest rates, but they account for a relatively small share, and the reaction in private consumption and corporate investments is more significant. After some years, the decline in activity increases unemployment and reduces employment.
1 According to economic growth theory, the real interest rate corresponds to real GDP growth plus a time preference premium. In the period 1875-2003, the average short-term real interest rate (compiled as the difference between a short-term money-market rate and consumer price inflation) was 2.9 per cent p.a., while real GDP growth was 2.8 per cent p.a., cf. Kim Abildgren, Interest-Rate Development in Denmark 1875-2003 – A Survey, Nationaløkonomisk Tidsskrift, Vol. 143, No. 2, 2005, pp. 153-167. Based on these figures, the time preference premium appears to be relatively modest (0.1 per cent p.a.). 2 Cf. Danmarks Nationalbank, Monetary Policy in Denmark, 2nd edition 2003. 3 Cf. Danmarks Nationalbank, MONA – a quarterly model of the Danish economy, 2003.

The growth in lending to households by the banks and mortgage-credit institutes was still at a high year-on-year level of around 12 per cent in March, but has diminished since the spring of 2006, cf. Chart 8 on p. 13. The growth in lending to the corporate sector eased a little in March, but is still high at approximately 18 per cent year-on-year. As in previous upswings, the growth in corporate lending has materialised later than the growth in lending to the households.^[3]

Adjusted for maturity differences, 10-year government bond yields in Denmark and Germany have been virtually identical since the turn of the year. After a few months in which portfolio flows to and from Den mark more or less balanced, there was a capital outflow in connection with portfolio investments in February, and a capital inflow in March. The capital inflow in March reflected non-residents' purchase of Danish bonds and residents' sale of foreign bonds.

Covered bonds (SDO)
On 28 March 2007, the Minister for Economic and Business Affairs tabled a bill on covered bonds. This legislative amendment is intended to give the banks access to issue covered bonds, and to allow mortgage-credit institutes and Danish Ship Finance to continue to issue covered bonds. The bill is a result of the EU's new capital-adequacy rules, which impose more rigorous requirements for bonds to be classified as covered bonds. The act is expected to enter into force on 1 July 2007^[4]. The rules have been designed to ensure that the new home-financing system is as secure as the existing mortgage-credit system.

In connection with the new regulation of covered bonds, a new balance principle will be established. Like the existing balance principle, the basic rule is that no interest-rate, option or exchange-rate risks may be incurred. Today, risk is hedged primarily by selling bonds that are exactly identical to the housing loans. Internationally, this is known as "back to back". This will still be possible under the new balance prin ciple, so that the mortgage-credit institutes can continue to grant loans and issue bonds in precisely the same way as before.

In addition, the new balance principle will make it possible to use financial instruments to hedge risk to a greater extent than is the case today. On the other hand, the hedging of risk will be subject to slightly more severe stress testing, in order to ensure an adequate hedging basis.

The regulation of covered bonds also entails a tightening of the current mortgage-credit legislation in order to comply with new EU directives. With covered bonds, an LTV (loan-to-value) limit of 80 per cent must be observed throughout the term of each housing loan that serves as collateral for the issue of bonds, i.e. the value of the loan must never exceed 80 per cent of the value of the mortgaged home. Under the present mortgage-credit legislation this only applies at the time that the loan is raised. If house prices fall, the banks and mortgage-credit institutes must therefore, if necessary, immediately supplement the collateral for the covered bonds that have been issued. They can do this by e.g. raising loans and investing in government bonds that are pledged as top-up collateral. The new covered bonds will therefore always be well collateralised, and their prices will not be influenced much by falling house prices or deterioration in the issuer's credit standing. If the expiry and refinancing of covered bonds coincide with problems for the issuer, this can primarily be expected to be reflected in a higher interest rate for any loan raised to finance the purchase of top-up collateral.

Covered bonds are extremely secure and can thus be sold at a good price, like today's mortgage-credit bonds. The ongoing observance of the LTV limit will make them extra secure.

The option for banks to finance lending by issuing covered bonds against real property as collateral will intensify the competition between banks and mortgage-credit institutes.

The improved opportunity to use financial instruments to hedge risk will enable the further decoupling of housing loans from the bonds issued. This may pave the way for new housing loan products from banks and mortgage-credit institutes. The new rules comprise a number of initiatives that increase the credit institutions' responsibility to give sound advice and make it easier for consumers to compare the costs of different housing loans.

THE DANISH ECONOMY

Economic activity, foreign trade and balance of payments
The revised national accounts data for Denmark shows an increase in real GDP by 3.2 per cent in 2006. In the 4th quarter, GDP grew by 0.4 per cent over the preceding quarter, cf. Chart 9. Private consumption rose by 0.7 per cent in the 4th quarter, after a strong drop of 1.5 per cent in the preceding quarter. Retail sales were particularly strong in the 4th quar ter. Growth was generally curbed by a strong increase in imports, cf. below.

The slowdown in private consumption appears to have continued into 2007. Seasonally adjusted purchases of new passenger cars have been more or less unchanged for the past year, and in the 1st quarter were 1.1 per cent higher year-on-year. This stagnation should be viewed against the very high level of car sales already reached during the upswing. The retail sales index fell by 0.8 per cent in the 1st quarter, after seasonal adjustment, but this is solely attributable to the record-high Christmas trade. Compared with the 1st quarter of 2006, retail sales increased by 1.4 per cent.

The growth in consumption is dampened by such factors as the raising of interest rates over the last 18 months, cf. above, which, combined with the slowdown in the housing market, has curtailed household borrowing. According to the Association of Danish Mortgage Banks, in the 1st quarter of 2007 the price per square metre of single-family and terraced houses rose by an average of 1.2 per cent from the preceding quarter, while prices of owner-occupied flats fell by 1.8 per cent. Overall, increases in housing prices have been relatively modest, but there are considerable regional variations. The largest price drop is registered for owner-occupied flats in Greater Copenhagen, where the price per square metre nevertheless remains very high compared with elsewhere in Denmark. The sluggish housing market is also reflected in the sales volume, which declined in the 1st quarter, particularly for owner-occupied flats. In addition, the number of homes put up for sale has increased further in recent months. Statistics Denmark's housing price data shows slightly weaker development in the 4th quarter of 2006 than the statistics from the Association of Danish Mortgage Banks.

Despite the housing market's dampening, the high employment rate and the strong income growth entail that consumption is not likely to diminish significantly in the short term. The increase in housing wealth in recent years has only been reflected in consumption to a limited extent, so the slowdown in the housing market is expected to have little impact on the propensity to consume. Consumer confidence was high in April.

Government consumption in constant prices rose by 1.2 per cent in 2006, primarily due to increasing purchases of goods and services from private suppliers. This indicates that fiscal policy in 2006 was ultimately not as tight as originally intended.

The economic upswing has had a considerable impact on corporate investments. Investments in machinery and transport equipment, etc. rose by 2.8 per cent in the 4th quarter, and by 16.6 per cent for the full year. Furthermore, non-residential construction grew significantly. The strong expansion of the capital stock to a high degree reflects how business enterprises are seeking to compensate for the shortage of labour and ease the pressure on capacity. Sound corporate earnings also facilitate capacity expansion.

Construction activity is booming, and the shortage of both labour and materials has been pronounced in this sector. The respective indicators of shortages of labour and materials in the building sector are lower than at the end of 2006, but both indicators are still higher than before. In the 1st quarter, seasonally adjusted employment within building and construction rose by a full 17 per cent against the preceding quarter, which indicates very strong growth in activity.

The volume index for industrial production has shown a clear upward trend in recent years; especially the manufacture of investment goods and intermediate products has increased. These goods contain a large import element. In the 1st quarter, industrial production was no less than 3.1 per cent higher than one quarter before. Industry's output expectations for the next three months fell from March to April, while the expectations of future export orders remain high. At the end of March, enterprises representing 14 per cent of employment in industry stated that the shortage of labour curtailed production. This is the highest ratio registered since the statistics began in 1980.

The strong growth in imports from 2006 has continued in recent months. The trade surplus was kr. 7.3 billion in the 1st quarter, or kr. 4.3 billion lower than one year before. The deterioration inter alia reflects a reduced surplus from energy trade due to falling production in the Danish oil and gas fields in recent months. There has also been a large deficit on trade in manufactured goods. The 1st quarter saw a current-account deficit of kr. 3.1 billion. Viewed over the past 12 months, the current account has shown a surplus of kr. 32 billion, cf. Chart 10. This is kr. 21 billion less than in the 12 months up to August 2006. The decline is related primarily to the balance of goods, which also includes the rising costs of bunkering.

In view of the shortage of especially labour, the strong growth in demand in 2006 was targeted mainly at imports, which rose by 14.0 per cent in constant prices, while exports rose by 9.6 per cent. Since the upswing set in, imports in constant prices have grown considerably more than exports. In the 4th quarter, imports in 2000 prices exceeded exports for the first time in some years, cf. Chart 11. However, the balance of goods and services still shows a sound surplus in current prices, due to the favourable terms of trade.

Labour market, wages and prices
The labour market has tightened further. The growth in output in recent years has significantly boosted employment. Seasonally adjusted employ ment rose rapidly in the 4th quarter of 2006, by 0.9 per cent or 24,800 people. In the same period, the number of hours worked increased by 2.4 per cent, so that the growth by 0.4 per cent in the national accounts entails an unexpected decline in productivity. The quarterly growth rates in the national accounts are characterised by high volatility, and prod uctivity has increased over the full year, but at a lower rate than earlier in the upswing. Employment rose by 52,200 in 2006 overall. An increase at this level has not been seen since the boom in the mid-1980s. The rise in employment in 2006 was driven by the private sector, particularly the service sector and building and construction. For the first time in many years, employment in manufacturing rose.

The labour force, calculated as the sum of those in employment and the unemployed, grew by approximately 19,000 in 2006, cf. Chart 12. The demographic development pointed to a reduction of the labour force by almost 5,000 from 2005 to 2006, but this was more than offset by an influx from abroad and a higher participation rate. The number of active work permits issued to people from the new EU member states in eastern Europe exceeded 10,000 in March. On an annual basis, the level was a good 6,000 higher. In addition, the number of commuters from especially Sweden and Germany has risen. The increasingly negative con tribution from demographic trends in the coming years will make it still more difficult to augment the labour force further.

In March, seasonally adjusted unemployment was 106,600, equivalent to 3.9 per cent of the labour force, or 3.4 per cent if the EU-harmonised definition is applied. With the Netherlands, Denmark was the EU member state with the lowest rate of unemployment in March, when unemploy ment was 1,500 lower than in December. Furthermore, the seasonally adjusted number of people in activation schemes fell by around 5,000 from December to March.

Unemployment has fallen by just over 80,000 since December 2003. The decline has been registered across virtually all regions and sectors and has to a great extent involved people who had been unemployed for a prolonged period, cf. Chart 13. Short-term unemployment, which includes seasonal unemployment, graduates who have not yet found work, and transitional unemployment, is not particularly cyclical and has by and large remained unchanged during the upswing.

The tight labour market and the rapid erosion of the current-account surplus both point in the same direction: for all practical purposes the economy has reached its capacity limit, and the pressure is set to con tinue, even though consumption growth is diminishing.

The economic policy for 2008 will be laid down in the coming months. The high degree of capacity utilisation in the Danish economy, and the favourable international economic outlook, call for a tight fiscal policy. A more detailed assessment should be made in connection with the 2008 Finance Act negotiations.

Despite the tight labour market, the statistics still show moderate wage increases. At present no wage statistics extending into 2007 are avail able, but in the 4th quarter of 2006 the rate of wage increase in the private sector was 3.1 per cent.

New 3-year collective agreements have been concluded by most of the private labour market, cf. Box 3. It cannot be said with certainty how wage costs will develop, since for most of the collective agreements this will depend mainly on the local wage negotiations at the individual work places. Assessed on the basis of the collective agreements that do include wage terms, called the normal-wage area, the overall average rate of wage increase will be higher than under the previous collective agree ments, and also higher than in Sweden and Germany. Higher wage in creases mean that productivity must be raised if Denmark's sound com petitiveness is to be maintained and inflation kept at bay. Other wise, wage levels will have a negative impact on employment in the coming years.

The overall rate of increase in Danish consumer prices is still moderate, cf. Chart 14. Measured by the HICP, consumer prices in April were 1.7 per cent higher than in April 2006. This is 0.2 percentage points lower than in March, reflecting a pronounced drop in electricity prices. Food and beverages account for the largest price increases over the last 12 months. Domestic market-determined inflation, IMI, has been rising since the end of 2004, but remains below HICP inflation. The IMI index is more sensitive to cyclical fluctuations in Denmark than the overall consumer price index, and the mounting domestic inflationary pressure indicated by the IMI index reflects such factors as the tight labour market^[5].