Recent Economic and Monetary Trends

This review covers the period from mid-June to mid-September 2008

The economy is slowing down worldwide. In the industrialised countries, the main factor is declining growth in domestic demand, while in the emerging market economies weakening export markets play a major role. The slowdown in growth is driven by continued financial turmoil, negative developments in the housing markets in a number of countries and high commodity prices. The prices of oil and other commodities have fallen in recent months, but inflation remains high in most parts of the world. The lower commodity prices and weakening economy reduce price pressures, but the risk that the high inflation is reflected in permanently elevated inflation expectations limits the scope for boost ing demand via expansionary economic policies.

The Danish economy is slowing down at a very high level. This reflects a gradual adaptation of the economy to a more sustainable level of activity after some years of strong growth. Nevertheless, the labour market remains tight with high employment, and unemployment down to a level not seen since the early 1970s. Output is still considerably above the level that is compatible with wage and price stability in the longer term. Consumer prices are surging, and the rate of wage increase is high. In such a situation, fiscal policy should not stimulate demand and thereby postpone the adaptation process. This would increase the risk of a wage and price spiral, which could ultimately lead to an unnecessarily strong and prolonged rise in unemployment.

THE GLOBAL ECONOMY

Global economic growth is slowing down, cf. Chart 1. In the industri alised countries, the main factor is declining growth in domestic de mand, while in the emerging market economies weakening export mar kets play a major role. The most recent assessment by the International Monetary Fund, IMF, predicts a fall in global GDP from 5.0 per cent in 2007 to 4.1 per cent in 2008 and 3.9 per cent in 2009, cf. Table 1. The downturn reflects strong inflation driven by high commodity prices, notably in the energy and agricultural sectors, as well as continued financial turmoil in the wake of the subprime crisis in the USA. The hous ing markets are also weak in a number of countries. The IMF expects a turnaround in 2009, when economic growth will pick up again.

Global inflationary pressures
Global inflationary pressures are strong. The IMF expects consumer prices in industrialised countries and emerging market economies to rise by 3.4 and 9.1 per cent, respectively, in 2008 compared with 2.2 and 6.4 per cent in 2007. In the industrialised world, the upward trend in infla tion has been particularly evident in the USA, where consumer prices in July were 5.6 per cent above the level one year earlier, cf. Chart 2. Infla tion is more subdued, but still high by historical standards, in the euro area, where consumer prices rose by 3.8 per cent year-on-year in August according to preliminary Eurostat data.

The rising consumer prices reflect higher world-market prices for com modities, especially energy and food. The derived effect on inflation has been particularly strong in the emerging market economies, where a relatively large share of income is spent on food. In the USA, core infla tion – a measure of the development in consumer prices excluding energy and food – has shown a slight upward trend since last autumn, while core inflation has declined a little in the euro area.

By early September, the price of a barrel of crude oil (Brent) had fallen to just under 105 dollars from a peak of 143 dollars at the beginning of July. The prices of metals and agricultural commodities have also fallen, cf. Chart 3. The development in commodity prices will dampen consumer price increases in the autumn. Combined with the weakening of the econ omy, the decline in oil and commodity prices should initially mitigate the risk of a permanent increase in inflation expectations and second-round effects on consumer prices, cf. Box 1, but the risk is still there.

SECOND-ROUND EFFECTS AND INFLATION	Box 1
The pronounced rise in inflation resulting from surging energy and food prices has reduced consumers' purchasing power. This has increased the risk of "second-round effects", which occur when wage demands are affected by the development in con sumer prices. In such a situation, higher commodity prices may have both a first-round effect (i.e. a direct impact on consumer prices, as well as an indirect impact via higher producer input prices) and a second-round effect (via higher payroll costs) on overall consumer prices. Both the Federal Reserve and the European Central Bank, ECB, have expressed serious concerns about the risk of second-round effects that could lead to permanently higher inflation. The scope and duration of second-round effects depend on inflation expectations among employees and employers. If inflation expectations rise, employees will de mand higher pay rises to compensate for the expected reduction in real wages. Busi ness enterprises are more likely to accept these demands if they expect to be able to pass on the additional costs by way of higher prices, i.e. if they expect competitors to do the same, thereby bringing about a general increase in the level of prices. Conversely, if inflation expectations are firmly anchored and governed less by very recent price developments, the risk of second-round effects is lower. This risk is increased by mechanisms for automatic regulation of wages to match in flation, such as the Danish cost-of-living adjustment ("dyrtidsregulering") that was abolished in the early 1980s. Inflation-linked indexation of wages has become less prevalent since the 1970s, but is still in widespread use in several European countries, e.g. Belgium and Spain and, to a lesser extent, France. Several studies indicate that oil-price shocks have a more lasting impact on inflation in Europe than in the USA as a consequence of the greater prevalence of inflation-linked indexation of wages. Inflation expectations cannot be observed directly, but are measured indirectly, e.g. via questionnaire surveys among consumers and business enterprises or via the gap between the yield on nominal bonds and the yield on index-linked bonds, known as "break-even inflation". Applying the latter measure, long-term inflation expectations in both the euro area and the USA have declined somewhat in recent months, but remain above 2 per cent in the euro area, cf. Chart 4.
10-YEAR BREAK-EVEN INFLATION	Chart 4
Note: The 10-year break-even inflation indicates the difference between the yield to maturity on a 10-year nominal government bond and the equivalent yield on a 10-year inflation-linked government bond. The most recent observations are from 4-5 September 2008. Source: EcoWin.

The falling commodity prices are mainly attributable to slower growth in the global economy, but at this point there are no indications that prices will return to the very low levels seen in previous years. The market for crude oil will remain tight as it takes time to expand production capacity. Strong demand, especially for food, from the emerging market economies will also buoy up prices until global supplies can be increased in the slightly longer term. FAO assesses the outlook for the 2008-09 crop to be good.

Financial markets
The financial crisis triggered by the US market for subprime mortgages in the summer of 2007 is still affecting the global financial system. A number of large financial institutions in the USA, Switzerland, Germany and France have adjusted losses on lending and investments in securities and financial derivatives upwards. The largest banks and stockbrokers have written down their assets by more than 500 billion dollars since the onset of the crisis. At the same time, the banks have received capital in jections in the range of 350 billion dollars. A sustained fall in equity prices, cf. Chart 5, has made capital increases more expensive. Conse quently, the financial system is under strong pressure to reduce balance sheets, which amplifies the economic slowdown.

The yields on 10-year US and German government bonds fell by around 0.5 per cent from mid-June to early September, and the yield spread has stabilised at a level where the German bond yield is approximately 0.5 per cent higher than its US counterpart, cf. Chart 6. The course and level of long-term yields do not indicate that the financial markets expect inflation to remain at the current high level in the longer term.

Following a prolonged weakening of the dollar vis-à-vis the euro and the yen, a reversal was seen in mid-July. By the beginning of September, the dollar had strengthened by 9 per cent against the euro, to 1.45 dollars per euro, against the background of military action in the Cau casus region and clearer signs of a slowdown in the euro area, among other factors.

INTERNATIONAL ECONOMIC DEVELOPMENT

USA
Growth in the US economy was relatively robust in the 1st half of 2008, but the underlying cyclical position is weak. Growth was underpinned by a positive trend in private consumption, supported by federal pay-outs following the homeowner initiatives launched by the administration in February. These pay-outs ceased in July, a fact that is expected to have a negative impact on consumption in the 3rd quarter. Retail trade fell slightly in July. The housing market remains weak, and non-agricultural employment has declined by 600,000 since December 2007. Unemploy ment rose to 6.1 per cent in August – nearly 1.5 percentage points higher than one year earlier. At the same time, wage inflation has fallen to 3.4 per cent from over 4 per cent in mid-2007. Coupled with high price in creases and rising unemployment, this entails lower real disposable in comes. The Federal Reserve has maintained the fed funds target rate at 2.0 per cent since April 2008, citing a trade-off between the risks of lower growth and rising inflation.

The turmoil in the money and capital markets has not diminished. At the end of July, the Federal Reserve extended access to its existing credit facilities to include stockbrokers, and the maturity of the newly intro duced Term Auction Facility was extended. During 2008, the federal authorities have wound up a number of banks, including IndyMac, the third-largest bank to fail in the USA. The negative development in the housing market has continued. According to the Case-Shiller index, the price of owner-occupied housing was down by more than 15 per cent in June compared with the same month of 2007. The instance of de faulted mortgages and foreclosures has risen. This development has undermined the capital base of the two US mortgage giants Fannie Mae and Freddie Mac. Combined, they account for almost half of all mortgage loans in the USA, and there have been widespread concerns about their continued ability to provide home financing. Against that background, the federal authorities in early September assumed con trol of the two mortgage institutions, cf. Box 2.

Europe
Following relatively strong developments in the 1st quarter, the slow down is beginning to be reflected in the European data releases, and both the euro area and the EU overall are likely to see stagnation in the 2nd half of 2008.

Euro area GDP declined by 0.2 per cent in the 2nd quarter compared with the 1st quarter, equivalent to an increase of 1.4 per cent on the 2nd quarter of 2007. This was the first time GDP fell since the introduc tion of the euro in 11 EU member states in 1999. Growth was negative in all of the large euro area member states (Germany, France and Italy).

Lower retail sales and declining consumer confidence point to lower consumption in the 2nd half of 2008. The confidence indicators for the business sector and industrial production have fallen in the context of the global slowdown in growth, financial turmoil and a relatively strong euro. The level of investment is low as a result of less optimistic earnings expectations in the corporate sector, tighter borrowing conditions and weak housing markets in several member states. Euro area employment increased by just over 440,000 in the 1st quarter, while unemployment rose a little in the 2nd quarter, to stand at 7.3 per cent in July.

Consumer prices, measured by the Harmonised Index of Consumer Prices, HICP, increased by 4.0 per cent year-on-year in July. The increase was mainly attributable to rapidly rising energy and food prices, cf. Chart 7. According to preliminary Eurostat data, HICP rose by 3.8 per cent in August.

The ECB's index of compensation per employee rose by 2.9 per cent in the 1st quarter compared with the same period of 2007. This was a somewhat higher rate of increase than in previous quarters. To prevent second-round effects and stem the tide of inflation, the ECB in July raised its minimum bid rate by 25 basis points to 4.25 per cent.

In the UK, GDP remained unchanged in the 2nd quarter compared with the previous quarter. The dampening primarily reflected lower con struction activity. In August, housing prices were more than 10 per cent down on the same month of 2007. The economic slowdown is beginning to show in the labour market, with unemployment rising to 5.4 per cent in May. Consumer prices were up by 4.4 per cent in July compared with the same month of 2007, which is considerably above the upper infla tion target of 3 per cent. The bank rate has remained unchanged since April, when it was lowered to 5 per cent. The Bank of England expects inflation to subside in the medium term as the energy, food and import price increases ease off and the weak cyclical development dampens inflationary pressures.

In Sweden, Sveriges Riksbank has raised the repo rate by 50 basis points in two increments, to stand at 4.75 per cent. Sveriges Riksbank saw these steps as necessary in order to prevent persistent high inflation. In Norway, Norges Bank in late June raised its key policy rate by 25 basis points to 5.75 per cent in view of higher-than-expected price increases.

In Iceland, Seðlabanki Íslands has kept its interest rates unchanged. The financing costs of the Icelandic banks have increased, and the credit default swap spread widened considerably from mid-June. From mid-June to early September the Icelandic krona weakened by almost 6 per cent against the euro. Inflation rose to 14.5 per cent year-on-year in August, and wage inflation rose above 9 per cent year-on-year. The terms and conditions for access to housing loans from the publicly owned Housing Financing Fund, HFF, have been eased, a step that was criticised by the IMF in connection with an Article IV consultation in July. On the same occasion, the IMF called on the Icelandic authorities to tighten fiscal policy.

THE DANISH ECONOMY: MONETARY AND EXCHANGE-RATE CONDITIONS

The money and foreign-exchange markets
The Danish krone has been stable around its central rate in ERM II, and Danmarks Nationalbank has not intervened in the foreign-exchange market. The foreign-exchange reserve was kr. 165 billion at end-August.

On 4 July, Danmarks Nationalbank, mirroring the ECB, raised its mon etary policy interest rates by 0.25 per cent. Since then the lending rate and rate of interest on certificates of deposit have been 4.6 per cent, while the discount and current-account rates have been 4.25 per cent.

The spread between uncollateralised and collateralised money-market interest rates has fluctuated around a somewhat higher level than be fore the onset of the financial turmoil in the summer of 2007, cf. Chart 8. At the same time, uncertainty in the money markets has caused con siderable volatility in the spread. A similar pattern has been observed in the euro area.

Overall, the banks' deposit deficit has increased since the end of 2004, although at a more moderate pace in 2007 and 2008 than in the pre ceding two years.¹ This development masks considerable differences with in the sector, reflecting diverging lending growth patterns, as well as dif ferent business models. The large and medium-sized banks have had deposit deficits for quite a few years, while deposit surpluses have recent ly given way to deposit deficits in the small banks, cf. Chart 9. As financing opportunities have become more scarce and more costly in the wake of the financial turmoil, some small and medium-sized banks have increas ingly had to make use of Danmarks Nationalbank's monetary-policy in struments. Since mid-2007 there has been a tendency for a larger group of banks to raise loans from Danmarks Nationalbank.

The net position of the banks and mortgage-credit institutes vis-à-vis Danmarks Nationalbank was reduced by kr. 51 billion from the end of July 2007 to the beginning of September 2008, cf. Chart 10. In the same period, these financial institutions increased their borrowing from Dan marks Nationalbank by kr. 124 billion, while their current-account de posits and certificates of deposit grew by a total of kr. 73 billion. Overall the financial institutions have thus increased their contingency liquidity since the financial turmoil set in.

The temporary lending facility at Danmarks Nationalbank that came into force on 23 May 2008, cf. Monetary Review, 2nd Quarter 2008, pp. 15ff, has been extended by one year until 21 May 2010, giving banks the opportunity to take the facility into account in their liquidity manage ment over a slightly longer horizon. By mid-September loan bills had been issued for an amount of kr. 5 billion. A considerable share of these loan bills have been pledged as collateral to other banks.

The yield on 10-year government bonds has decreased by 0.7 per cent since mid-June, to stand at 4.2 per cent at the beginning of September. The yield spread to the corresponding German government bonds has been stable at around 0.25 per cent over the same period.

In July, the Ecofin Council accepted Slovakia as a member of the euro area from 1 January 2009. The Slovak koruna will be replaced by the euro at a rate that is equivalent to the central rate in ERM II. Since the end of May 2008, the central rate of the koruna has been 30.1260 korunas per euro. From the turn of the year, Slovakia will no longer participate in ERM II. The conditions for the rest of the ERM II currencies, including the Dan ish krone, remain unchanged.

Bank interest rates and credit
Since the turn of the year, the banks have increased their deposit and lending rates, citing higher financing costs in the money and capital markets in connection with the financial turmoil. Since the onset of the turmoil in the summer of 2007, the average interest rate for loans to the corporate sector has risen by 0.5 per cent, while the equivalent increase for household lending is 0.4 per cent, cf. Chart 11. Average deposit rates have risen by more or less the same over this period.

Total growth in lending by banks and mortgage-credit institutes has by and large been stable since July 2007 at a high level of around 12 per cent year-on-year, cf. Chart 12. This is slightly lower than in the pre ceding years, reflecting more subdued domestic demand, among other factors. Demand for loans normally varies with the business cycle. If growth in lending slows down more than warranted by the cyclical position, and lending rates are rising, this could indicate a "credit squeeze", i.e. a situation in which the banks reduce their supply of credit excessively. Lending rates have indeed been rising, but the lending pat tern does not point to a credit squeeze in Denmark at the moment, cf. Box 3.

LENDING GROWTH, FINANCIAL TURMOIL AND CREDIT SQUEEZE	Boks 3
The financial turmoil affects economic activity in Denmark, e.g. via higher bank lend ing rates. At the international level, there has also been focus on the risk of a "credit squeeze", i.e. a situation in which the banks reduce their supply of credit excessively.1 The line of thought underlying the supply effects is that higher interest rates have a negative impact on the finances of borrowers and banks. When interest rates rise, borrowers may suffer a loss of wealth that reduces their ability to repay the loan or provide collateral. In reaction to the customers' reduced ability to pay, a bank may tighten its credit terms so that some customers cannot raise the desired loans, or their loan costs may rise more than the underlying increase in interest rates would warrant. Higher interest rates may also affect the banks' balance sheets, e.g. by reducing their capital adequacy. If the latter becomes low or falls below the statutory minimum, the banks may wish to reduce their lending portfolio, e.g. by tightening the extension of credit to some customers. Overall, this "credit channel" amplifies the impact of the higher interest rates on investments and private consumption.2 If the banks suffer unusually large losses or have difficulty in obtaining financing via deposits or in the financial markets, this may lead to a particularly serious credit squeeze (a "credit crunch") with scarce financing opportunities, even for creditworthy projects. The credit channel may also be triggered by cyclical developments. For example, banks may tighten credit terms and reduce the supply of lending in a downturn since the risk of default is heightened. Normally the credit channel does not seem to play any major role in Denmark. The scope for a credit channel is limited, partly because households and business enter prises are able to obtain alternative financing from mortgage-credit institutes, where the credit channel plays a minor role, except what follows from changes in the value of the mortgaged property. The balance principle for mortgage-credit institutes means that there are no significant supply effects via the mortgage-credit institutes' balance sheets. Unlike their counterparts in a number of other countries, Danish mort gage-credit institutes have been able to continue to issue bonds without any major problems for borrowers over the last year. The demand for loans also varies with the business cycle. Generally, demand for and growth in bank lending typically rise in an upswing and decline in a downturn. It is difficult to identify the exact extent to which slower growth in lending reflects lower demand for loans due to cyclical developments or a credit squeeze. If growth in lend ing is lower than normally warranted by cyclical developments and credit terms are tightened by way of higher lending rates, this could indicate a credit squeeze. In 2007, growth in total lending by the banks was at the highest level seen since the mid-1980s. It has only fallen slightly since then. The cyclical development can be measured by e.g. GDP. The banks' lending ratio, i.e. lending in relation to GDP, has been in creasing steadily during this upswing and had reached a very high level in mid-2008. This does not indicate that overall lending growth has been lower than usual in the current cyclical situation. The development in lending also depends on the size of the banks, cf. Chart 13 (left). Lending growth was particularly strong for small and medium-sized banks prior to the financial turmoil and then took a sharp downturn. In contrast, the largest banks, which account for almost two thirds of total lending, have seen a rise in lend ing growth. The lending growth rates for the various categories of banks are now relatively close to each other. It should be noted that lending growth in the small banks began to decline already at the beginning of 2007, i.e. before the onset of the financial turmoil. It is possible that small banks are more exposed to small business enterprises than large banks are. Such enterprises are often more sensitive to eco nomic fluctuations than their larger counterparts. Large and medium-sized banks have also shown different interest-rate patterns, the latter having raised their lending rates most significantly, cf. Chart 13 (right).3 The medium-sized banks have also raised deposit rates by more than the large banks, which indicates that the smaller banks have used interest rates more actively to try to attract new deposits and dampen lending growth. No large increases have been observed in the banks' average interest rates, partly because the large banks carry more weight in the statistics. In step with the economic slowdown and the financial turmoil, credit terms have been tightened, particularly by the small banks. This is a normal element of the trans mission mechanism. However, the capacity of the financial system is so great and the finances of the corporate and household sectors so sound that in the current situation there is no actual credit squeeze that amplifies the downturn.
BANK LENDING GROWTH AND INTEREST RATES, BY BANK SIZE	Chart 13
Note: Lending growth and lending rates for all counterparty sectors except MFIs. Grouped in accordance with the Danish Financial Supervisory Authority's groups 1-3. The most recent observations are from July 2008. Source: Danmarks Nationalbank.
1. See e.g. IMF, World Economic Outlook, April 2008. 2. The credit channel is described in Anders Mølgaard Pedersen, The Credit Channel in Monetary-Policy Analyses, Danmarks Nationalbank, Monetary Review, 4th Quarter 2003. 3 The small banks do not report deposit and lending rates for statistical purposes.

Danmarks Nationalbank and the Danish Financial Supervisory Authority encourage transparency
At the end of June, Danmarks Nationalbank and the Danish Financial Supervisory Authority published a joint statement concerning the need for new European legislation on the disclosure of the banks' and mort gage-credit institutes' individual capital requirements.² The sustained international financial turmoil has, among other things, reflected lack of information as to which banks were at risk of suffering losses, as well as the size of any such losses. This has highlighted the need for internation al initiatives to promote greater transparency concerning the risks incurred by individual banks. In their statement, Danmarks Nationalbank and the Danish Financial Supervisory Authority emphasise the import ance of ensuring transparency about the actual financial strength of the banks, and thus their ability to absorb losses.

Under the Basel II Capital Accord, the individual banks and mortgage-credit institutes must review their total risks with a view to assessing their capital requirements. The capital requirements may exceed the statutory 8 per cent. In their statement, Danmarks Nationalbank and the Danish Financial Supervisory Authority specifically suggest an amend ment to the European rules to the effect that such internal assessments are made available to investors and lenders.

THE DANISH ECONOMY: REAL ECONOMY

Economic activity
Economic activity has slowed down a little in the year so far. According to the available national accounts, the seasonally adjusted gross domes tic product, GDP, in volume terms fell by 0.5 per cent from the 2nd half of 2007 to the 1st half of 2008. Output was thus more or less in line with the level in the same period of 2007, cf. Chart 14. Growth has been de clining in recent years, reflecting high capacity utilisation in the Danish economy, to an extent that further increases in output have been re stricted by shortages of labour and capital.

Domestic demand showed a weak trend in the 1st half of 2008, with private consumption and fixed capital formation remaining almost flat compared with the 2nd half of 2007, while public consumption de creased by 0.5 per cent. Exports continued their positive trend. The de velopment in public consumption should be seen against the backdrop of strikes in the public sector, as well as the late adoption of the 2008 Finance Act in April 2008.

The stagnating private consumption in the 1st half of 2008 was attrib utable to, inter alia, rising interest rates, as well as surging consumer prices for products such as energy and food, which have eroded the purchasing power of the households. The slowdown in the housing mar ket with falling prices has also dampened consumption. The weak devel opment in private consumption is reflected in retail sales and consumer confidence, with the latter at a very low level in August. Car sales, on the other hand, have remained at a high level in the year to date.

Overall, household finances are sound. Net worth has deteriorated over the last year or so on account of capital losses on housing and equities, but in a longer-term perspective the decline has been modest. The households' total wealth is substantially above the level in 2003, when the upswing gained momentum. The households' disposable real incomes have risen steadily this year in spite of increasing interest payments on loans and higher prices for energy and food in particular. Incomes are set to rise at a faster pace in 2009 due to factors such as a considerable increase in real wages and planned tax cuts. Overall growth in the households' disposable real incomes is expected to be 1.5 per cent in 2008 and 2.5 per cent in 2009.

The corporate sector generally takes a less optimistic view of the fu ture. According to Statistics Denmark's business confidence indicators, confidence in the industrial and building and construction sectors has been falling since late 2006, when the Danish economy began to slacken its pace, cf. Chart 15. A similar trend is seen in the service sectors. The change of sentiment has been particularly evident in the building and construction sector, one of the most cyclically sensitive sectors. The confi dence indicators are typically used as indicators of developments in activity over the next 3-6 months and are calculated on the basis of expected output, turnover and/or employment. In recent months the confidence indicators have been close to the average over a longer historical horizon, reflecting that the situation in the business sector is normalising with more subdued expectations of future growth in activ ity. Confidence in the industrial and building and construction sectors is well above the level seen during the two slumps in the early 1980s and early 1990s, respectively.

For a number of years, the Danish economy has been characterised by very strong growth in domestic demand and considerable capacity pres sures, with further output growth being curbed by supply-side factors, not least a shortage of labour. This situation cannot persist in the long term, and the current low growth points to a return to a more sustain able situation in which demand pressures ease and business enterprises gradually approach a normal level of capacity utilisation. This does not mean that the Danish economy is in a recession, not to mention a slump, cf. Box 4. The current cyclical situation is best characterised as the late stage of a boom, with economic activity at a high level and continued pressure on the labour market. Developments do not indicate that the Danish economy will be severely affected by the international economic slowdown.

ASSESSMENT OF BUSINESS CYCLES	Box 4
In July, Statistics Denmark published national accounts showing negative quarterly GDP growth in both the 4th quarter of 2007 and the 1st quarter of 2008. This triggered a discussion of whether the Danish economy was in a recession. The back ground was that, in popular terms, the economy is in a "technical recession" if growth is negative for (at least) two successive quarters. This is a simplified definition that is frequently used in the financial markets, among other places. Subsequently Statistics Denmark published the national accounts for the 2nd quarter, which show that growth was positive in that quarter. Based on the above definition, the recession, if any, must be said to have been very brief. This illustrates the weaknesses of the definition. More generally speaking, an assessment of the current cyclical position requires a broader and more in-depth review of the economy. In the USA, the Business Cycle Dating Committee under the National Bureau of Economic Research, NBER, officially determines the peaks and troughs of the US business cycle. A recession requires a significant decline in economic activity across the economy. This is measured using a number of different indicators, of which real GDP is merely one. Other factors taken into account include employment, personal income and industrial production, but there is no exact definition of how to weight these factors. Thus, a certain element of estimate applies. Using the NBER defin ition, it can be concluded that the Danish economy is not in a recession at present. The decline in GDP was temporary and relatively limited, employment has risen in the year to date, and personal income is rising. There are no clear signs of a reduc tion of industrial production either. When assessing the cyclical position it is also important to make a distinction between growth rates and the level of economic activity. According to the NBER, a recession is simply a decline in activity, not necessarily a low level of activity. A situ ation with a low level of economic activity is referred to by the NBER as a slump. The level of activity can be measured in several ways, unemployment and capacity utilisation being core elements. A frequently used measure of capacity pressures and thus the level of activity is the "output gap", which is calculated as the gap between the actual output level and the level that is compatible with wage and price stability in the longer term. It is obvious that the Danish economy is not in a slump. Unemploy ment is at the lowest level seen since the 1970s, and according to calculations by the Ministry of Finance the output gap in 2007 was the largest since 1980, cf. Chart 16. Capacity utilisation in industry is at a level corresponding to the historical average. Denmark's current cyclical position can best be defined as the late stage of a boom, with activity having declined slightly in recent quarters from a very high level. The economy is still characterised by severe capacity pressures, with a tight labour market, and the gradual adjustment towards more sustainable capacity utilisation will also contribute to relatively low economic growth in a future per spective.
OUTPUT GAP AND ECONOMIC GROWTH	Chart 16
Note: Output gap as a percentage of potential GDP. Source: Statistics Denmark and Ministry of Finance, Economic Survey, August 2008.

The housing market
According to the Association of Danish Mortgage Banks, the price per square metre for single-family and terraced houses fell by 2.1 per cent in the 2nd quarter in relation to the previous quarter. For Denmark overall, housing prices have been relatively stable since early 2006, cf. Chart 17.

Over the past year prices have, however, shown a slight receding trend, in the 2nd quarter standing 3.9 per cent below the level in the 2nd quarter of 2007 when the prices of single-family and terraced houses peaked. Nevertheless, prices are still more than 50 per cent above the level at the beginning of 2004, when they really began to soar. Prices of owner-occupied flats have generally fallen somewhat more than house prices, in the 2nd quarter by 1.3 per cent on average compared with the preceding quarter, bringing them down to a level 13 per cent below the peak in mid-2006 for Denmark overall. Leisure cottages have also been declining a little in price over the past year or so and fell by 2.1 per cent in the 2nd quarter compared with the 1st quarter.

Price developments for single-family and terraced houses are subject to considerable regional differences, cf. Chart 17. The sharpest declines are still seen in Sealand, mainly Greater Copenhagen, while house prices rose in the 2nd quarter in the North Denmark Region. Recent develop ments confirm previous patterns, i.e. that the largest price drops are registered in the parts of the country where the price per square metre is highest, while price developments are more stable in the less expen sive areas of the country. However, in the 2nd quarter house prices did tend to fall in more parts of the country than previously.

The slowdown in the housing market still affects turnover. The trans action volume is relatively low and the number of homes for sale is high, particularly for single-family and terraced houses. This is reflected in long "for sale" periods. The number of enforced sales has also been ris ing. In August almost 300 enforced sales were announced, which is somewhat higher than the year before, but still low in a longer-term perspective. In comparison, the number of enforced sales per month was in the range of 1,700 during the housing crisis in the early 1990s.

The weak development in the housing market reflects factors such as the general slowdown in the economy, rising interest rates and exces sively high housing prices in some parts of the country. The housing mar ket can still be expected to be weak in the near future in view of the large supply of homes for sale. In a longer perspective, the strong labour market and the sound household finances will, however, buoy up prices at the national level.

Foreign trade and balance of payments
In spite of the international slowdown in growth, exports of goods have been robust in the year to date. Particularly industrial exports have been strong, including exports to the traditionally large export markets, i.e. Germany, the UK and Norway. Fuel exports have also increased against the background of rising oil prices. Looking ahead, exports can be ex pected to develop at a more measured pace as the slowdown hits Den mark's trading partners, although the intake of orders from export mar kets is high.

Growth in imports of goods for the corporate sector and for consump tion has moderated as a result of subdued domestic demand. The devel opment in exports and imports means that the seasonally adjusted monthly trade surplus (excluding ships, etc.) has been around kr. 3-4 bil lion from April to June. This is somewhat higher than at the beginning of the year.

The balance of payments has stabilised after pronounced deterioration of the current-account surplus in 2006 and the 1st half of 2007. For the 12-month period until July, the current-account surplus has been calcu lated at kr. 19.7 billion, cf. Chart 18. The stabilisation primarily reflects that the deterioration of the balance of goods has ceased. This is taken to indicate that the slowdown in growth has been stronger in Denmark than in its trading partner countries. The current-account surplus is sup ported by large surpluses on trade in services, including sea freight in particular.

Labour market
Output growth has declined, but the labour market nevertheless re mains strong. Private-sector employment is at a very high level and has continued to increase in 2008 to date. According to data from Statistics Denmark compiled on the basis of payments to ATP (Labour Market Sup plementary Pension), full-time equivalent employment in the private sector was almost 15,000 higher in the 2nd quarter of 2008 than in the 4th quarter of 2007, corresponding to an increase by 1 per cent, cf. Chart 19. This is mainly attributable to pronounced growth in employment at the beginning of the year. Employment has primarily risen in the private service sectors, including the financial sector, while it has been more stable in the industrial and building and construction sectors. The ATP statistics show that public-sector employment declined in the 2nd quar ter. However, this is because no ATP payments were made during the public-sector labour conflict in the spring, and thus the statistics do not reflect underlying developments in public-sector employment.

Unemployment has continued to fall. In July, seasonally adjusted un employment was 44,000 on a full-time basis, equivalent to 1.6 per cent of the labour force. This is the lowest level since the early 1970s. On average, unemployment has fallen by more than 2,000 persons a month since the reversal at the end of 2003, and this trend has continued at an almost unabated pace in recent months.

There are still indications of a shortage of labour in certain sectors al though the more subdued growth means that the shortage is not as pro nounced as previously. In the industrial sector the number of business enterprises reporting a shortage of labour has returned to a more nor mal level. Just under 10 per cent of building enterprises are short-staffed, which is a substantially lower number than earlier in the up swing, but nevertheless high in a longer-term historical perspective. Ac cording to the Dansk Jobindex indicator, the number of new jobs adver tised on the Internet also remains high, although it has declined since the turn of the year. In July the number of new job advertisements was approximately 32,000, which is estimated to correspond to 48,000 va cancies. The number of vacancies is confirmed by a survey performed by the Danish Labour Market Authority, which has looked into the re cruitment situation of business enterprises in the first months of 2008.³ Particularly the public and private service sectors have had difficulty in attracting labour, and positions for both skilled and unskilled labour have remained unfilled.

Employment and unemployment usually react to a slowdown in active ity with a certain lag. The substantial number of vacancies suggests that unemployment will remain very low for some time yet, but in the slight ly longer term it can be expected gradually to rise to a more sustainable level. The labour market will remain tight, reflecting demographic changes that will reduce the labour force as the population groups with the highest participation rates diminish. An increase in unemployment could also entail a reduction in labour market participation, notably in the older age groups, and the supply of foreign labour may also fall. This will curb the rise in unemployment. If labour-market pressures are to be eased further, reforms are required that will increase the supply of labour. This is a challenge to the Danish economy also in the longer term.⁴

Wages and prices
Labour-market pressures are reflected in strong wage increases. According to the Confederation of Danish Employers (DA), hourly earn ings in the 2nd quarter of 2008 were 4.9 per cent higher than in the same quarter of 2007, cf. Chart 20. Wage increases have thus picked up compared to the 1st quarter. Wage developments were particularly strong in service-oriented sectors and industry, in which the rates of increase in the 2nd quarter were the highest seen in this upswing. In the construction sector, on the other hand, wage increases slowed down markedly from the high level in the preceding quarters. According to DA, the rate of wage increase in the 2nd quarter may be slightly overestimated as more local wage bargaining had been concluded when the statistical data was collected than was the case in 2007.

The rapid wage developments put pressure on the international competitiveness of Danish enterprises. In the industrial sector, Danish wage increases have significantly exceeded those of Denmark's trading partners in recent years. Pressure on wage competitiveness has been intensified by significant appreciation of the Danish krone against the currencies of Denmark's trading partners over the last year or so. In the 2nd quarter, the real effective exchange rate of the krone, based on hourly wages, was 4.5 per cent above the level in the same quarter of 2007, indicating equivalent deterioration of wage competitiveness.

The results of the collective bargaining in the spring entail a substan tial wage boost for public-sector employees, with wage increases in ex cess of 5 per cent in 2008. Wages in the public sector are thus rising considerably faster than previously. In the current situation where pri vate-sector wage increases are already high in an international context it is essential that the increases in the public sector do not have a rub-off effect on the private sector.

Consumer prices are surging. In August, the Harmonised Index of Con sumer Prices, HICP, was 4.8 per cent higher than in the same month of 2007. Price increases have gained considerable momentum since the late summer of 2007 and this trend has continued in recent months, cf. Chart 21. The strong inflation primarily reflects the soaring energy and food prices. Core inflation, which is defined as the increase in HICP excluding energy and food, has also risen, however, to 2.6 per cent year-on-year in August. This was somewhat higher than one month earlier and substan tially higher than in the late summer of 2007.

Domestic inflationary pressures have been moderate so far, parti cularly in view of the cyclical position. Domestic market-determined inflation, IMI, was 1.0 per cent year-on-year in August. This was also markedly higher than one month earlier, but still below the level in 2007 and early 2008. IMI differs from core inflation in that it is stripped of the development in, inter alia, import prices and certain adminis tered prices, including rent, and is a measure of developments in domestic payroll costs and profit margins. The relatively low level of IMI reflects reduced corporate profit margins. Initially, business enter prises absorb price rises on production factors such as energy by cutting profit margins, rather than letting the additional costs be fully reflected in sales prices, cf. Box 5. On the other hand, stronger domes tic inflationary pressures can be expected in future, as profit margins are adjusted upwards again.

PRICE DEVELOPMENTS	Box 5
The rate of price increase has risen sharply from the trough of 0.9 per cent year-on-year in August 2007 to 4.8 per cent year-on-year in August 2008. This is not a purely Danish phenomenon, but reflects considerable and strongly increasing global infla tionary pressures. The steep increase in the overall index of consumer prices is chiefly driven by surging energy and food prices, cf. Chart 22 (left). Measured in Danish kroner, the price of crude oil almost doubled from the beginning of 2007 to August 2008, and the net retail price (consumer price stripped of taxes) of energy goods overall rose by around 20 per cent over the same period. The reason why higher oil prices are not fully reflected in Danish energy prices is that the latter also comprise e.g. electricity and district heating, which are not to the same extent affected by international oil prices. Food prices have increased by around 10 per cent since the autumn of 2007 as a result of substantially higher international commodity prices. Imported goods are also rising more steeply than last year, and the year-on-year rate of increase in import prices has been in the range of 3 per cent throughout most of 2008.
NET PRICES, IMI AND UNIT LABOUR COSTS	Chart 22
Note: 4-quarter moving averages of increases in unit labour costs in the non-farm business sector (right). Source: Statistics Denmark and own calculations.
Headline inflation has been curbed by moderate domestic market-determined inflation, IMI, cf. Chart 22 (right). IMI is a measure of the price development for value added in domestic industries manufacturing and supplying consumer goods and services. IMI thus captures changes in Danish payroll costs and profit margins. The relatively low level of IMI is not attributable to developments in payroll costs, as the high rate of wage increase has not been accompanied by an equivalent rise in productivity according to the available national accounts. This has led to a clear upward trend in unit labour costs, which is not seen in IMI. Instead, the low IMI is likely to reflect lower profit margins in the business sector since the rising costs for e.g. energy have not initially been passed on to customers by way of higher prices. A similar pattern was seen in 2004-06 and 1999-2000, when increasing prices for energy and imported goods coincided with a fall in IMI. Looking ahead, profit margins can be expected to rebound, which will contribute to higher domestic inflationary pressures. This has also been the case on previous occasions, e.g. in 2001-03 and to a lesser extent in 2006-07, when the inflation contribution from IMI increased when energy and import prices had stopped rising. The outlook for price developments in the near future is discussed in the article The Danish Economy 2008-10.

Economic outlook
Denmark is in the late stage of a boom with continued high pressure on the labour market. This pressure will ease in the coming years as unem ployment begins to rise, but for some time yet activity will be above the level that is compatible with wage and price stability in the longer term, cf. the article The Danish Economy 2008-10. Consumer prices have risen steeply, and it is essential to sustainable development that the surge in consumer prices is not channelled into wage acceleration. Persistent capacity pressures in the Danish economy entail a risk of a wage and price spiral that could ultimately lead to an unnecessarily high and pro tracted increase in unemployment. This risk is amplified if fiscal policy stimulates demand in 2009. If economic policy is aimed at maintaining the current low level of unemployment, there is an imminent risk that it will be unsuccessful, at considerable cost to society and to individual citizens.