Recent Economic and Monetary Trends

This review covers the period from the middle of November 2005 to the middle of February 2006

Growth in the global economy remained high in the 2nd half of 2005, even though 4th-quarter growth in the USA was disappointing. The upswing was more broadly based than previously, as there was also sound growth in the euro area and Japan. Oil prices surged at the beginning of September in the wake of a violent hurricane in the Mexican Gulf, and even though prices then dropped the level is still high, at around 60 dollars per barrel. Combined with the robust growth, this has led to greater concern about rising inflation. As a consequence, monetary policy was tightened in e.g. the euro area and in the USA, where the series of interest-rate increases continued.

INTERNATIONAL FINANCIAL AND COMMODITY MARKETS

The strengthening of the US dollar vis-à-vis the euro throughout 2005 ceased at the end of the year, after which the dollar weakened a little to 1.19 dollars per euro in mid-February. This is approximately 10 per cent stronger than one year before. An equivalent development was seen against the Japanese yen.

Over the last year, the 10-year US government bond yield has fluctuated at a level of around 4.25 per cent, cf. Chart 1. Combined with the continued tightening of monetary policy, and thus rising short-term interest rates, this has led to a significant flattening and, most recently, inversion of the yield curve, as the 3-month money-market interest rate has exceeded the long-term yield since the turn of the year. Since the summer, the long-term yield in Germany has moved in parallel with the US yield, but at a level approximately one percentage point lower, and the flattening of the German yield curve is less pronounced as short-term interest rates have risen less.

Viewed in a historical perspective, the reaction of the long-term yield to the strong economic position has been very subdued. This reflects expectations in the market so far that inflation will remain moderate in the medium term. In general, there are very few concrete indications of wage effects derived from the high oil price.

The oil price reached almost 70 dollars per barrel (Brent) at the beginning of September in the wake of a violent hurricane in the Mexican Gulf that damaged production facilities and refineries in the area. Subsequently the oil price dropped again, to 60 dollars per barrel in mid-February, cf. Chart 2.

The stock markets, particularly outside the USA, have risen considerably. The Danish OMXC20 index has risen by 30 per cent within the last year and is among the best-performing indices, except within the last month.

The gold price has increased strongly and in mid-February reached the highest level in dollar terms since 1981. Part of the explanation may be that several investors, e.g. hedge funds, have begun to invest in gold, in anticipation of continued price rises. Another factor is the growth in the global economy, which has generally boosted the demand for industrial metals. The most recent increase in the gold price does not stand out from the prices of other metals. The prices of many other commodities have also been rising strongly.

INTERNATIONAL ECONOMIC DEVELOPMENT

USA
The US economy grew by only 0.3 per cent in the 4th quarter. This was lower than in the preceding quarters and less than expected (consensus forecasts). This development is presumably attributable to temporary factors such as a fall in car purchases after a strong 3rd quarter, lower military expenditure and the effects of the hurricanes in the autumn. The US economy has previously proved to be very robust, so there is no reason to believe that it is facing an imminent period of low growth, cf. Box 1. Compared with the 4th quarter of 2004, growth was 3.1 per cent.

The sustained rise in housing prices has been the key factor behind the US upswing in recent years. At the national level, property prices have almost doubled since 1995. The increase can to a large degree be explained by economic fundamentals such as low interest rates, rising disposable incomes and moderate unemployment. In the last few months there have, however, been initial indications that the housing market is cooling off. Prices in certain areas have flattened out, and the length of time that new houses are offered in the market has increased. The development is in line with the tightening of monetary policy since mid-2004.

Large capital gains, primarily on housing, but also on shares and bonds, have contributed to reducing savings as a ratio of the households' disposable incomes in recent years. In spite of a sound improvement in the fiscal year 2004-05, the federal budget also shows a considerable deficit which looks set to deteriorate further in the current fiscal year, partly as a result of emergency relief following the hurricanes in the autumn. Consequently, the imbalances in relation to the rest of the world have reached new levels, with a trade deficit of more than 6 per cent of GDP in 2005. Since the USA accounts for around one third of the global economy (not purchasing-power-parity adjusted), a deficit of this magnitude absorbs a large proportion of global savings. Perhaps the most important issue for the global economy in the near future is how and how soon the US economic imbalances can be reduced, since they are not sustainable in the long term. Higher growth rates in Europe and Japan may contribute, but cannot in themselves solve the imbalances since a higher US savings ratio is required.

SLOPE OF THE YIELD CURVE AND RECESSIONS IN THE USA	Box 1
Since January 2004, the spread between the 1-year and 10-year US government bond yields has narrowed from 250 basis points to 0 basis points. Previously, flattening of the yield curve has preceded economic recessions 1. Prior to five out of six recessions in the USA since 1970, the yield curve flattened significantly, cf. Chart 3. Among other things this reflects that monetary policy must typically be tightened during an upswing in order to keep down current and expected inflation, and cannot be eased again until the economy has cooled down.
SLOPE OF THE YIELD CURVE AND RECESSIONS IN THE USA	Chart 3
Both actual inflation and inflation expectations are low today, despite the upswing. In previous upswings, inflation expectations, and thus long-term yields, have tended to drift upwards. At the same time, real interest rates are relatively low. In key areas the situation today therefore differs from previously so there is reason to believe that this time the flattening of the yield curve will probably not be followed by a recession.
1 The NBER's official dating of recessions has been applied, cf. www.nber.org.

The consumer price index increased by 3.4 per cent year-on-year in December. Core inflation is stable at a level of around 2 per cent, and there are no indications of derived effects from the price increases for oil and other commodities. The most recent wage figures do, however, point to a stronger increase than seen so far. Unemployment is approximately 5 per cent.

The Federal Reserve has raised its target rate by 25 basis points at each of the last 14 meetings of the Federal Open Market Committee, FOMC. At the meeting in January, the benchmark official interest rate, the fed funds target rate, reached 4.50 per cent, cf. Chart 4. The press release in connection with the FOMC meeting indicates that further tightening may be necessary. The financial markets expect the Federal Reserve to raise interest rates by a further 25 to 50 basis points in 2006.

Euro area
The beginning upswing in the euro area continued in the 4th quarter with quarterly growth of 0.3 per cent. Germany saw zero growth. The weak link was German private consumption, which continued to stagnate. A stronger, more self-sustained upswing in the euro area will require more pronounced development in consumption in Germany, which in turn requires a change of mood among consumers. There are some indications that this change is on its way, but the German
economy has previously showed signs of a revival that subsequently petered away.

Indicators such as consumer confidence and the PMI index of business confidence, cf. Chart 5, point to a continued positive tendency in the euro area, and growth is expected to be around 2 per cent in the current year.

The German coalition government has presented a detailed Coalition Agreement aimed at solving the problems of low growth and a substantial budget deficit which significantly limits the options for fiscal-policy stimulation of the economy. In 2006, the budget deficit is expected to exceed 3 per cent of GDP for the fifth consecutive year, but the government is aiming for a deficit below 3 per cent of GDP in 2007.

The initiatives in the Coalition Agreement include a general increase in VAT from 16 to 19 per cent as from January 2007, which is expected to improve government finances by approximately 1 per cent of GDP. The announcement of the VAT increase may speed up consumption, thereby stimulating the economy in the current year. However, the question is whether this is sufficient to boost business investments and thus make a more durable contribution to growth.

Measures in the longer term include plans to raise the retirement age by one month a year from 2012 onwards, to 67 years in 2035.

Unemployment in the euro area fell steadily in 2005, but rose a little in December, to 8.4 per cent. In some months, the fall was particularly strong in Germany, but from a high level. In January, German unemploy­ment rose again. Employment in Germany is affected by the loss of nearly 2 million jobs with full payment of social-security contributions since 2001, but employment has only fallen by one fourth of this. The explanation is more people in subsidised employment, known as "1 euro jobs", "mini jobs", etc. The decrease in the number of real jobs undermines the finan­cing of social security funds and impedes consumption growth .

In 2006, five euro area member states, including Germany, France and Italy, will again have substantial government budget deficits and are expected to exceed the limit of 3 per cent of GDP stipulated in the EU Treaty. The prospects of stronger growth in the euro area increase the possibilities of reducing the government deficit, and these possibilities should be utilised. However, a sustained improvement cannot solely be based on cyclical factors, but also requires measures of a more structural nature, since these member states are faced with an even more acute demographic challenge than Denmark, with an increasing number of retired people and ever fewer of working age in the coming decades.

Consumer prices in HICP terms rose by 2.4 per cent in January. This is more than at the beginning of 2005, but slightly less than in the autumn. The development to a large extent reflects energy prices. Core inflation, measured as HICP exclusive of food, energy, alcohol and tobacco, remained unchanged at around 1.5 per cent in January. The underlying inflationary pressure in the euro area is thus moderate, a conclusion that is supported by subdued wage increases.

On 1 December, the European Central Bank, ECB, raised its minimum bid rate by 25 basis points to 2.25 per cent, the first increase since June 2003. According to the ECB the increase is to be seen as part of the efforts to keep medium-term inflation expectations at bay, while ensuring that monetary policy continues to support growth in the economy.

Asia
The Japanese economy grew by 4.2 per cent year-on-year in the 4th quarter, which is somewhat higher than in the preceding quarters. The labour market is picking up with rising employment and falling un­employment. Monetary policy is highly expansionary, and the government budgets show a substantial deficit.

Property prices in Tokyo stabilised in 2005 after having fallen for 15 years. This is an indication that Japan may be on its way out of the deflation that has characterised the economy for several years. Concurrently with this development, the zero-interest-rate policy is coming to an end. The Bank of Japan has indicated that the rate of interest will not be raised before core inflation has become positive on a sustainable basis. The Bank of Japan finds it increasingly probable that this will be in the fiscal year 2006-07^[1]. Core inflation was 0.1 per cent in December.

The Chinese economy grew at an unabated rate of almost 10 per cent year-on-year in the 4th quarter. If growth continues at this level, GDP in volume terms will double in only seven years. Growth in domestic demand picked up again after dampening in the 1st half of 2005.

The Chinese trade surplus tripled in 2005 compared with the preceding years. This was reflected in sustained growth in the Chinese foreign-exchange reserve, which closed the year at 820 billion dollars, equivalent to 45 per cent of Chinese GDP. The foreign-exchange reserve has mainly been invested in US government securities.

UK
The economy is in a period of stable, but dampened growth. GDP rose by 1.7 per cent year-on-year in the 4th quarter. Growth in private consumption was moderate as a result of subdued development in housing prices and disposable incomes. The rate of increase in cash prices fell to below 5 per cent p.a. at the beginning of 2006, after at one point exceeding 25 per cent p.a. This development should e.g. be seen against the background of the tightening of monetary policy by a total of 125 basis points to 4.75 per cent during 2003 and 2004. This has dampened the strong growth in housing prices. The base rate has remained unchanged in recent months after having been lowered to 4.50 per cent in August 2005.

There are imbalances in the UK economy. The trade deficit is large and increasing, and the government deficit was 3.3 per cent of GDP in 2005. A similar deficit is expected in 2006.

Inflation in the UK was 1.9 per cent in January and thus close to the government's target for the rate of price increase. For 2005 overall, average inflation was 2.1 per cent, which is the highest level since 1997. Core inflation was slightly lower, and there are no indications of derived wage effects from the rising energy prices. The exchange rate of the pound sterling against the euro has remained unchanged for the last six months, while the effective sterling rate has fallen a little.

Sweden
After weakening temporarily in the 1st half of 2005, the Swedish economy rallied strongly in the 3rd quarter, with annual growth of 3.4 per cent in real GDP. Domestic demand and exports both contributed positively to GDP growth. The high growth seems set to continue in 2006, e.g. as a result of highly expansionary monetary and fiscal policy. At the same time, housing prices are rising strongly. In addition, the Swedish krona has weakened during the past year, which in the short term improves competitiveness and squeezes capacity further. In mid-February, the effective krona rate was almost 10 per cent below the level one year earlier. The exchange rate vis-à-vis the Danish krone had fallen back to below 0.80 krone per krona by mid-February.

So far the high growth has not really been reflected in the labour market, which is only marginally picking up. Unemployment has fallen only slightly during the last year, to 5.4 per cent in December. However, the number of vacancies continues to rise. Inflation measured by the KPI index was 0.6 per cent year-on-year in January and thus still below Sveriges Riksbank's target zone of 1-3 per cent. The rate of wage increase is not alarming either.

Due to prospects of sustained high activity, Sveriges Riksbank found it necessary to raise its repo rate by a total of 50 basis points in two stages in the first months of 2006, to 2.00 per cent. The 10-year government bond yield was 3.4 per cent in mid-February.

Norway
Growth in the Norwegian economy remains high. Mainland GDP increased by 3.1 per cent year-on-year in the 3rd quarter. The rate of growth is expected to be maintained in subsequent quarters.

Underlying inflation, measured by Norges Bank's preferred inflation measure (the KPI-JAE index), which excludes energy and indirect taxes, is still considerably below the target of 2.5 per cent. The sight deposit rate has been unchanged in recent months after an increase by 25 basis points, to 2.25 per cent, at the beginning of November.

DEVELOPMENT IN THE DANISH FINANCIAL MARKETS

In the period under review, the krone was close to its central rate in ERM II of 7.46038 kroner per euro.

Danmarks Nationalbank responded to the ECB's raising of its interest rates on 1 December by raising the lending rate by 25 basis points, to 2.40 per cent. The discount and current-account rates were also increased by 25 basis points, to 2.25 per cent. The increases had been expected in the market and did not give rise to any particular market reactions.

Danmarks Nationalbank did not intervene in the foreign-exchange market in January, and at end-January the foreign-exchange reserve was kr. 213.1 billion. The first part of February, however, saw an outflow of foreign exchange in connection with e.g. institutional investors' purchases of foreign shares and other securities, and on 17 February the lending rate was raised by 10 basis points to 2.50 per cent. The discount and current-account rates remained unchanged .

Following an increase by 50 basis points in the autumn, the 10-year government bond yield has fallen slightly since November, to around 3.5 per cent in mid-February. After Danmarks Nationalbank's raising of the lending rate, the 3-month yield (uncollateralised) rose by 7 basis points, to 2.7 per cent. In Denmark too, the spread between short- and long-term yields has generally narrowed in recent years.

The yield spread between Denmark and the euro area has narrowed since the summer of 2004, both for short-term money-market interest rates and for long-term bond yields. Since May 2005, the 10-year yield spread has been eliminated, i.e. the yield in Denmark has been at the same level as in the euro area. The yield spread is close to zero along the entire yield curve up to 10 years. Combined with the fact that the krone remains very close to its central rate, this can be taken to express great confidence in the strong Danish economy and the fixed-exchange-rate policy.

In late November 2005, Slovakia joined ERM II, cf. Box 2.

THE EXCHANGE-RATE MECHANISM, ERM II	Box 2
On 28 November 2005, Slovakia joined the exchange-rate mechanism, ERM II. The central rate and fluctuation band of the Slovakian koruna have been fixed in relation to the euro, cf. Table 1. In recent years, Slovakia has managed its monetary policy according to an inflation target and as a managed float of the koruna, with the euro as the reference currency. Slovakia 's membership does not entail any adjustment of the central rate, fluctuation band and other terms for the Danish krone in ERM II, and nor have there been any adjustments for the other participants. The obligation to intervene if a participating currency reaches one of its fluctuation limits rests exclusively on the central bank of the relevant member state and the ECB. The other participants have no obligation to intervene.
INFLATION IN EU MEMBER STATES, DECEMBER 2005	Chart 6
Note: Inflation is calculated as a year-on-year increase in a 12-month moving average of the HICP index over the preceding 12 months. The criterion value is determined as the average of inflation in the three member states with the lowest inflation, plus 1.5 percentage points. The "criterion value" is the upper limit for inflation in accordance with the calculation of the inflation criterion previously applied to the assessment of convergence. Source: Eurostat.
With Slovakia's membership, ERM II comprised eight member states in mid-February 2006. In a few months, Estonia, Lithuania and Slovenia have been ERM II members for two years, which is one of the conditions for adopting the single currency, the euro. Cyprus, Latvia and Malta joined ERM II on 2 May 2005. In addition to being an ERM II member for two years, EU member states wishing to adopt the euro must meet four convergence criteria relating to inflation, long-term nominal interest rates, budget deficits and government debt, the latter two as ratios of GDP. Convergence assessments of Estonia, Lithuania and Slovenia will take place in the 1st half of 2006. Compliance with the inflation criterion may prove to be especially difficult for Estonia, cf. Chart 6. One of the reasons is that energy typically weighs heavier in the consumer price index in low-income EU member states than in the more affluent member states. A number of member states, including Poland and Hungary, have excessive budget deficits. For many of the new EU member states further convergence is thus necessary before they are ready to adopt the euro.
CENTRAL RATES AND FLUCTUATION BANDS IN ERM II Table 1 National currency units per euro Upper limit Central rate Lower limit Fluctuation band, per cent Danish kroner 7.62824 7.46038 7.29252 +/- 2.25 Estonian kroons 17.9936 15.6466 13.2996 +/- 15 Cyprus pounds 0.673065 0.585274 0.497483 +/- 15 Latvian lats 0.808225 0.702804 0.597383 +/- 15 Lithuanian litas 3.97072 3.45280 2.93488 +/- 15 Maltese lira 0.493695 0.429300 0.364905 +/- 15 Slovenian tolars 275.586 239.640 203.694 +/- 15 Slovakian koruna 44.2233 38.4550 32.6868 +/- 15 Note: Several member states unilaterally observe narrower fluctuation bands.

The positive development in the Danish economy is reflected in the financial balances. Growth in lending to households and the business sector by banks and mortgage-credit institutes was around 14 per cent year-on-year in the latter part of 2005, cf. Chart 7. This is the highest growth in lending since the mid-1980s. Some of the proceeds are invested in pension schemes.

At approximately 40 per cent in December, growth in the banks' lending for housing purposes was particularly strong. It is matched by a considerable increase in bank deposits from households since the autumn of 2004. This reflects the structure of the banks' mortgage loans, whereby a loan against the home as collateral is established concurrently with a deposit account for the nominal value of the loan. The proceeds are not necessarily spent all at once. Therefore deposits increase, and thereby the money stock (M2), which has risen by 15 per cent over the last year.

On 2 January 2006, Danmarks Nationalbank made a minor adjustment to the framework for the monetary-policy counterparties' current-account deposits. The overall current-account limit was increased from approximately kr. 20 billion to approximately kr. 25 billion. A large part of the increase is attributable to simplification of the system so that the counterparties are now allocated standard limits. This entails that small counterparties are generally allocated higher limits than previously. The raising of the overall current-account limit should also be viewed against the background of the general economic growth since the last adjustment of the current-account limits in 2003. No counterparties' current-account limits were reduced in connection with the adjustment. The current-account-limit system is described in Box 3.

The Danish economy

Overall
The economic upswing has continued at full speed. The improvement has become more broadly based in recent quarters, as export growth has picked up, while the increase in domestic demand has continued unabated. This increases the risk of capacity problems in the economy. The labour market has clearly tightened, but so far generally without acceleration in wages, according to the wage statistics of the Confederation of Danish Employers. Government finances and the current account show sound surpluses, so Denmark does not face the same imbalances as many other countries, including the USA. The principal risk is overheating of the economy, which could derail the upswing, cf. Box 4.

RISK OF OVERHEATING OF THE DANISH ECONOMY	Box 4
The rate of wage increase in Denmark has been stable during the last quarters, and only slightly above the level abroad. Nevertheless, there is a risk of overheating since the strong growth in the Danish economy and the continued fall in unemployment increase the risk of capacity problems. The relatively moderate wage increases in view of the economic situation, cf. Chart 8, should be viewed against the background of even lower wage increases in the euro area and in Asia. Business enterprises and their employees are thus faced with fierce foreign competition. Today this is to some extent also true of the building and construction sector, which has traditionally been oriented towards the domestic market and highly cyclically sensitive. Compared with previously, the labour market has generally become much more flexible, e.g. as a result of the labour-market reforms in the 1990s, as well as more decentralised wage formation. In addition, the level of Danish wages is among the very highest in the world, at any rate within manufacturing, where comparable statistics are available 1. Typically, wages react to cyclical trends with a considerable lag, however.
UNEMPLOYMENT AND RATE OF WAGE INCREASE	Chart 8
Source: Statistics Denmark and the Confederation of Danish Employers.
A positive consequence of wages only reacting to the strong growth to a limited extent is that the sectors exposed to competition carry a smaller share of the burden of adjusting to a tight labour market than in previous upswings. On the other hand, there is a higher risk that the consumption and investment ratios, i.e. in volume terms, and housing prices become too high, leading to a subsequent backlash. However, neither the consumption nor the investment ratio is at an alarmingly high level at present. If the low level of wage increase is maintained, the upswing may therefore prove to be sustainable in the long term . The most appropriate reaction in the current favourable cyclical situation is to keep demand, including government demand, on a tight rein, and to expand the supply of labour as quickly as possible.
1 Cf. US Bureau of Labor.

Economic activity, the labour market and fiscal policy
GDP in volume terms grew by 1.4 per cent in the 3rd quarter. Compared with the same quarter of the preceding year, growth was almost 5 per cent. This rate of growth in one quarter has not been seen since 1994 in the wake of the "kick-start". However, at that time the upswing came after seven years' recession, and started from a far lower level with high unemployment and a stagnant housing market.

Growth in the 3rd quarter was driven by both private and government consumption as well as investments, and for the third consecutive quarter exports grew at a faster rate than imports. This reflects higher growth among Denmark's trading partners, particularly the euro area, but also that Denmark has regained some of the market shares lost since 2002.

Most of the economic indicators, such as retail sales, car sales and consumer expectations, point to continued growth. The confidence indicator for construction continued to rise, while the indicators for industry and services fell slightly at the end of the year. Manufacturing output rose substantially towards the turn of the year.

Employment, calculated on the basis of payments to ATP (the Labour Market Supplementary Pension Fund), rose by 8,500 in the 3rd quarter, a tendency that can be expected to have continued in the 4th quarter in view of the development in unemployment figures and other indicators for the Danish economy. Growth in employment has mainly been seen in the private sector, and especially in service areas aimed at the domestic market. The development in manufacturing industry, which is strongly export-oriented, has been weaker.

The future demographic development will make it ever more difficult to increase employment. The population aged 25-60 will decline by more than 100,000 in the next five years.

Unemployment has fallen at generally the same rate as employment has risen, and was down to 5.1 per cent in December. The decline in unemployment is broadly distributed on regions and sectors. It is thus obvious that the labour market is seriously beginning to tighten, cf. Chart 9. The number of bottlenecks has increased and there are recruitment problems in several areas. So far the impact on wages has been moderate, according to the statistics of the Confederation of Danish Employers. However, there are several areas, e.g. parts of the financial sector, where wages and salaries for some types of labour appear to be increasing substantially. The financial sector is not included in the statistics from the Confederation of Danish Employers.

The scheduling of wage negotiations between employees and employers may affect the timing of potential wage accelerations. The collective agreements within several key areas run until the spring of 2007, but the reaction to the favourable economy may be apparent from the local negotiations, which usually take place in the spring. Normally wages react to cyclical developments with a certain time lag.

The government's net cash surplus in 2005 was almost kr. 80 billion. The large surplus was not just a result of the cyclical upturn, but also reflected extraordinarily high revenue from e.g. taxation of pension yields (PAL taxation) and from corporate tax, including taxation of oil and gas activities in the North Sea and taxation of the banks. Much of the revenue taxed is thus based on high oil prices and capital gains as a result of higher share and bond prices, and is thus of a non-recurring nature. Such extraordinary income cannot be used to finance permanent improvements in public services or tax cuts without affecting fiscal-policy sustainability in the long term. The extra revenue should therefore solely be used to reduce debt.

The cyclical position with pressure on capacity and the labour market requires tight management of government expenditure, and the situation does not call for easing of fiscal policy. At present it is best for the Danish economy not to stimulate demand further via the government budgets. Historically it has proved to be very difficult to keep government expenditure within the targets set, and again in 2005 the government's target of real growth in government expenditure of maximum 0.5 per cent is likely to have been exceeded.

The prospects for the Danish economy in 2006 are positive, but there are risks. Sound growth can be expected. The short-term challenge is to ensure that the substantial cyclical upswing does not accelerate too much and lead to overheating. In this context, reactions in the labour market play a key role. So far, wages have not reacted strongly, but experience shows that the situation may change rapidly. Consequently, it is necessary to expand the labour force immediately. To some degree this can be achieved by importing qualified labour, and there does indeed seem to be a growing interest in employing foreign labour under normal Danish collective agreements. Imported labour from e.g. eastern Europe has helped to ease the pressure on the labour market in countries such as Ireland and the UK. In the long term, more fundamental reforms are required, as stated in the final report from the Danish Welfare Commission, cf. Box 5.

REPORT FROM THE DANISH WELFARE COMMISSION	Box 5
Danish society faces a considerable challenge in the coming decades since the proportion of elderly people in the population will rise substantially, while there will be fewer of working age. This will put government finances under pressure because many welfare services are financed collectively via taxation. The report from the Danish Welfare Commission 1 contains 43 specific proposals aimed at ensuring sustainable government finances and better equipping the welfare society to handle the demographic changes by increasing the number of people in employment, compared to a situation where no action is taken. In relation to employment, the key proposal is gradual postponement of the retirement age, combined with gradual phasing-out of the early retirement scheme. Viewed in isolation, these two measures will gradually increase employment by 150,000 up to 2040, cf. Chart 10. If the proposals are only partly implemented, or the phasing-in period is more prolonged, the employment effects will be lower. Realisation of the two proposals will not have any decisive impact on the labour market today. Other proposals from the Welfare Commission include stepping up activities aimed at young people and increasing the use of qualified foreign labour, e.g. from eastern Europe.
CONSEQUENCES TO EMPLOYMENT OF PHASING-OUT OF EARLY RETIREMENT AND POSTPONEMENT OF THE RETIREMENT AGE	Chart 10
Note: Early retirement is phased out over 20 years, starting in 2009. The retirement age is increased by one month every year from 2013. Source: Danish Welfare Commission.
The proposed postponement of the retirement age can by and large finance the impact on government expenditure of the expected future growth in mean life expectancy . Letting the retirement age follow the mean life expectancy makes the welfare society far more robust to the fact that people live longer. This is important in relation to ensuring fiscal-policy sustainability. Overall, the proposed postponement of the retirement age and phasing-out of the early retirement scheme will improve the government balance by more than 4 per cent of GDP in 2040, compared to a situation where no action is taken. These proposals thus contribute significantly to ensuring fiscal-policy sustainability. If the proposals are only partly implemented, the effects on the government budgets are equivalently smaller, entailing a need for future adjustment. The proposals of the Welfare Commission include amendment of the tax system, whereby the middle tax bracket is eliminated, and the lower limit for payment of top-bracket tax and the employment allowance are both increased. This is, inter alia, to be financed by gradually increasing property tax and raising the retirement age. A tax reform along these lines will undoubtedly increase the supply of labour since the marginal tax on earned income is lowered for most people. However, this taxation package is underfinanced. This contributes to a negative government budget balance for many years if the full package is implemented. Altogether, the Welfare Commission's report constitutes an important review of the challenges faced by the Danish society in the coming decades, while also containing a list of proposed solutions. The sooner action is taken, the less extensive the measures required to achieve the desired effect.
1 The report "Fremtidens velfærd – vores valg" (Future welfare – our choice) was published in January 2006 and is available in Danish at www.velfaerd.dk.

Balance of payments and foreign trade
The current-account surplus was more than kr. 50 billion in 2005, equivalent to 3.5 per cent of GDP. Due to restructuring of the balance-of-payments statistics, figures are not directly comparable with previous years, but the surplus in the last three months of 2005, when statistics are comparable, was approximately kr. 2 billion below the same period of the preceding year. The large current-account surplus is surprising in view of the strong domestic economy, and the development is in stark contrast to historical experience. This is to a large extent attributable to the fact that since the mid-1990s Denmark has been a net exporter of oil and gas, which have been sold at high prices in recent years, and furthermore rates for sea freight have been high. The high current-account surplus was set off by increasing surpluses and savings in the corporate sector.

Both exports and imports of goods grew strongly in 2005, cf. Chart 11. The same applies to exports of services, e.g. sea freight. Manufactured exports have risen by 15 per cent in value terms in the last year. Danish business enterprises are thus gaining market shares after some years' losses. The growth in imports for both consumption and the business sector has been high.

Prices
Inflation remains low in Denmark. Consumer prices in HICP terms rose by 2.0 per cent in January and are thus still very close to the ECB's inflation target. The major contribution to the price-increase rate still came from energy, which rose by just over 10 per cent. Energy is included in the consumer price index with a weight of approximately 10 per cent. Generally, the strongest price impulses were external, while domestic market-determined inflation, which is stripped of the price development in food, including alcohol and tobacco, and administered prices, was close to zero. This shows that the higher prices for energy and other commodities have not been fully passed on to sales prices so far. Total revenue in the business sector has not been affected to the same extent since the volumes sold have increased. The low domestic pressure on prices should also be viewed against the background of dampened wage development and sound productivity gains.

The housing market
The strong development in the housing market continued in the 4th quarter with increases of more than 20 per cent for single-family houses within the last year, but with large geographical variations. Prices for owner-occupied apartments, which are concentrated in the cities, have risen by almost 30 per cent on average, cf. Chart 12. Prices are rising more than previous experience would indicate, and this rate of increase cannot continue. However, the strong economy, the low interest rates, low unemployment and the freeze on property-value tax provide a firm foundation for the housing market, and the tide is scarcely likely to turn in the immediate future. Nonetheless, there are aspects of the most recent development that are unsound and increase the risk of a runaway upswing. Surveys show that in some parts of the market there are widespread expectations that cash prices will continue to rise at a higher rate than inflation in general. This entails a risk that residential investments are made on a speculative basis to achieve a capital gain, rather than just a home.

Particularly in the Greater Copenhagen area, the continued urbanisation and the fact that there are many educational institutions and highly paid jobs also exert upward pressure on housing prices. In the slightly longer term, demographic changes, viewed in isolation, are likely to dampen growth in cash prices, cf. the article on p. 87. Other factors may, however, have the opposite effect, e.g. the underlying increase in housing demand as incomes rise, and the steadily increasing number of one-person households.

The high prices per square metre have made new construction profitable, and construction of multi-storey housing has expanded significantly, particularly in the Copenhagen area, cf. Chart 13.