Economic Outlook: Inflation Again

This week's highlights
In the first week of August, it was confirmed that the high rate of inflation is still a cause for concern among the members of the Fed's monetary policy committee. In June inflation reached 5%. Inflation has not been this high since the early 1990s.
This is mainly due to rising energy and food prices. Adjusted for the price rises of these product groups, inflation is 'only' 2.3%. What is even more important is that so far there have not been signs of an underlying rise. There are thus limited signs that the price rises on food and energy have spilled over into the other product groups.
One reason behind this is the slowdown in growth, which has partly led to weaker demand growth and partly to rising unemployment and thus lower wage increases. Moreover, productivity growth in the economy has increased in recent quarters and the growth in unit wage costs has thus fallen. This dampens the spreading of the price increases on food and energy to other products.
There are also other reasons why the rising commodities are no longer having such a significant effect. The price of the commodity, i.e. corn, wheat, meat and the like, accounts for a smaller and smaller part of the price in the shops. In 1950, commodities accounted for 41% of the shop price while the share had fallen to 20% in 2005. Costs for wages, transportation, marketing and packaging have increased more than the prices on commodities. The 20% are of course an average. Commodities only account for 6% of the price on bread while the share for steaks is almost 50%.
All other things being equal, this means that both rising and falling food prices have a lower effect on consumer prices than what has traditionally been the case. We are thus not particularly concerned about the risk of sustained and rising core inflation in the US.

This week's other highlights

• The US: trade balance, import prices, retail sales and industrial production.
• The euro zone: GDP, Q2 and consumer prices
• The UK: RICS, consumer prices, inflation report from the BoE and labour market report
• China: consumer prices
• Japan: GDP, Q2
• Norway: monetary-policy meetings at Norges Bank and consumer prices

Monday

The UK: RICS - July

The survey from the Royal Institute of Chartered Surveyors has over the past year indicated a markedly weaker development in the housing market, and we expect this trend to continue.
The ratio between home sales and the stock of unsold homes fell further in June and is now at the lowest level since 1995. This indicates further price declines in the coming months. The house price index in the RICS survey rose slightly in May and June, but the level remains low and points to marked price declines. According to Nationwide, house prices fell by 7.9% y/y in July. The number of deals is very low, and this indicates that the tight credit conditions are inducing many potential house buyers to stay out of the market and the number of mortgages is historically low. There are thus not many indications that the housing market will turn any time soon.

Norway: consumer prices - July

Since the turn of the year, inflation has been markedly above Norges Bank's target, and we expect this situation to continue in the coming months. Inflation is lifted by rises in food and energy prices, but also the underlying inflationary pressure is on the rise.

We assess that consumer prices will continue to rise in July, among other things because Norwegian food prices are first now catching up on global food prices. In June, food prices pushed down inflation which we expect will be reversed in July when the new annual agreement with the farmers takes effect. Domestic inflation rose in June to 3.9% y/y due to a tight labour market and sharp wage growth. Imported inflation, on the other hand, is negative (-1% y/y in June) due to the development in global prices on for instance electronics and clothes and the effect from the exchange rate. This emphasises Norges Bank's focus on avoiding a weakening of the currency.
In the slightly longer term, we expect that the inflationary pressure abates as growth slows down and the pressure on the resources of the economy is reduced, just as the base effect from commodity prices will disappear. However, not until the turn of the year will lower inflation begin to show.

China: consumer prices - July

Inflation has fallen a little over the past months due to lower food prices, and we expect the falling trend to continue for the rest of the year. Consumer prices are now rising by 7.1% y/y against 8.7% in February which was the sharpest rate of increase since 1996. Inflation in food prices has fallen to 17.3% from 23.3% over the same period.

We expect inflation to fall below 7% in July which is not yet seen in 2008. It will again be a fall in food prices which will control headline inflation. A statement of the prices on fresh food in July showed a fall in three of four weeks - driven down by pork, chicken, fish and not least vegetables. These product groups have been affected by swine disease and the snow storm earlier in the year and are now normalising.
Inflation exclusive of food prices has, on the other hand, increased lately due to the government's increases of energy and fuel prices. In June, inflation exclusive of food prices was 1.9% y/y against 1.5% in January. Energy prices do not have a large share in the consumer price index - less than 5 % - while food prices account for 1/3. The development in inflation will therefore still dominate headline inflation.

Tuesday

The US: trade balance - July

The trade balance is interesting for a number of reasons. Above all, exports and imports in June are not included in the GDP statement for the second quarter. The first statement of GDP is based on expectations of exports and imports in June, and if the deficit is lower than expected it may lift growth and vice versa. Moreover, imports may reveal how much the rest of the world is affected by slower US growth. We have already seen a negative development in the sentiment indicators in the euro zone. Finally, there are prospects of a falling deficit due to the fall in the oil prices, but this will not show until the coming months, at the earliest.
The deficit has since late 2006 averaged around USD 60bn, and in May it was 59.7bn. Slightly more than a third of the deficit is due to oil. The US imports about 60% of its oil consumption and with the price rises seen so far this has a vehement effect on the deficit. Since oil prices rose further from May to June, there are prospects of a solid rise in oil imports. According to our model of oil imports, a rise of about 4bn in oil imports is probable, and this is expected to increase the deficit.

Adjusted for oil imports there are prospects of continuing improvement of the trade balance. This is because American demand for import goods is falling in connection with the economic crisis. The fact that foreign demand for American export goods remains strong is reflected in the ISM export index which indicates a solid increase in exports. ISM's import index points to a fall in imports. Overall we expect a solid rise in the deficit on the trade balance.
Focus will also be on imports of capital goods, since this is an indicator of corporate investment. Traditionally corporate investment falls sharply during recessions, but this has not been the case so far. The import of capital goods adjusted for inflation shows a rise of 6% which is rather solid.

The UK: consumer prices - July

Following a rise of 3.8% y/y in June, inflation is now at the highest it has been since 1992. It is mainly driven by rising food and energy prices and exclusive of these June inflation rose by a modest 1.6%. We expect inflation to remain high in July. However, in the longer term we expect that the inflationary pressure abates as the bleak growth picture materialises and the pressure on the resources of the economy is reduced, just as the basis effect from commodity prices will disappear. The sharply rising inflation rate is a cause for concern at the Bank of England and means that interest-rate cuts are not on the agenda - despite slower growth.

Japan: GDP, Q2

GDP grew at a surprisingly strong rate in the first quarter (1% q/q), partly driven by net exports. Notably exports to Asia but also to Europe kept up momentum - but consumer spending also grew. The prospects for Q2 are, however, somewhat bleaker. Exports and consumer spending are expected to have an adverse effect and so is the leap year effect. We expect a negative GDP growth in the second quarter in the range of -0.2 to -0.4% q/q.

The growth contribution from net exports will fall along with the slowdown in global growth. US exports have long been on the decline and lately exports to Europe and Asia have also slowed. Consumer spending is struggling, and we assess that growth in this sector will be negative in Q2. The rising food and energy prices erode the purchasing power of households and since employment growth and wages are on the decline, the disposable income looks set to fall. Private investment is under pressure due to the more bleak growth picture and the pressure on corporate profit margins in the wake of the rising commodity prices.

Wednesday

The US: import prices - July

Import prices have risen significantly in the wake of the rising prices for energy and food and the weak US dollar, but we have actually in the course of July seen a turn in these prices and the US dollar. The prices for energy including petrol and natural gas have fallen sharply. Furthermore, food prices have also fallen, and finally the US dollar has appreciated in the course of July. It should, however, be noted that the average oil price has only fallen slightly from June to July and the US dollar has actually depreciated from June to July in net terms. Therefore, major declines in import prices are not to be expected already in July. If the trend continues, the development will put a clear mark in August.
In June, import prices rose by 20.5 % y/y which is the largest rise ever since the early 1980s. A considerable part of the price rises comes from oil prices. Disregarding energy prices, import prices rose by 7.3%.

The US: retail sales - July

Retail sales are one of the most important economic indicators this week. Retail sales account for approx. 40% of private consumption and it is generally expected that this indicator will push the economy into recession.
Retail sales have given mixed signals about the development recently. The figures rose much in May but were quite moderate in June. Disregarding car sales which have pulled down sales, retail sales have actually shown solid rises over the past four months. A part of this increase was due to price rises of energy and food. Looking on the very cyclical part of consumption, i.e. the long-term consumer discretionaries, consumers' appetite has declined in eight out of the past nine months.

A number of factors will affect retail sales in July:

• The sale of vehicles has fallen even sharper in July than over the previous months, and this will pull down retail sales significantly.
• Tax reliefs which started at the end of April stopped in mid-July. They may, however, still have a positive impact on retail sales.
• Petrol prices have once again fallen to below USD 4, but the decline was limited in relation to the average over the month. This will have a slight adverse effect on retail sales, which are measured as volume times prices.
• The sales figures from the retail sector have risen solidly over the past weeks.

All in all, we expect a minor decline in retail sales but exclusive of vehicles there are prospects of a moderate increase.

The UK: inflation report from the BoE

The inflation report includes the Bank of England's most recent forecast for inflation and growth and may give us an indication of the future monetary policy.
In May, the BoE indicated that interest rates were to be cut further (about 25 bp) in the course of 2008. The BoE downgraded its growth anticipations slightly further and upgraded its inflation forecast to above 3.5% in H2 2008 and then expects a fall towards the target from the beginning of 2009. The BoE believes that the risks for the growth estimate were on the downside, whereas the risks for the inflation estimate were on the upside.
Meanwhile the inflation prospect have deteriorated even further, whereas the slowdown in growth is being increasingly clear. In the letter of explanation to the Finance Minister in mid-June, the BoE estimates that inflation will rise to above 4% later in the year primarily driven by food and energy, and minutes from the monetary-policy meeting also showed that it is now likely that inflation will peak at an even higher level. But the BoE also points out that there is reason to believe that the steep inflation is temporary and that there are no signs that prices and wages are generally on the rise. The BoE also believes that a certain slowdown in growth is necessary to reduce the inflation rate to about the target at two years' term.
We expect that the inflation report will continue this line and indicate that the BoE will now raise interest rates to fight inflation and that further interest-rate cuts are some months down the road.

The UK: job report - July

The weak economy has started to affect the labour market, and the wage development remains limited inclusive and exclusive of bonus. We expect this trend to continue in August.
Currently, focus is on the development of wages due to the risk that the high and rising inflation will spread to wages. Average wages exclusive of bonuses declined to 3.8% (3-month moving average) in June from 3.9% in May. Inclusive of bonuses the rate of increase at 3.8% was maintained in June. Hence, wages remain decently below the long-term average, and there are no indications that the high inflation will affect wages.
The number of unemployed has now risen for the fifth consecutive month, and the rise of 15,500 persons in June was the highest since 1992. The unemployment rate (ILO) declined, however, from 5.3% to 5.2% in May, which more or less corresponds to the natural rate of unemployment that is compatible with stable inflation.

Norway: monetary-policy meeting at Norges Bank

The dilemma for Norges Bank is intact. On the one hand, economic growth is slowing down, and on the other, inflation is speeding up. At the meeting in June, interest rates were once again raised to 5.75%, and we expect that Norges Bank will at this meeting wait and see and maintain its interest rates unchanged.
Slower economic growth in Norway and on a global scale as well as the financial crisis point to unchanged interest rates. Add to this, the falling Norwegian house prices and the impact from the high market rates, and the long-term inflation prospects are still stable around 2.5%. Also our expectations that the ECB will not make additional tightenings point to unchanged Norwegian interest rates since Norges Bank is concerned about a weaker exchange rate (and higher imported inflation) due to a narrowing of the spread vis-à-vis the euro zone. On the other hand, there are also factors pointing to yet another hike. Inflation is on the increase and especially domestic inflation is a cause for concern at Norges Bank. The labour market is still tight and wage growth is escalating. However, we expect the pressure on the labour market to fall as the bleaker growth scenario materialises.
In its monetary-policy report from June, Norges Bank upgraded its inflation forecast, and at the same time the growth forecast was downgraded. According to Norges Bank, interest rates are expected to peak at 5.88% in March 2009, indicating a 50/50 likelihood that interest rates will be raised yet again. Still, we believe that interest rates have peaked, but admit that there are risks of additional interestrate hikes.

Thursday

US: consumer prices - July

See This week's highlights.

The euro zone: GDP, Q2 (1st announcement)

When GDP figures for the euro zone are released, we already know the GDP figures for Italy, Spain, France and Germany. For Germany, Spain and France the figures will be released a couple of hours before whereas the Italian figures will be published on Friday 8 August.
GDP in Q1 was rather strong, showing an increase of 0.7% q-o-q, but special seasonal factors were behind the strong GDP. Adjustments in this respect will be made in Q2 where we anticipate that growth will be sluggish and negative. Private consumption, investments and inventories are expected to be weak. However, net exports may come as so much of a surprise that growth remains positive.

The euro zone: consumer prices - July

Preliminary consumer prices have been published, so we know the general inflation trend. According to the preliminary statement, total inflation was 4.1% in July. This time also core inflation data will be released. If the underlying consumer prices still show a moderate rate of increase, it may give the ECB some time to breathe. On the other hand, rising core inflation will, quickly prompt the ECB to begin rattling the sabre again and indicate new interest-rate hikes.

Friday

The US: industrial production - July

Industrial production is interesting, since it is traditionally highly cyclical and since it is followed by the committee responsible for deciding when the US is in recession. In addition, a negative trend in industrial production will lead to an even higher number of lay-offs in manufacturing industry.
It was a surprise that industrial production rose by 0.5% from May to June. The advance was, however, exclusively generated by rising car production. We believe that this advance is temporary since it materialises after a couple of months dominated by massive falls in connection with a strike earlier in the year at a sub-supplier to the car industry. Exclusive of cars, production declined by 0.2%.

Generally, the manufacturing industry is in good shape with thick order books and a moderate increase in the inventory to sales ratio. The car industry and the housing-related part of the manufacturing industry are, however, in serious trouble. Generally, we anticipate a weakening of industrial production but to a lower degree than has been the case during previous recessions.
We expect a decline in industrial production for June due to the following signs:

• The manufacturing industry is still cutting jobs. In July the total number of working hours declined by 0.1%, but due to productivity it indicates a marginal increase in production.
• ISM manufacturing was in July 50, indicating unchanged production. ISM production was 52.9, indicating a small rise in production.
• New orders in the manufacturing industry have risen solidly in recent months, but part of the rise covers price rises
• The order books of manufacturing companies are very thick. They will act as a buffer against a temporary fall in the demand for industrial products.
• Inventories edged down again.
• Production rose surprisingly sharply in June, and we may see a correction in July.

Overall, we expect a minor fall of industrial production in July.
Jyske Markets - FX Research
http://www.jyskebank.dk/finansnyt
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