Economic Outlook: The Fed's Concern Over Inflation (?)

This week's highlights

Next week's most important event is the FOMC meeting. We expect the Fed to leave interest rates unchanged at the meeting, which is also confirmed by rumours about Fed people who have reportedly indicated that they will not raise interest rates until the autumn unless inflation increases significantly.
There is speculation that the Fed will raise interest rates over the rest of the year. This is due to new signals from the ECB and announcements by Bernanke who stated that inflation is high and that the probability of a deep and long-lasting recession has fallen.
The Fed will presumably note that consumer spending and corporate spending remain low and that the labour market has weakened further. On the other hand, there is room for a comment that the pressure on the financial markets has abated. The tightening of credit conditions and the weakening of the housing market will still put a damper on growth in coming quarters.
The most interesting thing will be the Fed's view on inflation. In connection with the latest meeting, the Fed assessed that core inflation had moderated. Oil and commodity prices, on the other hand, had increased and there were indications that the inflation expectations had increased. However, the Fed expected that inflation would decline in coming quarters, but that it would also be necessary to monitor the inflation development.
There is a risk that the Fed will intensify its inflation rhetoric. Some of the presidents of the 12 Federal Reserve banks have been very aggressive, requiring interest rates to be raised to contain inflation. The tone of the members of the board of governors, on the other hand, has been somewhat more moderate.

This week's other highlights

• The US: consumer confidence, home sales, personal income and consumption
• The euro zone: PMI
• Germany: consumer prices and IFO

In the course of the week

Germany: consumer prices - June

The German consumer prices rose again in May to 3.0% after a temporary fall in April to 2.4%. The German consumer prices are the first indication of the flash estimate of inflation in the euro zone and will be announced on 30 June. Therefore, the data will attract much attention - considering the ECB's interest-rate announcement on 3 July.

The UK: house prices - June

According to Nationwide, house prices have fallen in the past seven months and the fall in May of 2.5% m/m was the sharpest fall in the history of the series. The annual rate of increase is currently -4.4% compared with 10.5% in May last year.

Most indicators show that the housing market is likely to show weakness for some months yet, with the rise in house prices slowing further. Among other things, the ratio between housing sales and the stock of unsold houses in the RICS survey - which is a good indicator of future house prices - is still falling, and the number of mortgage loans used for house purchases has fallen to an all-time low since the start of the series in 1993.

Monday

The euro zone: PMI June

The PMI flash estimate from France and Germany will be announced a bit earlier than the data for the entire euro zone. We expect further declines in the PMIs, which means that we expect slower growth. A weaker global economy and moderate domestic consumer spending, which is under pressure from higher inflation, will put a damper on demand. To this should be added that the forward-looking indices, such as new orders, delivery times, stocks and order books all indicate that the economy will slow down in coming quarters.

Germany: IFO - June

IFO has been surprisingly strong for a long time, which has to some extent been justified since the German economy has outperformed the euro-zone average. However, some black clouds are hovering over the euro-zone economy at the moment. Internal demand in the euro zone is weak - especially from Southern Europe. A high oil price and inflation reduce consumers' purchasing power. The strong euro and slower global growth put a damper on export growth, and the forwardlooking indicators (IFO's expectations index) and the PMI order indices etc. and not least the actual number of new orders have clearly indicated a slowdown. We expect a fall in IFO in June.

Tuesday

The US: home prices in April

There are various measurements of home prices in the US. This week data from Case/ Shiller and Ofheo will be announced. Case/Shiller measures the price development of homes in the large cities. That is why Case/Shiller often increases/falls more than the entire housing market. In March home prices had fallen by 14.4% over the past years, which is the sharpest fall since the start of data collection. It is cause for concern that the fall in home prices looks set to accelerate. If it is measured in terms of a three-month period and compared with the preceding three months and in y/y terms, the fall is 25%.
Ofheo's price index measures the price development of homes for which the financing has been arranged through the large mortgage institutions. This means that the most expensive homes and homes financed by untraditional mortgage loans (including subprime) are not included. As a result, the Ofheo index underestimates the fall in home prices to some extent.
Home prices in terms of Ofheo have only fallen by 3.1% y/y.
The actual fall is presumably between the two statements.

The US: consumer confidence, June

Consumer confidence as reported by the Conference Board is usually the most important consumer confidence indicator. Consumer confidence has declined by 51 points over the past 12 months, which is the largest fall since the early 1990s. This shows that consumers are under severe pressure. It could indicate a rather sharp slowdown in consumer spending, but consumer confidence is not always a reliable indicator of consumer spending. The part of consumer confidence which has the strongest correlation with consumer spending is the expectations index. This is at the lowest it has been since December 1973.

Consumer confidence is expected to be affected by the following factors:

• The development in the financial markets has not supported the consumers given falling equity prices and rising interest rates
• Unemployment rose substantially last month
• Mortgage rates have increased significantly since mid-March
• The situation in the housing market will probably have an adverse effect on consumer confidence.
• Petrol prices have increased to above USD 4 a gallon
• The other consumer confidence indicators, ABC and the University of Michigan, have shown mixed developments. ABC has increased, while Uni. of Michigan has fallen further

We expect a further fall in consumer confidence in June but point out that consumer confidence has already fallen considerably.
There will also be focus on consumers' assessment of the labour-market situation through their assessment of 'how difficult it is to get a new job' and 'plenty of new jobs'. These assessments are expected to show that consumers have grown even more pessimistic due to the rise in unemployment.

Wednesday

The US: durable goods orders for the manufacturing industry - May

Durable goods orders are an indicator of the demand for industrial products, and the indicator is thus important as to the assessment of the future industrial production. However, new orders fluctuate heavily thanks to orders for transportation equipment, including private aircraft (from Boeing).
Generally, we assess that the weakening of the economy will also affect the number of new orders. This is also emphasised by the ISM index of new orders, which is 46.5, indicating a fall in new orders. But it is also worth noting that new orders have not fallen to the same degree as in the recession in 2001. This is presumably due to the fact that the companies, which are the main buyers of industrial products, are in a stronger position than during the last recession.
Durable goods orders have shown a moderate fall over the past nine months. In April, they declined by 0.5% compared with March. The fall in March was mainly due to a fall in orders for transportation while electronic equipment pulled up. Boeing has also reported a small increase in new orders for civil aircraft and in principle this will pull up. However, one should be aware that new orders rose very much last year and it may affect the seasonal correction. On the other hand, new orders for cars, etc., decline and we expect this trend to continue.
One of the sub-components is investment orders exclusive of defence and aircraft, and thus an indicator of corporate investment. These investments are interesting because they almost always fall during a recession. The surprising thing is that new orders for investment goods have increased in the past six months. We expect investment goods orders to begin to fall in coming months.

The US: new home sales - May

New home sales are important, since traditionally they bottom out 2-4 months before the end of a recession. Sales are also important since builders have plenty of new homes for sale. This hampers the construction of new homes and hence construction investment. Construction investment has pulled down GDP growth by almost 1 percentage point over the past eight quarters.
New home sales have already fallen by 62% since the peak in the autumn of 2005. This is the largest fall recorded in the period with data available (back to 1963). The average fall is 44% and this is an indication after all that the worst is over with respect to new home sales.
In April sales increased, and given the fact that new home sales have previously been an interesting indicator as to when a recession is over, it is interesting to see whether the data are about to stabilise. We doubt that, since we expect renewed weakening in home sales:

• Home buyers may be held back by rising mortgage yields, and banks are very reluctant to grant loans to home purchases
• Mortgage applications have fallen slightly
• Builders are still very pessimistic about current sales.

There is good news:

• Pending home sales have shown some stabilisation over the past six months
• The index of consumers' disposable income for home purchases has risen steeply during the last six months, which earlier caused some stabilisation in home sales. However, the index has fallen a little over the past two months
• Builders lower prices for new homes On the whole, we expect a minor fall in new home sales.

The US: monetary-policy meeting

See This week's highlight

Norway: monetary-policy meeting at Norges Bank

Norges Bank is in a difficult balancing act. On one hand, growth is slowing while on the other inflation continues to surprise to the upside. We expect Norges Bank to leave interest rates unchanged at the meeting. However, the uncertainty is high and another hike cannot be ruled out.
The weak housing market and slower growth in both Norway and globally point to unchanged interest rates. There is also the influence from the high market rates which are significantly above the official interest rate just as long-term inflation expectations remain stable around 2.5%. On the other hand, there are also factors pointing to one further hike. Inflation is on the rise and notably domestic inflation is a cause for concern at Norges Bank. The labour market is still red hot and wage growth very high. However, we expect the pressure on the labour market to fall as the more bleak growth scenario materialises.

All in all, a very close race but our main expectation is unchanged interest rates. Norges Bank will also publish its monetary-policy report. It will be interesting to see whether the expected key policy rate will be raised as this will indicate whether further tightening is on the way.

Thursday

The US: GDP - Q1 (second revision)

The gross domestic product is the total production of goods and services. The second announcement showed growth of 0.9%. Offhand, there are no indications that the US is in recession, although we have actually had recessions where GDP did not fall for two quarters as is the rule of thumb.
There are indications of a small upward revision of growth since retail sales, for instance, were revised up.

The US: existing home sales - May

Existing home sales have already fallen steeply and much more than the previous declines in home sales. However, in recent months there has been some stabilisation in home sales, and the main question is of course whether this will continue.
The fundamentals behind home purchases have improved somewhat over the past six months due to falling yields, lower house prices and a rise in consumers' income. This type of rise has previously stimulated home sales.
But lately the improvement has slowed down. Mortgage yields have increased and consumers are under severe pressure from rising energy and food prices, falling employment and rising unemployment. Moreover, banks have become more reluctant to lend to potential home owners. Also expectations of additional falls in house prices may cause potential buyers of a speculative disposition to hesitate.
Overall, there are signs that the housing market will continue to be under pressure in the coming months.

The signals about home sales in May were mixed. Pending home sales have stabilised to a certain extent, indicating that home sales are stable. Builders are still very pessimistic about the current and expected sale, and mortgage applications are still on the decline.
Therefore we expect a minor fall in home sales in April.
Also, there is focus on the number of homes for sale. The stock of homes for sale is one the rise after a fall in late 2007. This pushed up the average sales time to 11.2 months which is the highest it has been since 1985.

The euro zone: M3 - May

The ECB is concerned about the high rate of inflation, but currently it is not the development of M3 which is extraordinarily affected by the turmoil in the financial markets, portfolio switches, etc. that is the cause of the concern. It is rather the oil price and the risk of second-round effects. The continued strong lending growth which is published together with M3 is currently attracting more attention. The data will show whether banks have become more reluctant to lend money or whether demand is slower, thereby helping to dampen lending growth. The ECB's quarterly survey of bank lending showed signs of significant tightening in credit conditions, notably for large enterprises and household loans. In the actual data, this tightening is only reflected in lending growth for households, while lending growth for companies has continued to increase. This has been emphasised and noted by the ECB, which finds this divergence a bit odd.

Japan: consumer prices - May

The global rise in food and energy prices has prompted Japanese consumer prices to increase. The fall in inflation to 0.9% y/y in April was due to suspension of a petrol tax, and since this was reintroduced in May, inflation will again rise above 1%. And in view of the continued rising energy prices, we generally expect inflation to continue rising in the next couple of months. Consumer prices are not expected to fall again until late in the year.

In spite of the significant increase in consumer prices, by Japanese standards, there are not yet any indications that inflation is generally on the increase. Economic growth is slowing; wage growth has only recently turned positive; and core inflation (exclusive of food and energy) shows a marginal fall. We expect core inflation to turn positive again but only through a marginal rise. Generally, we do not expect that inflation will begin to show a convincingly positive development in the near future.

Japan: industrial production - May

Industrial production is still growing fast. In April it grew by 1.8% y/y and the year on year rise for the past three months is 2.1%. We expect the slower global and Japanese activity to be increasingly reflected in the economic indicators for both industrial production and exports. This has also been reflected in forwardlooking indicators such as PMI which shows that new orders are on the decline and stocks are accumulated.

Japan: unemployment - May

The unemployment rate rose to 4% in April, so the fall in unemployment which has lasted for a couple of years appears to be over. Since the number of vacant jobs per applicant was reduced to 0.93 (which is still relatively high) and the number of new jobs is on the decline, the tight labour market appears to be softening. Economic growth is also slowing and profit in the corporate sector is under pressure from the high oil and commodity prices, for instance. This will influence the labour market which we expect will soften further.

Friday

The US: personal income and spending - May

These data include two interesting perspectives. The first is of course the PCE deflator exclusive of food and energy which is the Fed's preferred indicator of inflation. And the PCE deflator is interesting due to the current focus on inflation.

The PCE deflator exclusive of food and energy has increased slightly in two of the past three months, but there are signs of a slightly higher rise in May due to core consumer prices in May. We thus expect the PCE deflator to rise largely in line with trend growth of 0.2%.
The second is consumer spending. Under consumer confidence we mentioned that consumers are squeezed. This is expected to influence consumer spending although this will be boosted by the tax cuts. Generally, the fundamentals indicate slower growth in consumer spending. Income is growing at a slower pace, real wages are falling due to price increases in food and energy and house prices are also falling. Banks are very reluctant to extend credit which is a problem in view of the rising prices on food and petrol.
Consumer confidence is rising very slowly, but this may be due to the tax cuts in May. The tax cuts are expected to lift the disposable income quite a bit. There are thus prospects of a sharp rise in the savings ratio, but the rise is only temporary since the tax cuts end in mid-July.
We have seen a solid rise in retail sales in May which will boost consumer spending in May. Part of the rise will be driven by rising prices, and it will be interesting to see the rise of consumer spending adjusted for inflation.
Jyske Markets - FX Research http://www.jyskebank.dk/finansnyt
The analysis is based on information which Jyske Bank finds reliable, but Jyske Bank does not assume any responsibility for the correctness of the material nor for transactions made on the basis of the information or the estimates of the analysis. The estimates and recommendation of the analysis may be changed without notice.