Economic Outlook: The ECB Caught in a Cleft Stick

This week's highlights

In our view, the ECB will leave interest rates unchanged at today's meeting. But no doubt the press conference after the meeting will shed light on three highly interesting subjects. Two of them will be mentioned but whether the third one is, is not quite certain.

1. The first point is whether the ECB signals that interest rates may be changed at the following meeting. We do not expect the ECB to do so. Focus will be on Mr Trichet's wording in the press release and at the subsequent press conference. We expect the wording "monitor very closely" will be used, which normally means unchanged interest rates. Back in June the wording was extended by a nuance, viz. that the Bank was "in a state of heightened alertness". This should be interpreted as an approach to "strong vigilance" which is a certain sign of a hike the following month - or almost a certain sign. We expect the ECB to be explicit at today's meeting and signal that there will be no hike at the next meeting. However, given the ECB's surprise message back in June to the effect that the Bank would raise interest rates the following month, it cannot be deduced beyond doubt the Bank will not again take everyone by surprise.
2. At today's monetary policy meeting the ECB will release a new forecast of economic growth and inflation which is expected to show a reduced estimate of growth for this year and next year. The ECB has not quite missed the point that growth was weaker during the first six months of the year than expected by the ECB, and that most business indicators have signalled a significant slowdown in the economy. And the slowdown has been sharper than what the ECB has so far projected in its estimates. Whether the ECB accentuates the downside risks for growth in the press release is a little doubtful, for the Bank did so already in its comments on the last meeting. Yet the comments were not really negative. But we doubt that the Bank will change its inflation estimate much. It may indicate a marginal reduction of the estimate, but we do not expect so. This means that expectations for full-2009 are above 2%. It is therefore also probable that Mr Trichet will voice strong concern over the inflation rate and inflation expectations - despite the lower-than-expected growth rate and the weaker prospects for growth - and intimate that the Bank is concerned to note that unit wage costs have risen, and that the Bank will follow this development closely.
3. The third point that the ECB may air is the ECB's role in the money market. The ECB is extensively instrumental in ensuring sufficient liquidity for the banks. The ECB worries that the banks may have been spoilt by the ECB's role in that market, and some ECB members have expressed the view that the banks have drawn too much on the liquidity that has been made available. In that connection, it has been queried whether the security provided for the loans is adequate. Changes in some form are therefore on the cards. However, the latest news is that the ECB will not have the new initiatives ready by 4 September.

This week's other highlights

• The US: ISM manufacturing and service, Beige Book, car sales, job report
• Germany: industrial production
• The UK: interest-rate announcement from the BoE
• Sweden: interest-rate announcement from the Swedish central bank

Monday

The UK: PMI manufacturing - August

The business indicator for the manufacturing industry continued to fall in July and is now the lowest it has been since 1998. The PMI index has been below 50 for three consecutive months, which indicates slowdown in the industry. The sub-indices for production, new orders and employment have also fallen significantly all of them, which does not bode well for the future, just as also the order indices of the CBI survey of the manufacturing industry fell again in August. Moreover, the PMI price indices continued to rise.

This means that there are prospects of a setback in the manufacturing industry, while the inflation rate is rising, and the PMI thus still reflects the Bank of England's monetary policy dilemma. We expect PMI to remain week over the coming months.

Tuesday

The US: ISM Manufacturing - August

ISM is the nationwide sentiment indicator for the manufacturing industry and gives a reasonable indication of the development in industrial production and GDP. What the financial markets will focus on is whether the ISM continues to signal surprising robustness in the teeth of economic slowdown. As we see it, there is a risk of a fairly heavy fall.

In July, ISM fell marginally, to 50 from 50.2, which indicates unchanged activity in the manufacturing industry. It is thus much above the level that we normally see at times of economic slowdowns/recession. Yet there were signs of beginning slowdown when the order intake index fell by almost 5 points to 45. The order intake often turns round before the overall ISM index. Moreover, it was mainly employment which pulled up the ISM index strongly. It rose by more than 8 points, the biggest rise since 1983. That rise is one thing at least that we see as highly problematic.

We expect a fall in ISM in August due to the following:

• according to our ISM indicator, ISM may fall comparatively sharply, to 46;
• turmoil in the financial markets may pull ISM down;
• the sentiment index of small businesses has fallen further and by considerably more than has ISM, signalling a fall in PMI;
• the employment index is expected to fall.

There are, however, a few elements which pull up ISM:

• new orders in the manufacturing industry have risen robustly since February;
• the fall in commodity prices, mainly the oil prices, may calm down the corporate sector.

In addition to the index, focus will be on new orders, employment and the price index. And among those, particularly on the price index which fell back in July to 88.5, which is a very high number. Given the fall in oil prices, the price index may fall further.

Wednesday

The US: car sales - August

Factory car sales are interesting, because the number has fallen massive since the beginning of the year. In December 2007, factory car sales were almost 16 million cars, but in July sales fell to 12.5 million, the lowest level since 1992.

There are no immediate prospects of any improvement for the short term. Because of the sharp fall we do not rule out a stabilisation, but neither do we rule out another fall.

The prices of oil and gasoline have fallen, but they are still relatively high. Another factor that pulls down car sales is the fact that consumers are under pressure from, e.g., lower employment, higher unemployment, slowing wage rises and lower house prices. During such situations, consumers traditionally put off buying durable consumer goods such as cars. Moreover, the banks are making it more difficult for customers to take up loans, and interest rates for car loans have been raised.

The car factories have responded as usual by introducing huge discounts to stimulate car sales. One of the car factories has extended its employee discounts to all its outdated models and some of the new ones. That initiative stimulated car sales on earlier occasions, but it is questionable whether it will work this time.

The US: Beige Book from the Fed

The Beige Book is one of three reports produced up to the Fed meeting on 16 September, but it is the only one of them to be published. It is an extract of comments from businesses across the US. The comments describe the development in the various sectors of the economy such as the manufacturing industry, retail sales, the housing market, the financial sector, etc. Moreover, there are comments across the sectors about employment, wages and prices. The report is thus a relatively updated description of the US economy, but it should be mentioned that the Fed is the author and that the report reflects the views of the Fed.

It also reflects the Fed's numerous contacts in the US corporate sector, and it is one of the instances where the Fed is better informed than the rest of the market.

The UK: PMI Service - August

The business indicator for the service sector rose marginally in July (to 47.4 from 47.1) and is below 50 for the third consecutive month. This means that there are still prospects of a setback in the service sector which accounts for about three fourths of the UK economy. The majority of sub-indices - which are not included in the overall index - indicate a setback, and also the index of expectations has fallen sharply (to 56.1) and is now the lowest it has been since the series started in 1996. Input prices, however, remain very high, which puts pressure on profits, because selling prices have not risen correspondingly.

We expect PMI Service to remain weak for the coming months, because most surveys indicate low consumer spending, and also the weak housing market will have a depressing effect.

Thursday

The US: ISM Service - August

The sentiment indicator ISM service is important since the service sector accounts for 90% of employment and thus for the most important part of the economy. In July, ISM Service rose from 48.2 to 49.5 and this proved, together with ISM Manufacturing, that the corporate sector has been hit less hard by the crisis than have consumers.

The service sector is relatively exposed to the consumers, and this ought to make for a weak reading of ISM for the service sector. Turmoil in the financial markets may also make sentiment more sour.

Besides the overall index, there will be particular focus on the employment and order intake indices after the sharp falls. Also the price index will command attention. It is at 80.8, which indicates sharply rising prices. There is a chance that the price falls of oil and food may work through here.

The euro zone: interest-rate announcement from the ECB

See 'This week's highlight'.

Germany: industrial orders - July

Industrial orders have fallen for seven consecutive months, and even if there is a correction now and then, the direction is still clearly down, judging by the PMI Industry survey. We also expect orders to have fallen in July.

The UK: interest-rate announcement from the Bank of England

In our view, the Bank of England will keep interest rates at 5% at the meeting, since the dilemma of high and rising inflation in combination with slowing growth is intact.

The global rise in food and energy prices has pulled the inflation rate up to 4.4%, the highest level since 1992. Also core inflation has risen (to 1.9%) but it remains below the target. Moreover, the rise in wages has begun to abate from a moderate level, just as the long-term inflation expectations of the financial markets have been reduced in line with the falling food and energy prices that have prevailed for the past few weeks. The Bank of England expects that inflation will peak at about 5% at the end of the year and then decline gradually to a level below the 2-year target. This should be seen in the light of expectations of a slowdown in growth and disappearance of the basis effect of commodity prices.

Overall, we find that the Bank of England will refrain from raising interest rates to curb mounting inflation, and that it will be some months before interest-rate cuts are likely again.

If interest rates are left unchanged, the interest- rate decision is often not followed by any comments so the details from the meeting will probably not be revealed until the minutes are released on 17 September.

Sweden: interest-rate announcement from the Swedish central bank

The high and rising inflation rate and clearly slowing growth put the Riksbank into a dilemma. At the meeting in July, the fear of inflation won the battle, since interest rates were raised once again just as the interest-rate path was raised significantly. At this meeting, we assess that the Riksbank will play wait-and-see and leave interest rates unchanged. However, we acknowledge that there is a significant risk that the Riksbank after the aggressive statements in the inflation report in July will raise interest rates again in spite of the bleak growth prospects and lower commodity prices.

Several factors point to unchanged interest rates:

• Inflation is mainly driven by food and energy prices, and adjusted for these inflation only increased by 1.5% y/y.
• Commodity prices have fallen significantly since the last meeting. Oil has thus fallen by approx. USD 30 in one month, which eases the inflationary pressure in combination with lower food prices.
• The growth prospects have become bleaker still since the last meeting (this applies both to the domestic economy and the export sector). As a small open economy, Sweden is strongly dependent on the development in e.g. the euro zone for which darker times are in store.
• The minutes of the last meeting showed disagreement (3-3) as to the aggressive increase of the interest-rate path. Thus it will not take much to tip the balance to the benefit of a wait-and-see mode.

The following factors may point to yet another interest-rate hike:

• If the general inflation rate remains high over a long period - even though it has increased due to temporary effects such as food and energy prices - it will increase the risk of accelerating wage growth and inflation expectations.
• It takes time for the inflation expectations to fall. Inflation expectations based on market rates have, however, started to fall, but they remain high in the confidence surveys.
• Productivity is again in negative territory, which leads to higher labour costs and thus inflationary pressure.

On the whole, we assess that the Riksbank will play wait-and-see and leave interest rates unchanged at 4.5%, but the decision will be close and another hike cannot at all be ruled out.

Friday

The US: job report - August

Employment is usually the most important indicator for the financial markets. Employment gives a good indication of the state of the economy although employment has showed a much poorer development than has GDP. This could be an indication that companies have been quicker to react to the slowdown in the economy than they were during earlier recessions.

In July employment declined by only 51,000, and employment in the two earlier months was revised up by 26,000. This means that employment has only declined by an average of 50,000 over the past three months, which is a smaller amount than usual during periods of recession.

Employment falls in the cyclical sectors such as the manufacturing industry, construction, trade, transportation as well as corporate service. Employment in the public, education and the health sectors, on the other hand, goes up. We expect that employment in coming months will fall at a stronger rate - by up to 100,000- 200,000 per month.

This is corroborated by the fact that most indicators signal an increasing fall in employment.

We expect a fall in employment of about 80,000 in June, but we still await a number of indicators which are not released until next week.

• Jobless claims have increased by as much as 60,000 between the two data collection weeks, but the jobless claims have been artificially lifted due to an extension of the cash benefit period (from 26 to 39 weeks) and therefore it is difficult to make predictions, but the increase indicates a fall in employment.
• The ISM employment index for the manufacturing industry rose by just above 8 points to 51.9. This was the largest increase since 1983. Since we generally expect a structural fall in employment combined with weak business trends, this indicates an additional fall in employment in the manufacturing industry.
• The ISM employment index for the service sector also increased in July, but it is still at a level (47.1) which indicates a very weak development in employment.

On the whole, we expect a fall in employment of 80,000, but please note that some indicators have not been announced yet such as the latest ISM reports and ADP's employment report.

Unemployment is of particular interest this time. It has increased very strongly in the past five months, and 15-24 year-old persons account for some of the increase. Some of the increase can be attributed to the fact that they have not had a job in the summer holiday as usual but have been unemployed instead. Some of them will go back to school in August and September and this may in fact lead to a fall in unemployment. But generally we expect unemployment to increase until some time in 2009.

Due to high inflation, wage increases attract attention in the financial markets. In July, wages increased by 0.3% from June and by 3.4% y/y. The general rise in unemployment is expected to lead to a lower rate of wage increase and hence to weakening inflationary pressure from the labour market.

Germany: industrial production - July

The trend in industrial production is on the decline - in spite of a minor increase last month. This happens after a very sharp fall the month before. The development in PMI and industrial orders clearly points to an additional fall, and we also expect a fall in July.

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.