Economic Outlook: Will Trichet Charge the Gun?

This week's highlights

No, we do not believe that he will do that at the monetary-policy meeting next week. But he is carefully considering whether he needs to pull out the drawer with the cartridge or the interestrate weapon. The growth scenario in Europe has become more uncertain and the risk that American growth caves in - with a spill-over effect on the European economy - has increased over the past month after a string of very weak economic indicators.

We therefore expect the ECB to change its estimates when it presents new growth and inflation projections. With respect to growth, this means that the picture has become more negative and we therefore expect the ECB to cut 0.2-0.4 percentage point off its current growth estimate for 2008 which is 2.0%, i.e. growth will fall below the potential growth rate.

This is a growth scenario which matches our own growth estimate at the moment, but also a growth estimate which is currently under pressure by the weak American indicators. We still expect growth around 1.75% this year when growth will be weakest in the first six months but rise slowly in the last six months given that inflation falls and thus contributes to lifting the purchasing power of consumers, which will boost consumer spending a little.

With respect to inflation, the ECB is likely to revise up its inflation estimate from the current 2.5% to about 2.7%. This is a growing concern at the ECB. A current rate of inflation at 3.2% is much too high to the liking of the ECB. And it is the highest rise in the history of the ECB's monetary-policy.

Although the ECB may see and also say that a very large part of the high rate of inflation can be ascribed to temporary factors - high energy and food prices - the bank's concern is not removed with a stroke of the pen. The reason is that it fears that the high rate of inflation will lead to second-round effects, including that the current inflation rate will give the German unions another alibi in the on-going collective bargaining - in addition to sharply falling unemployment - to demand high wage increases.

This fear means that the ECB will be somewhat hesitant to cut interest rates although we assess that the high rate of inflation in the first six months of 2008 will fall towards 2% at the end of the year. However, a somewhat weaker growth picture than the current may prompt the ECB to react - also because slower growth puts a damper on the inflationary pressure - although the market forces are not always known to dampen prices and wages in all European countries due to rigid structures in the labour market. This means that if the growth scenario deteriorates and thus also the ECB's assessment of the growth scenario, the first interest-rate cuts may come already in the last six months. We still expect unchanged ECB rates for the rest of the year.

This week's other highlights

- The US: employment report and ISM for both the manufacturing industry and the service sector
- Japan: monetary-policy meeting at the Bank of Japan
- The UK: monetary-policy meeting at the Bank of England and PMIs

Monday

The US: ISM Manufacturing - February

ISM is the nationwide sentiment indicator for the manufacturing industry and gives a good indication of the development in industrial production and GDP. ISM may also signal whether the manufacturing industry has been hit by the financial crisis and the slowdown in the housing market. Moreover, it indicates how close the US is to a recession. Usually, ISM must fall to around 42 before the US is in recession.

The regional indices announced over the past few weeks - NY Empire State and Philly Fed - are both pointing towards a weak ISM number for February. Moreover, the leading indicators of the ISM Index: order intake, order books and stocks also point towards a weaker ISM overall.

Since the last announcement, the negative view has been strengthened by weak data about consumer confidence, the struggling housing market and a weak development in employment. We therefore expect ISM to fall after its rise in January, when it rose from 48.4 to 50.7.

In addition to the index, focus will be on new orders, production, employment and the price index.

The UK: PMI manufacturing - February

For the past couple of months, PMI Manufacturing has been falling, and in January it was 50.6 against 53.9 in November 2007. This means that the index is now at its lowest level since August 2005.. The order index pulled down overall PMI, falling in January to 49.7 which (since it is below 50), indicates a fall in new orders. It has not happened since 2005. This is partly due to export orders - the index of export orders fell to 47.6 from 55.3 in November 2007. Expecting slower growth in the UK as well as the important business partners the US and the euro zone - particularly during the first six months of the year - we find it likely that PMI will remain low or fall further in February.

Wednesday

The US: ISM Service - February

Moreover, the sentiment indicator ISM for the service sector, is important since it accounts for about 80% of the economy. The financial sector is part of the service sector. This is thus one of the indices where any consequences of the financial crisis are reflected. ISM for the service sector has so far been represented in the form of a production index, but as from January the ISM was calculated as a weighted index as is the case for the manufacturing industry. This will undoubtedly increase the interest in the ISM for the service sector, since it is expected to make the index more representative and less volatile.

The service sector index plunged in January to 44.6 from 53.2 (our calculation based on the indices included in the aggregate index). Although the growth situation has deteriorated in recent months and there was a certain degree of unrest in the financial markets in January, it is hard to see that the situation should have deteriorated this much in such a short time. We therefore expect ISM Service to stage a small come-back in February, albeit remaining at a low level. For instance, the order index fell sharply, and the order book thinned slightly in January. Overall, it does not point towards great activity in February.

The US: ADP employment - February

The ADP employment report gives an indication of the rise in employment in February (job report to be released on Friday). The survey covers only the private sector and is based on reports from the agency which manages wage payments to about 24 million employees (ADP). It corresponds to a little more than 20% of the overall staff in the US private sector. As it refers only to the private sector, the trend growth in public-sector employment of just over 21,000 a month should be added to the aggregate number of employees.

However, ADP is not always the best indicator of employment growth. For instance, ADP greatly overestimated growth in January when ADP reported a rise of 130,000 persons, whereas the overall employment fell by 17,000, and employment in the private sector rose by a mere 1,000 persons. This means that ADP's estimate is likely to be regarded with scepticism.

The UK: PMI service - February

PMI service rose marginally in the past two months after a sharp fall during the period September-November. The index is now at 52.5 against 51.9 in November 2007 - the lowest level since May 2003. In August 2007 PMI service was 57.6. We expect that PMI service will fall slightly again as a result of slower-thanexpected growth - not least in consumer spending - a slowdown in the housing market and continued financial turbulence.

Thursday

The US: pending home sales - January

The number of pending home sales is a relatively good leading indicator of home sales. Pending home sales cover only about 20% of all home sales but are nevertheless a good indication of home sales in the following two months.

After two months of increases in pending home sales, we saw a fall in the past two months and they have therefore stabilised in the past four months just below index 90 (85.9 in December). However, home sales are still falling, though at a more measured pace than in Q3 2007.

Interest rates and house prices have fallen, and consumers' disposable income for home purchases has risen by more than 17% since July 2007, pointing to an improvement in the housing market. On the other hand, the number of mortgage loan applications indicates falling home sales, and the combination of a large volume of homes for sales and falling house prices makes it less attractive for the speculative buyer to enter the market.

We expect the number of pending home sales to remain at the low level below 90 in January. This is an indication that we do not expect any decisive turn in home sales in coming months.

The UK: monetary-policy meeting at the BoE

We expect the Bank of England to leave interest rates unchanged at 5.25% following a quarterpoint cut at the meeting in February. Since the last meeting, the inflation report with updated inflation and growth forecasts from the BoE has been announced. The report indicated that the BoE will not lower interest rates so much as market participants had expected at some time, but the report still emphasised that lower interest rates are necessary. The monetarypolicy committee (MPC) is currently faced with an expected sharp slowdown in growth combined with rising inflation in the short term.

Inflation was above the BoE's target of 2% y/y in January, and several indicators signal that it will rise further in coming months. The majority of the large gas and electricity suppliers have announced that they will increase prices in January and February, and a new calculation method for the consumer price index as of February will mean that these increases will affect inflation immediately (previously it took four months before such price changes were reflected in the inflation rates).

With respect to growth, retail sales delivered a surprise with a significant increase in January, but there are many indications that they were driven by an unusual level of sales in January, and the CBI survey of retail sales in fact indicated that retail sales will decline again in February. Furthermore, figures from the housing market still indicate signs of weakness, which will also contribute to slower growth in future.

Hence, nothing much has changed compared to the picture given by the BoE in the inflation report from the last monetary-policy meeting. The MPC is still facing an important decision since it has to weigh the risk that a significant decline in growth will pull inflation down below the target against the risk that rising inflation and high inflation expectations will result in a more lasting high inflation rate above the target in the longer term. We therefore expect interest-rate cuts from the BoE will take place gradually, i.e. we expect interest rates to remain unchanged over the next two months and then we expect an additional quarter-point cut to 5% in May.

Japan: monetary-policy meeting at the BoJ

The Bank of Japan has left interest rates unchanged at 0.5% since February last year, and we do not expect changes within the near future. According to the monthly report from February, the BoJ still expects moderate economic progress although growth seems to be slowing down. The BoJ also expects headline inflation to rise due to rising energy and food prices for the short term and higher growth for the long term. Core inflation (exclusive of food and energy) was still below zero in December.

Few economic indicators have been released since the latest meeting at the BoJ on 14 February. Figures for the industrial production in January have been released. The industrial production has fluctuated quite a lot since mid- 2007 and declined in January by 2% m/m, the largest fall since the same month the year before. However, in y/y terms, it is still at a fair level around 2½%. The manufacturers also expect the production to fall by an additional 2.9% in February followed by a rise of 2.8% in March. This means that the production will fall by 2½% in Q1, which will then be the largest fall since Q4 2001.

Given the prospects of slower growth in Japan and in the global markets, we do not expect the BoJ to raise interest rates again within the next months. A hike will not be mentioned again until core inflation (exclusive of food and energy) will start to show a convincing positive trend. Uncertainty about the development in the global economy increases the probability of slower-than-expected growth in Japan, which will keep the BoJ from raising interest rates in the short term. Therefore, we do not expect interest rates to be raised until late 2008.

Germany: industrial orders - January

New orders have been solid, and they are an important indicator since they indicate the future development of the industrial production. On the basis of the development in PMI new orders for Germany - this index has been below the long-term average in the past four months - we assess that new orders will now also be affected. We therefore expect a weak order intake in January.

Friday

The US: job report - February

As usual the job report is a very important economic indicator from the US. And focus on the job report has only grown after the surprising data in January when employment declined by 17,000 - the first fall in employment since August 2003. The employment indices for manufacturing and service for January indicate that a significant upward revision of the employment data in January should not be expected. Thus employment as indicated by ISM service declined from 51.8 to 43.9 (the lowest level since February 2002), and employment as indicated by ISM manufacturing declined from 48.7 to 47.1 (the lowest level since September 2003). After a sharp increase in unemployment in December to 5% from 4.7% unemployment declined slightly in January to 4.9%.

More important employment indicators for February will be announced next week - e.g. the ISM employment index and ADP. However, other economic indicators have been released which indicate that the labour market continues to weaken:

The number of jobless claims has been quite high in recent weeks. The four-week moving average was 360,500 in week 7, which is the highest level for the average since 2005. In February Conference Board Consumer Confidence stated that it has become increasingly difficult to get a new job (the jobshard- to-get index rose) and furthermore, there are not so many vacant jobs any longer (the jobs plentiful index declined).

With respect to the regional business indicators, the index of the Empire State dipped below zero for the first time since 2003, while the corresponding Philly Fed index increased in February.

Focus will also be on the wage development in the job report. Following significant wage growth in December of 0.4% m/m, average wages rose at a more moderate pace in January by 0.2% m/m. The annual rate of increase in wages has declined slightly in recent months to 3.7% y/y in January from. 4.1% in September. We also expect moderate wage growth in February.

Germany: industrial production - January

For December, the industrial production increased by 0.8%. This happened after two months of small declines in the industrial production, and with an average monthly increase of 0.4% over the past six months, the industrial production has shown quite a solid development and perhaps a better development than that of PMI manufacturing. The increase in orders in recent months - in spite of the fall in December - points to an increase in January. For the period ahead, a fall in the number of new orders is expected, which is also expected to spill over into the industrial production.

Jyske Markets - FX Research

Posted in: Economy,Forex