United States of America
Dramatic revisions to labour cost data for the first quarter of this year call into question the expected slowdown
in the rate of inflation in the USA. The original estimate of the rate of increase of unit labour costs in the
manufacturing sector in the first quarter was 1.4%. This was revised up to 9.3%. For the business sector as a
whole the revision was from 2.3% to 8.7%. The source of the revisions was sharply higher estimates of hourly
compensation in most sectors of the economy. The annualized rate of increase of hourly compensation was
13.6% in the business sector, nearly double the original estimate of 6.9%. In the second quarter these rates of
increase moderated somewhat as the momentum of wage increases slowed. Unit labour costs rose by 4.8% in
the business sector. The eventual impact of strong growth in labour incomes on the economy depends on the
reaction of the monetary authorities. In the near term activity will be higher, reflecting strong consumer spending.
US consumer spending in July rose the most since January and further strength was recorded in August. Thus far
rising employment incomes are clearly having a greater effect on consumer spending than the possibility of a
weaker housing market. The recent fall in gasoline prices should improve consumer sentiment following the
setback in August and support household spending in the third quarter.
This recent growth in real incomes may offset the decline in spending brought about by the continued weakness
of the housing market although the impact of lower demand on house prices is not yet clear. The National
Association of Realtors recently reduced its forecast of house sales for 2006, noting that a record number of
houses on the market may cause prices to fall for the first time since 1993. The slowdown in housing will limit the
ability of consumers to refinance their mortgage debt to cover current expenses and will have a direct effect on
the level of residential investment in 2007.
Looking towards the end of 2006 the US Federal Reserve may be forced to raise interest rates above the
current level of 5¼% if higher labour costs feed into the price level but US financial markets do not anticipate any
further rate increases this year. Increased competition and the prospect of waning demand are currently deterring
companies from raising prices to recoup higher energy and labour costs: easing concerns that higher input costs
might affect core inflation rates. Another reason is widespread confidence that economic growth will slow in the
second half of the year. On balance the Federal Reserve will probably be cautious and wait to assess preliminary
data for the third quarter.
Overall GDP growth is expected to be less than 3% in the second half of this year. The auto industry, in
particular, is planning sharp cuts in output in order to reduce inventory levels indeed the recent ‘Beige Book’
from the Federal Reserve noted slower growth in auto and housingrelated spending in most Districts. In 2007
GDP growth is expected to fall further to 2.6% as lower growth of business investment, exports and government
spending takes effect.
Revised second quarter data showed surprise stagnation in corporate profits and a fall in companies’ investment
in new equipment and software. Next year may see an end to the strong growth in investment recorded since
2004. Consumer spending growth may also be lower than this year. With the stock market leveling off and home
price inflation falling rapidly, asset markets may no longer provide savings for households and next year those
households will have to begin to save more of their current income. A gradual increase in the savings rate means
that consumer spending will have to fall below the growth of income.
Revisions to second quarter GDP data have made little difference to the expected performance of the Japanese
economy in the remainder of the year. Most of the weakness in the second quarter was probably due to
temporary factors ? notably bad weather ? and domestic demand is expected to recover, keeping GDP
growth above 2.5% in the second half. Labour conditions have continued to improve, stronger asset prices
indicate solid confidence in the economic recovery and the gradual rise in consumer prices should help the health
of the financial system. Companies remain committed to robust capital investment in the current financial year and
are aggressively building up inventories in response to steady domestic demand. Corporate profits are expected
to grow by more than 10% this year. Although nominal labour incomes are growing at only 1-2% annually
despite the tight labour market, consumption should be maintained as consumers have greater confidence in the
job market. The contribution to GDP from net exports in the second quarter was slightly negative and it appears
that the slowing in the US economy has begun to affect Japan. The second quarter GDP results for the US
confirmed a reduction in spending on IT equipment and this deterioration will reduce the growth of exports from
many Asian economies.
Lower exports to the USA may put pressure on Japanese companies and in July industrial production fell by
0.9%. If the demand weakness does materialize, inventories will continue to build in the high tech sector and a
further production adjustment may be necessary before the end of the year. Despite this concern capital spending
surveys confirm that companies remain optimistic. The Ministry of Finance corporate survey showed that
business investment expanded at a 14% year-to-year rate in the second quarter, following a 16% rise in the first.
Manufacturing investment continued to grow at a high rate but, more notably, capital outlays by the
nonmanufacturing sector have also accelerated ? including the spending of small companies.
The underlying trend in inflation has not changed as dramatically as it initially appeared when the rebased data
appeared last month. The larger-than-expected revision in core inflation to 0.2% in July was due to a new
treatment of mobile phone charges. It is most likely that core CPI inflation will rebound to 0.4-0.5% by the end
of the year. This rate of inflation will probably be maintained through 2007. Unless there is any further rise in
energy costs, it seems likely that the low rate of increase in labour costs should keep core inflation at 0.5% or
less in 2007.
The revision to the price data will probably not alter the basic inflation assessment of the Bank of Japan. As a
result of the new data the Bank will likely have to revise down its fiscal 2006 core CPI forecast from a 0.6% rise
to 0.3% but the assessment for fiscal 2007 may not be changed. Most market participants consider that the
timing of the next interest rate increase may be delayed slightly. In any case lower energy costs and the
depressed trend of unit labour costs mean that the Bank will be under little pressure to raise rates in the
remainder of this year. The expected moderation in world economic activity will also have its effect on Japan in
the second half of this year ? moreover the appreciating yen will also serve to tighten financial conditions in the
economy. One consequence of the higher input costs faced by companies seems to be a greater determination to
control labour costs and this should dampen inflationary expectations in the household sector. On balance it is
unlikely that Japanese interest rates will rise further until 2007 unless unexpected strength in US demand leads to
a much higher rate of growth of economic activity in the remainder of the year.
Against the background of upward revisions to past GDP growth, higher-than-expected growth in the second
quarter and indications for continued robust activity in Germany in the third quarter, the growth forecast for the
whole of 2006 has been raised to 2.2%. There is no doubt that the first half of 2006 was a strong period of
growth for the Euro-zone but the second quarter might have marked the peak of this expansion. This momentum
is likely to spur capital investment spending in the second half of the year but external demand may be slowing
and business confidence indicators, including the composite index of the Purchasing Managers’ Institute, have
started to ease in the third quarter. French industrial production fell in July in contrast to the buoyant data from
Germany. Production fell across all areas of France with the biggest falls in the electrical goods, motor and
manufactured goods sectors. Perhaps this weakness signals declines in export business since the data for retail
spending in the Euro-zone showed continued growth. In July total retail sales rose by 2.5% above the level of
2005 with French consumers particularly active as retail sales rose by 5.5%. German consumers remained
cautious and sales rose by only 0.8%.
Beyond 2006 the outlook is much more uncertain. With monetary policy likely to tighten further in October, an
expected easing in global growth and a significant tightening in fiscal policy, Euro-zone growth is expected to fall
to 1.5% in 2007. The forecasts of the European Central Bank are more optimistic and the Bank expects 2007
GDP growth to be in the range 1.6%-2.6%. Euro-zone inflation fell to 2.4% in July, remaining well above the
target rate. Unless the recent decline in oil prices gathers speed, it is likely that the rate will remain clearly above
2% for the foreseeable future; indeed the Bank’s own inflation forecast for 2007 was raised to 2.4%. A hike in
euro interest rates in October is most likely and rates are likely to continue rising, perhaps reaching 3.5% by
year-end. The financial futures markets anticipate that the 3 month rate of interest will be 3.69% by December
2006 and 3.8% by March 2007 which should mark the end of the upward rate adjustment process. By
mid-2007 a slower pace of growth should allow the Bank to abstain from much further tightening and the peak of
official interest rates should be no higher than 3¾ - 4%.
In 2006 the Euro-zone will benefit again from substantial growth in exports but in 2007 the stronger value of the
euro should restrain growth. Tighter monetary conditions and slower world growth will impact the Euro-zone and
the overall rate of growth in 2007 may struggle to exceed 1.5%. Fiscal policy will add a further uncertainty next
year. This year the Euro-zone fiscal deficit has improved as a result of the improvement in economic growth
although the stance of policy has been broadly neutral. In 2007 tighter fiscal policies (notably in Germany and
Italy) may reduce Euro-zone growth by as much as 0.5% as VAT rates are increased.
Former Soviet Union
The summer recovery in economic activity accelerated in July thanks mainly to buoyant exports. According to the
Ministry of Economic Development and Trade, GDP grew by 7.4% year-on-year in July. For the first half of
2006 GDP rose by 6.3% driven by construction activity and retail and wholesale trade. As a result of these
trends, the forecast for GDP growth in 2006 has been raised to 6.4%. Industrial production growth was
maintained at 2.9% in July and the growth rate for the first seven months of 2006 was 4.2% in comparison to the
3.5% recorded in 2005. Construction output increased by 15% in July and growth in the output of the extractive
sector showed some improvement, rising by 2.3% in the first seven months of the year. In July inflation remained
under control at 9.3%, despite higher food prices and this improvement may ease pressure on the non-oil sector
of the Russian economy. In the first seven months of 2006 the rouble has appreciated by 7.9% in real terms as
very high earnings from oil and minerals exports boosted the currency. In response to the fall in inflation in June
the Central Bank of Russia cut its main policy rate to 11.5%. The strong performance of energy export revenues
has worsened the inflationary situation in Russia as these revenues have enabled further fiscal loosening. The
Ministry of Finance has proposed that expenditures of fiscal revenues from the oil and gas sector be reduced as a
proportion of GDP to 3.7% by 2009 and that the scope of the Stabilization Fund be extended to limit the
inflationary impact of hydrocarbon revenues.
The Polish economy continued to perform well in the second quarter and the rate of growth of GDP was 5.5%,
above the 5.2% achieved in the first quarter. Strong wage and employment growth were behind a surge in
private consumption which was also accompanied by robust 14.4% growth in fixed investment spending. Net
trade also contributed to GDP. Further political uncertainty weakened the zloty which fell to nearly €/PLN 4 by
the end of August. The weakness in the Hungarian currency was the result both of political factors and the
ongoing problem of the very high budget deficit. The deficit is projected to reach 8% of GDP this year with little
improvement likely in 2007. In response the National Bank of Hungary raised interest rates by ½% in July – a
move which surprised financial markets. The forint strengthened to €/HUF 270 by the end of July. Despite the
turmoil in Hungarian financial markets, the real economy continues to grow at about 4%. Nevertheless tighter
monetary conditions, fiscal adjustments and lower exports to the Euro-zone are expected to lead to much slower
growth in 2007. The Czech economy grew by 7.4% in the first quarter of the year but the economy could not
maintain this pace. The second quarter was volatile. Industrial production growth faltered in April, rising by only
3.6%, but this pause was followed by sharp acceleration in May as production rose by over 12%. In June the
growth of industrial production fell slightly to 10.5%. The fastest growing sector continues to be transport
equipment which expanded production by 18% in the second quarter. The rate of inflation fell to 1.9% in 2005
but has risen to 2.9% in the first half of this year as a result of higher energy and utility prices. The Czech trade
balance deteriorated slightly in the second quarter as higher exports of road vehicles and parts could not match
the extra expenditure on imported fuels. The public finance deficit was lower than expected at only 2.6% of GDP
in 2005. The planned deficit for 2006 is 2.3% of projected GDP – well below the Maastricht limit for accession
to the Euro-zone – but the outlook for 2007 is much worse and austerity measures may be needed to prevent the
date for accession to the Euro-zone from slipping beyond 2011.
Recent data show that the Chinese economy began to respond to government efforts to cool down growth. The
National Bureau of Statistics (NBS) mentioned that the government was successful in controlling excessive
lending and investment to sectors at risk of overheating such as real estate. The government is trying to stimulate
consumer spending by focusing on expanding the middle class as a key driver of future growth. According to the
NBS, inflation edged higher in August. CPI rose by 1.3% y-o-y compared with just 1% in July. Food prices
accounted for about one third of CPI increase. In other developments, China registered a new record surplus in
August which might increase the fear of rising calls for the yuan devaluation. Exports of goods grew by 32.8%
y-o-y to about $90.8bn, the fastest monthly growth so far in 2006.
The Reserve Bank of India (RBI) raised interest rates by 25 basis points to 6% on 25 July. The RBI is trying to
control inflationary pressures which have been caused by credit demand growth and susceptibility of high oil
prices. Higher interest rates are likely to affect small and medium enterprises which might damage business
Inflation in Brazil has edged down in August largely due to a 0.3% fall in transport costs. On an annual basis the
national statistics agency IBGE has predicted that inflation is edging down to 3.8% which is below the central
bank’s official target of 4.5%. The central bank may make further interest rate cuts during the remainder of 2006
which could help in the recovering of GDP growth. In Argentina the manufacturing output rose by 8.6% y-o-y
compared with a 8.9% gain in June.
The monthly report of the Finance Ministry in Egypt states that the external debt was reduced by 4.5% to
US$29.7bn in December 2005, which was equivalent to less than 40% of GNI. The World Bank uses the 50%
mark as an indication of highly indebted status. The report said that the GDP during the second quarter of 2006
grew by 6.4% according to production factors compared to a 4.7% growth rate in the same quarter last year.
Interest rates were sustained by the Central Bank at 8% in May, as inflation was lowered to 3.8% in the first
quarter from 7.4% in the same period last year.
OPEC Member Countries
In its mid-annual report, the Saudi financial group SAMBA has predicted that inflation in Saudi Arabia has been
less than 1% for the last 9 years, but was up 0.79% in the first 4 months of 2006. Its forecast for the whole year
is 1.4%, still low given the strength of the economy. GDP growth for 2006 is forecast at a rate of 19.9% in
nominal terms and 5.84% in real terms. The private sector is growing in healthy patterns together with the
economic growth of the country. Liberalization and reforms are pushing the sector to grow as well as attracting
direct foreign investment to flow into the country. More oil money has been invested domestically in contrast to
the first oil boom when much of the oil wealth was invested abroad.
The UAE central bank predicted that inflation would retreat to 4% this year versus the 8% registered last year.
The decline in inflation comes as a result of the cooling of the property markets.
Oil prices, the US dollar and inflation
The US dollar began to weaken slightly from the middle of April and the move accelerated in May. In June,
however, the markets detected a change in the policy stance of the US authorities and expectations of further
increases in US interest rates supported the dollar. The euro strengthened slightly in August as it became clear
that the ECB is very likely to raise interest rates further in October. In August the dollar fell by 0.6% against the
euro and fell by 1.2% against the British pound, 0.4% against the Swiss franc and by 0.9% versus the
In August the OPEC Reference Basket fell to $68.81/b from $68.89/b in July. In real terms (base July
1990=100), after accounting for inflation and currency fluctuations, the Basket price fell by 1.0% to $46.64/b
from $47.13/b. The value of the dollar fell by 0.7% as measured by the import-weighted modified Geneva I +US