• US economy. The Fed cannot justify a further rate cut solely on macroeconomic developments. While the signs clearly point to a slowdown in the short term, retail sales started the fourth quarter on a strongerthan- expected note, and the labor market is weakening only gradually (pages 7-8 & chart below).

  • Fed forecast. According to the most recent FOMC minutes, the Fed expects a slight improvement in GDP growth in the course of 2008. Fed members claim that its past rate cuts of 75 basis points should be enough to stabilize growth next year – even though it has lowered its GDP forecasts overall (pages 3-6).

  • Freddie Mac scare. The renewed flare-up of the financial market turbulence, triggered by huge losses reported by mortgage giant Freddie Mac, is, however, intensifying pressure on the Fed to prevent the financial market crisis from spilling over onto the economy. The risk of a further rate cut has, therefore, increased appreciably.

  • Ben's Dilemma. Persistent inflationary pressure (also because of slowing trend growth) and the danger of giving the impression that the Fed is just satisfying market expectations, however, are Bernanke’s dilemma. The next FOMC decision will, therefore, be an extremely close call – unless there are renewed aftershocks in financial markets.

  • Further topics:
         – Weekly Comment: Anything but a quiet Advent season (page 2).
     – Spain facing more difficult times ahead (page 8).
     – Belgium: Political crisis puts pressure on yields (page 10).
     – Data outlook: Business climate in the EMU to deteriorate further, inflation to accelerate again; US consumers more pessimistic (p. 13).
     – Market outlook: EUR-USD to test 1.50; bonds in demand (p. 22).


Anything but a quiet Advent Season


 The outlook for the eurozone is getting more challenging in several respects. The most obvious one is perhaps the second wave of major tensions in financial markets, which is again triggering a liquidity squeeze. At the moment, the heightened concerns on the health of banks are focused on the US, as they are closely linked to fears of further deterioration in the housing sector with a potential sharper fall in house prices and a possible increase in delinquencies on consumer and corporate borrowing. As we have seen recently with Swiss Re, however, not all the subprime related exposure in the European financial sector has come to light yet. Therefore, there is still a clear risk that a new wave of bad news might bring back concerns about the European banking sector, and about the risk of a credit crunch. Meanwhile, bond markets are pricing in an increasingly gloomy outlook for the US economy, where downside risks do seem to have increased. Even though we do not believe the US is headed for a recession, we do recognize that stronger downside risks to US growth in turn imply increased risks to European growth.

 Pessimism on the US growth prospects is also undermining the USD, a problem compounded by recurrent discussions on the extent to which central banks and Sovereign Wealth Funds are diversifying away from the US currency, and even fears of a sudden generalized loss of confidence in the USD translating quickly in a flight from US assets. These concerns are also exaggerated, in our view. First, we believe that the US will experience a soft landing, and its recovery in H2 2008 should restore confidence in the currency. Second, and perhaps most important, a disorderly depreciation of the USD would go against almost everyone’s interest, and is the one scenario that might quickly bring about some form of coordinated action in currency markets. Even emerging market central banks and SWFs would not be happy to see a diversification of their assets quickly brought about by a halving of the value of their dollar holdings. In the coming months, however, sentiment on the USD will remain weak, and this will continue to translate into strengthening pressure on the EUR. European policymakers are stepping up pressure on China, hoping that a faster appreciation of Asian currencies will take some pressure off the euro, but this is unlikely to yield immediate results. With EUR-USD headed for 1.50, exporters will face stronger headwinds.

 The sustained rise in energy and food prices is another challenge, especially for consumers. Beyond their mechanical impact on headline inflation, and leaving aside the risks of a feed-through into higher inflation expectations, food and fuel prices are very visible to consumers, and their rise immediately painful. This is, in our view, playing no small part in the deterioration of consumer confidence that poses an obstacle to faster consumer spending, notwithstanding a stronger labor market.

 Against this background, the wave of strikes which has hit France and Germany constitutes a key test. It is important to realize that it is largely thanks to past structural reforms, both spontaneous and policy-driven, that Europe can face the challenges listed above with the help of robust growth momentum, relatively low inflation, and a more resilient economic system. Labor market reforms, while suboptimal to the extent that they have created two-tier systems, have played a crucial role in increasing flexibility and bringing about a structural reduction in unemployment that would have seemed unthinkable ten years ago. Structurally lower unemployment constitutes a key asset at this time. Similarly, the transformations in the corporate sector that have improved export competitiveness for some euro-area countries (notably Germany) have been an important factor in helping the eurozone cope with a gradually strengthening currency. Especially at this time, it is particularly important to remember the benefits we are drawing from these achievements, and to realize that this is the time to redouble our efforts towards further structural reforms. Even if the EUR were to weaken to a more competitive level, the pressure from globalization will continue, and will require increased flexibility to contain costs and to innovate. Pension system reforms and durable cuts in unproductive public spending are still needed to allow for reductions in the tax burden that would support private sector businesses and consumers. Renewed impetus to reform the services sector is still needed to introduce more competition and thereby bring about a reduction in services prices that could offset the inflationary impact of food and energy prices and support households’ purchasing power. The tougher environment should push us to redouble our efforts to make the European economy stronger and lay the basis for a sustained rise in living standards in the coming years and decades. Now more than ever, policymakers need to provide real leadership.