Highlights

  • ECB projections could be higher on growth, lower on inflation
  • Strong growth in Japan gives BoJ scope for further interest rate step
  • US growth optimism after GDP data gives way to more cautious assessment

Yen recovers – without any help from the G7

At the beginning of the week, things did not look good for the yen. Admittedly, the G7 finance ministers did advise market participants to reassess their risk exposure in the light of a strengthening Japanese economy. ECB president Jean- Claude Trichet even went one step further by saying “we want the markets to be aware of the risks of one-way bets, in particular on the foreign exchange market”. But apart from these words of advice, there was no reference to the issue. Thus the yen eased at first on Monday: EUR-JPY came within a whisker of 159 – a new record high; USD-JPY approached 122.

However, subsequently, the market turned. Compared with the end of the previous week, the dollar lost about 1% against the euro and even more against the yen – about 2%. Three factors were responsible for this development:

First: strong growth in the euro area

Based on industrial production data, Q4 economic growth had been expected to be on the moderate side, at least in Germany. The actual figures were thus all the more surprising: according to preliminary data, German real GDP rose by 0.9% quarter-on-quarter. At the same time, Q3 growth was revised upwards from 0.6 to 0.8%. Italian growth significantly surpassed expectations too, at 1.1% quarter-on-quarter, and even the French and Spanish figures were slightly higher than forecast. For the eurozone as a whole, GDP rose by 0.9%.

If EMU GDP were to remain flat at the Q4 2006 level in 2007, the average annual growth rate would be around 1.2%. Although we expect the economy to lose some momentum, we think a growth rate of 2.4% is within reach. This is what the EU Commission expects too.

In view of the data, we assume that the ECB will revise its growth projection for 2007 upwards in March from 2.2 to about 2.4%. Thus the eurozone economy would grow above potential for the second year running. The upward revision of the growth projection will presumably be accompanied by a downward revision of the inflation forecast. The VAT increase in Germany has had much less impact on prices than assumed by the ECB (0.5 percentage points for the whole of the EMU). Furthermore, crude oil prices are around $5 below the prices used in the December projection. In our view, a downward revision from 2.0 to 1.7% would be justified. The EU Commission’s forecast is 1.8%.

However, contrary to ECB president Trichet, German central bank president Axel Weber has voiced the expectation that both German and European inflation rates will be “around 2%” in 2007. This is based on the assumption that the German VAT hike will be passed on more or less fully after a while. We think this unlikely; but if this view is reflected in the ECB projections, the downward revision would be smaller.

Second: BoJ rate rise more likely after GDP data

With a Q4 GDP increase of 1.2% quarter-onquarter, the Japanese economy made amends for the previous quarter. Private consumption in particular rebounded, but private investment in housing as well as in plant and equipment also contributed significantly to growth. On the whole, the main impetus came from domestic demand; net exports’ contribution to growth was only 0.2 percentage points.

Looking at the year-on-year growth rates shows that over the year, exports (+6.8% yoy) and investment in machinery and equipment (+9.8%) have provided the main demand impetus. But private consumption has gone up by 0.6% yearon- year too. In our view, the GDP data prove that Japan’s upswing, now in its fifth year, has not slowed down. This will give the BoJ scope to normalize financing conditions on the Japanese money market a little further. We do not expect the BoJ to postpone its next interest rate step any longer.

Third: Bernanke more relaxed on inflation

In the Monetary Policy Report presented to Congress, Fed chairman Ben Bernanke confirmed the positions of the last few weeks: due to high production capacity utilization and the labour market, inflation remains the Fed’s main worry.

However, price increases have slowed down; if the growth rate remains moderate (in the region of 2¾ to 3%), the inflation rate, measured by the PCE core deflator, would fall below 2% again in the longer term. Mr Bernanke even pointed out that price risks were less acute, as a result of favourable productivity growth and companies’ above-average profit margins. Although Mr Bernanke’s comments did not indicate that the Fed might be considering cutting interest rates in the foreseeable future, the overall tone was slightly dovish.

After the release of Q4 GDP data, the markets’ optimistic view on the US economy was reflected in interest rates and the dollar. However, most of this week’s numerous economic data did not come up to expectations: the trade deficit rose by about $3bn in December, which, combined with inventory data, suggests a significant downward revision of Q4 GDP data. Weak car sales dampened both retail sales and industrial production in January. The Philly Fed Index and the Empire Manufacturing Index are pointing in opposite directions for February. For the last few months, the figures show a significant slowdown for Philadelphia at least. Initial jobless claims rose from 313,000 to 357,000, mainly for weatherrelated reasons. All in all, it seems that the markets’ upbeat view of the US economy was exaggerated.