nordic outlook - sebfinland is bouncing back after last year’s major strike, norway looks as if it...

ECONOMIC RESEARCH · ENGLISH EDITION

Nordic Outlook

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Global: Soft landing in the US – Asia and Europe pick up speed Sweden: Sustainable growth and more jobs – inflation remains low

FEBRUARY 2006

Nordic Outlook - February 2006

2

SEB Economic Research

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Klas Eklund, Chief Economist +46 40 667 [email protected]

Håkan Frisén, Head of Economic Research +46 8 763 [email protected]

Bo Enegren, Economist [email protected]

Ann Enshagen Lavebrink, Research Assistant [email protected]

Olle Holmgren, Economist [email protected]

Mikael Johansson, Economist [email protected]

Tomas Lindström, Economist [email protected]

Fax no. +46 8 763 9300

Contributions to the section on Germany in this report have been made by Thomas Köbel and Klaus Schrüfer fromSEB Frankfurt/M. Contributions to the section on Norway have been made by Elisabeth Holvik from Trading Strategy,Merchant Banking, Oslo.

SEB, Economic Research, K A3, SE-106 40 STOCKHOLM

This report was published on February 7, 2006.Cut-off date for calculations and forecasts was February 1, 2006.

3


Summary

The international economyThe global economy will remain strong for another year. All major regions will grow at the sametime — even Japan and the euro zone — and unemployment will fall. Inflation will stay low anyway,thanks to rapid productivity growth and a global price squeeze.

The United States is furthest along in its business cycle. Despite a temporary setback late in 2005,growth will continue for most of 2006. The Fed will hike its key interest rate to 5 per cent thisspring, then begin a rate-cutting cycle in early 2007. American bond yields are close to peaking andthe yield curve will become inverted.

The euro zone’s recovery is on firmer ground. Growth will end up at around 2¼ per cent this year, orabove trend. The ECB’s key rate will continue upward — but slowly, since capacity utilisationwill remain low and inflation will decelerate during 2006.

Next year, growth will cool in the US as the housing market slows significantly and householdsavings rise. The dollar will weaken but not dramatically, since Asian central banks will cushionits slide. The Chinese yuan will be revalued by a total of 10 per cent against the dollar during 2006and 2007.

The main threats to the world economy are posed by high oil prices and political unrest in the MiddleEast, as well as by American economic imbalances — the adjustment may come faster and morebrutally than we have assumed.

SwedenGDP growth will be strong: 3½ per cent this year and 3 per cent in 2007. Private consumption willincrease sharply, sustained by expansive fiscal policy, while capital spending continues its upturn.Employment will rise by 1½ per cent or 70,000 people this year; one third of this will be due to gov-ernment-financed labour market programmes.

Resource utilisation is low. In addition, due to an increased labour supply the resource gap in thelabour market will only shrink slowly. There is little risk of inflation-driving pay hikes. Underlyinginflation will be only 1.4 per cent this year and 1.6 per cent in 2007.

The Riksbank will continue to base interest rate policy on its inflation forecast, despite all talk of assetprices. Interest rate hikes will thus be modest. The repo rate will be raised to 2.50 per cent bythe end of 2006 and to 3.25 per cent at the end of 2007. The krona will appreciate to SEK 9.00 pereuro by the end of 2006, then further to SEK 8.70 next year.

Other Nordic countriesIn Denmark, GDP will steam along above trend both in 2006 and 2007. Unemployment will fallto historically low levels, but labour market “flexicurity” will help avoid inflation pressure in the nextcouple of years. Nevertheless, Danish fiscal policy must eventually be tightened.

Norway will benefit from high oil and commodity prices. Current account and budget surpluses willset records. Growth will stay at about 3 per cent a year. Inflation will gradually rise from a low leveland Norges Bank will slowly raise its key interest rate. The krone will be under pressure, sincethe ECB and Sweden’s Riksbank will hike their key rates earlier, but will then gradually strengthen.

The Finnish economy will expand at a healthy clip and unemployment will fall. Inflation will riseslowly from an extremely low level. Due to spare capacity, the risk of overheating is small.

4


Contents

Summary 3

International overview 5

The United States 11

Japan 14

China 15

The euro zone 16

The United Kingdom 19

Central and Eastern Europe 20

Sweden 21

Denmark 29

Norway 30

Finland 32

Nordic key economic data 33

International key economic data 35

Boxes

No big threat from high commodity prices 6

Iran: A new political risk factor 7

Bird flu: Less risk in reality than in the media 9

The United States: Who’s afraid of the yield curve? 13

China: New statistics confirm economic strength 15

The euro zone: Merkel effect in Germany 17

The United Kingdom: Housing market a headache for the BoE 19

Central and Eastern Europe: Continued inflation divergence 20

Sweden: Inflation target with optimal path 26

5


International overview

One more strong yearSynchronised growth in 2006Soft landing in the US next year, butimbalances pose a threatFlat yield curve not a recession signal.Weaker dollar

The global economy still looks strong in 2006. TheUS will recover after the dip in late 2005 and chugalong for another while. Asia is continuing its ad-vance, with Japan and China as economic engines.Continental Europe is gaining speed. When theAmerican economy decelerates during 2007, Asia andEurope will keep up their growth relatively well.

The inflation outlook is bright, enabling central banksto proceed cautiously with their interest rate hikes.American bond yields are not far from their peak. Inthis environment, there is room for stock markets toclimb further. Profits are high, and at the low interestrates we foresee, share valuations do not appearespecially high, despite the bull market of recentyears.

This scenario is not risk-free, however. Americanimbalances continue to cast a shadow over the future.Furthermore, political instability in the Middle East hasdriven up oil prices again; they are approaching levelsthat may hurt global growth.

GDP growthYear-on-year percentage change

2004 2005 2006 2007United States 4.2 3.4 3.2 2.6Japan 2.6 2.5 2.5 2.0China 10.1 9.9 9.5 9.0Euro zone 1.8 1.5 2.2 1.9OECD 3.3 2.7 2.9 2.6World economy 5.1 4.4 4.5 4.2Sources: OECD, SEB

Synchronised growthDespite these threats, our economic scenario for theimmediate future is bright. The reason is that atpresent, the world economy is undergoing a synchro-nised upswing.

The US is well into an economic upturn, whichmay continue for another while despite interest ratehikes and temporary setbacks. Rapid productivitygrowth has improved the bottom line at companies,which points towards a continued upturn in capitalspending.

The Japanese upswing has gained a firmer foot-ing. China’s strong growth is continuing andIndia also seems to have achieved stable growth ata high level.

Russia is profiting from high gas and oil prices andcontinuing its rapid economic growth. EasternEurope and the Baltic countries are continuingtheir catch-up process.

All the Nordic countries are in an upward econom-ic cycle. Denmark is showing stable growth,Finland is bouncing back after last year’s majorstrike, Norway looks as if it can balance oil reve-nues without letting its currency become toostrong, and Sweden is moving towards a growthpeak this year.

Even the laggard – continental Europe – isstarting to build up steam. Confidence in the futurehas climbed in Germany and other countries,unemployment is finally on the way down, orderbookings are strong and capital spending plans areoptimistic.

The world economy has not seen such a broad-basedupswing for decades. For the first time in more than15 years, unemployment is falling in all importantregions.

Potential for a sustainable upturnThe recovery following the economic crash associat-ed with burst bubbles, terrorist attacks and corporatescandals early in this decade has now been underwayfor a number of years. By global standards, the upturnhas been both stronger and lengthier than anyonepredicted. This has happened even though the path ofrecovery has been lined with constant dangers suchas the Iraq war, sharply rising energy prices andominous American economic imbalances.

A number of underlying structural factors help explainthe resilience of the world economy:

The forceful expansion in China and India hasprovided a stronger stimulus than forecasters couldforesee. This applies not only to economic growthin these countries as such, but to the productionand profits it has generated for companies aroundthe world.

Productivity growth has been an upside surprise.This is partly a result of globalisation, but is alsodue to the positive effects of the IT revolution,which is now maturing and spreading to more andmore countries and economic sectors. In thatsense, we are now truly living in a “new econo-my”.

Looking ahead, these forces will continue to sustainglobal growth. We can also identify cyclical factorsthat point towards continued robust global growth inthe coming year, and which may last even longer insome regions.

6



No big threat from high commodity pricesOil prices are not the only prices that have risen lately.Prices of commodities excluding energy have gainednew upward momentum over the past six months orso. Their price movements closely reflect develop-ments in the world economy, showing temporarysigns of weakness last spring, followed by newevidence of strength due to the upturn in Japan andEurope.

The price increase has been especially strong in thepast few months. In dollar terms, commodity pricesexcluding energy have now reached their 1988 record(according to the HWWA Index). Measured in euros,however, there is still some way to go to the mid-1980s peak. The slide in the US dollar limited thepressure of commodity prices in Europe during 2002-2004. Over the past year, however, the price upturnhas been larger in euro terms.

In earlier issues of Nordic Outlook, we have ana-lysed why oil prices pose a less serious threat to theworld economy than previously. Economies havebecome more energy-efficient, inflationary pressureis generally lower, and central banks do not viscerallyrespond to higher oil prices by raising interest rates.The world economy is thus currently exhibiting asignificant immunity to high commodity prices.

Because of the upturn in oil futures that has occurredsince our last forecast, we have made downwardrevisions for this year, especially in American eco-nomic growth – but only by 0.1-0.2 percentage points.Nevertheless, oil prices are beginning to approach levels where they could cause major damage. Ifprices should rise to USD 90 per barrel and stay putfor six months or longer, the forecast scenario forglobal growth would be a different and more pessi-mistic one than the one presented in this NordicOutlook.

No signs of inflation dispersionWhen it comes to inflation, the danger is that higherpetrol and oil prices might gradually begin having“second-round effects”, i. e. rising inflationary expec-tations and pay demands. However, there are still nosigns that the increase in commodity prices will

trigger such effects. Globalisation and higher produc-tion in low-wage countries are an effective counter-force to upward price pressures due to rising cost ofinput goods.

This picture is confirmed by analyses of price devel-opments in different production phases. A weightedaverage of producer prices in the big OECD econo-mies and China indicates continued downwardpressure on prices. We include China because wewant to catch any inflationary impulses coming fromChinese producers. Prices of durable consumptiongoods are continuing their long-term decline. Therise of consumption goods as a whole, which hasbeen pushed up by food prices, hovers around only 1per cent.

The same picture also emerges when we lookdirectly at consumer prices. Rising energy priceshave indeed caused repeated spikes in the OECD’sheadline CPI, with 3 per cent in October as thehighest peak. But core inflation — CPI excluding foodand energy — has not been infected by this. After acertain upturn in 2004 when deflation worries fadedin the US, there was a downward trend throughoutthe OECD during most of 2005.

06050403020100999897

2

1

0

-1

-2

-3

-4

2

1

0

-1

-2

-3

-4

Source: SEB

Producer prices in OECD and ChinaYear-on-year percentage change

Consumption goods

Durable consumption goods

06050403020100999897

3.0

2.5

2.0

1.5

1.0

3.0

2.5

2.0

1.5

1.0

Source: SEB

OECD: CPIYear-on-year percentage change

CPI excl. food and energyCPI

Index 2000=100Prices of commodities excluding energy

EUR USDSource: HWWA

80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 0570

80

90

100

110

120

130

140

150

160

70

80

90

100

110

120

130

140

150

160

7



Lukewarm forecasts of the future and the lingeringpain from the burst stock market bubble have ledto cautious behaviour in many respects. Forexample, companies have held back from capitalspending and acquisitions, which has kept variousexcesses at a healthy distance. This also meansthere is potential for a continued upturn in capitalspending.

Japan and the euro zone have been the largest dragon the world economy in recent years. At the sametime, their long slump represents a significantpotential for recovery as soon as economicplayers regain their optimism in earnest. In thatsense, there are good prospects that an Americanslowdown may be offset by expansion elsewhere.

Imbalances and commodity pricesThe threat to stable economic development comesmainly from those areas where the cost of globalgrowth in recent years is most clearly apparent, i.e. inthe form of burgeoning American imbalances as wellas rising energy and commodity prices. In our mainscenario, these factors are mainly impediments toeven faster growth, but they also pose a risk ofconsiderably poorer growth if the adjustment processshould turn out to be more dramatic.

American economic imbalances have continued toworsen. The Federal Reserve’s aggressive interestrate cuts right after the economic crisis enabled theUS economy, especially American households, toshoulder a heavy burden in maintaining global de-mand. Although the Fed has gradually restored its keyrate to more normal levels, this trend has intensified.Because the US current account deficit has continuedto swell and household savings have now fallen wellbelow zero, the correction may be larger and moresevere once it comes. Our main scenario implies thatthe Fed will succeed in engineering a soft landing forthe American economy, but there are large downsiderisks.

Oil and commodity prices will continue upwardToday’s broad-based global growth entails underlyingpressure on commodity prices. Commodity pricesexcluding energy have followed the economic cyclerelatively closely in the past year. They fell during theslowdown last spring and have climbed again inrecent months. Petrol and oil prices are also beingpushed upward by strong underlying growth indemand, while years of deferred investments inrefinery capacity have strained production. Oil pricesare thus sensitive to disruptions. Our forecast isbased on an oil price of USD 67 per barrel in 2006.But new instability in the Middle East – especially thegrowing tension between Western powers and Iran –may cause new spikes.

Central banks in different phasesDespite renewed pressure from energy and commodi-ty prices, inflation has fallen since last autumn’senergy-driven upturns. The inflation worries thatcharacterised financial markets during the autumnhave therefore largely disappeared. Disinflationaryforces thus continue to dominate the picture. (SeeNordic Outlook, November 2005.) The Chinese andIndian supply shocks in the global labour and productmarkets are continuing to squeeze costs and prices,while the credibility of central banks is high. InEurope and Japan, low capacity utilisation is alsohelping to hold down inflation.

Because of strong disinflationary forces and their ownhigh credibility, central banks do not need to resort tothe key interest rate levels that were common inprevious economic upturns. However, there are stilllarge cyclical differences between the US, the eurozone and Japan.

In the US, the Fed has clearly signalled that its “auto-pilot” period – 25 basis points per meeting – is nowover and that monetary policy will become more data-driven. The Fed is thus approaching its peak interestrate, but still faces a tricky late-cycle balancing act.We see the slowdown in the fourth quarter of 2005 as

Iran: A new political risk factorOne uncertainty factor — impossible to quantify — isgeopolitical tensions in the Middle East. Terroristattacks can destroy oil production capacity or dam-age transport systems. Given today’s strainedcapacity situation, such incidents might drive upprices very high.

In this respect, the risk seems to have increased inrecent months. The victory of Hamas in the Palestini-an election raises the temperature in the region.Tensions between the Western world and Iranconcerning that country’s nuclear capabilities aremounting. Today no solution to the conflict is in sight.China and Russia oppose sanctions, and we doubt

whether the US and Israel would carry out armedactions on their own. For their part, the Iranians havelarge resources, both in foreign exchange andpeople, their nuclear facilities are numerous andhard to find, and their country is well equipped toresist foreign pressure for a long time.

This indicates that in 2006 we will see an intricategame of high-stakes negotiations. If the situationshould become genuinely acute, there is a signifi-cantly higher risk of disruptions in oil shipmentsthrough the Straits of Hormuz. This means that oilprice spikes may very well occur during the comingyear.

8



temporary. The tight labour market situation, withunemployment likely to fall to 4½ per cent this spring,points towards two more rate hikes. We are thussticking to our earlier forecast that the federal fundsrate will peak at 5 per cent. During 2007 the Fedwill begin to lower its key rate as the economydecelerates. The Fed will thus place a cushion underthe housing market and achieve a successful softlanding by the American economy.

The ECB chose to begin its rate-hiking cycle as earlyas December 2005, even though the economic upturnin the euro zone still appeared uncertain. This upturnis now on firmer ground, but given falling inflationand low capacity utilisation, and having strengthenedits authority, the ECB can proceed relatively cautious-ly. We foresee a new rate hike in March, but after thatthe ECB can bide its time, waiting to see whether themuch-anticipated cyclical upswing actually materialis-es. Since we have adjusted our euro zone growthforecast for 2006 upward, we have assumed some-what earlier rate hikes. In December 2006, theECB’s refi rate will stand at 2.75 per cent and inDecember 2007 at 3.00.

The Bank of Japan faces the task of beginning tonormalise its monetary policy. We anticipate that thisyear, deflation will be replaced by inflation and thatthis will make it possible for the BoJ to graduallyreduce its large injections of liquidity. But not untilstable inflationary expectations have been establishedwill the BoJ cautiously begin to raise its key rate fromtoday’s zero level. Given the need to co-ordinatemonetary normalisation with fiscal normalisation, thebank will be very careful. The BoJ will not relin-quish its zero interest rate policy until early 2007.

Flat yield curvesBond yields have not risen, despite the brightereconomic outlook and even though central banks aregenerally in a rate-hiking cycle. When inflation wor-ries vanished last autumn, long-term yields declined.

In today’s well-established low-inflation environment,apparently bond yield movements will be small.

The high credibility of central bank inflation targetsthus implies that monetary policy operates to alesser extent through bond yields and to a greaterextent via exchange rates. The current level of keyinterest rates is becoming less important to bondprices, since the long-term inflation level is not inquestion. Conversely, differentials between key rateshave a greater impact on exchange rate movements,since a higher return can be obtained without thisgenuinely reflecting any long-term differential ininflation risks. The interest rate parity theorem is thuspartly invalidated in the short term by the solid credi-bility of inflation targets.

Our forecast implies that American 10-year Treasuryyields will peak at 4.60 per cent this spring, while thecorresponding German yields will climb gradually andvery slowly to 4.00 per cent towards the end of 2007.This is a downward revision since our last NordicOutlook. We are thus anticipating that bond yieldswill peak at clearly lower levels than those thathave been historically common.

Consequently yield curves will now graduallybecome ever flatter. The US yield curve will eventurn negative, as the Fed continues hiking its key rate.Other Western countries have a positive yield curve,but since all central banks (except the Bank of Eng-land) are in rate-hiking phases, these curves willbecome flatter. The current Swedish curve is compar-atively steep as a result of the Riksbank’s low reporate, but since the Riksbank will be hiking this keyrate faster during our forecast period than most othercentral banks, Sweden’s yield curve will also becomeconsiderably flatter in the future.

In the US, an inverted yield curve is usually a signal ofapproaching recession. But earlier periods of invertedcurves have ordinarily come about because the Fedpushed up its key rate to considerably higher levels

07060504030201009998

7

6

5

4

3

2

1

0

7

6

5

4

3

2

1

0

Sources: ECB, Fed, SEB

Key ratesPer cent

forecastSEB

Euro zone: Refi rate (Germany until 1999)US: Fed funds

0706050403

4

3

2

1

0

-1

4

3

2

1

0

-1

Source: SEB

Yield curves in selected countries10-year government bond yield minus key rate

US

Germany

Sweden

SEB forecast

9



than today’s in order to kill inflation. Today interestrates are clearly lower. We thus believe that theinversion of the yield curve is mainly a functionof the Fed’s credibility and of low inflationaryexpectations in the new economy. It is therefore nota signal of a coming recession.

Mixed stock market pictureThe international environment remains favourable toasset prices, but not to the same extent as last year.Although interest rates are climbing in most places,the upturn is occurring from a very low level. Liquidi-ty is high, as is risk appetite. The pursuit of goodreturns combined with low interest rates means thatinvestors will continue actively searching for alterna-tive investments. This favours commodities, emergingmarkets and real estate.

Rising short-term interest rates usually hurt stockmarkets. But the picture is more uncertain today. InEurope and Japan, stock markets have been extremelyrobust in the past year, thanks to low interest ratesand strong profits. After such a vigorous upturn, wecan expect profit-taking and stock market dips whenthere is bad news. Valuations nevertheless do notappear exaggerated, and price downturns may attractliquidity in search of investments. Our main forecastis thus based on a certain additional upturn —albeit considerably smaller than last year.

US stock markets performed comparatively poorlyduring 2005, despite record profits. The reason wasthe Fed’s mechanical rate hikes, without any clearending in sight, as well as the stronger dollar. But nowthat the Fed is approaching its interest rate peak andAmerican economy will remain strong for anotheryear or so, there is a chance of a rally. Another factor,which will benefit the export sector a bit furtherahead, is that the dollar will fall.

One specific risk is the American auto industry.Both GM and Ford are teetering on the brink ofcollapse and a full-blown bankruptcy by a US car-maker would make huge waves. The root of theproblem is that these companies are simply finding ithard to sell their cars. Regardless of whether therestructuring process occurs via bankruptcy orpreventive downsizing, the auto sector faces extensivecapacity cutbacks.

Gradually weakening dollarLast year, exchange rate movements were determinedto an unusually great extent by short-term interest ratedifferentials. The Fed’s interest rate hikes thus provid-ed strong support to the dollar, which strengtheneddespite the growing US trade deficit.

The short-term interest rate gap may widen somewhatfurther over the next few months, which may providesupport to the dollar. During the latter part of 2006,however, the interest rate trend will pull the dollar in

Bird flu: Less risk in reality thanin the mediaThere is growing concern that the avian influenza(bird flu) virus will mutate, enabling the disease tospread directly from human to human and thus eruptinto a widespread epidemic, or pandemic. In modernhistory this has happened three times on a largescale: The “Spanish flu” after the First World Warclaimed the lives of some 50 million people, the“Asian flu” of the late 1950s took 4 million lives andthe “Hong Kong flu” a decade later killed around 2million people. In the two latter cases, a few hundredthousand lives were lost in Western Europe. Deathrates were far higher in Asia. As a comparison, it isworth mentioning that the SARS epidemic of 2003claimed only 800 lives.

The Asian and Hong Kong flu epidemics had onlyminor economic effects on the West. The reason wasprobably — cynical as it may sound — that most ofthe victims were older people outside the labourmarket. The economic impact of SARS was not somuch attributable to the disease itself as to the costsof fewer trips and goods shipments to certain regionswith strict quarantine regulations. These effects wereshort-term, lasting only 1-2 quarters, and were offsetby a rapid resurgence of production after the epidem-ic. But what might happen if today’s bird flu virusactually developed into a human-to-human virus?

Three factors distinguish today’s world from that ofseveral decades ago, when the last major epidemicsoccurred.

Health care is more widely available, especiallyin the Asian countries that are usually the sourceof the epidemic. This means far fewer deaths arelikely.

The spread of contagious diseases may, on theother hand, occur faster. People travel more,which means that more people are likely to fall ill.

Because of increasing global economic integra-tion, the economic consequences will probablybe larger. In particular, East Asia — where suchviruses generally arise — is now the “workshopof the world”. Sensationalist media reports maypossibly reinforce the psychological effect.

The medical risks thus seem less dangerous than inearlier major pandemics. The economic effect (givenan epidemic of a certain size) resulting from reducedtrade and travel might nevertheless be larger in theshort term. Considering that no epidemic in moderntimes has affected the global growth pattern, howev-er, it is unlikely that bird flu will have any lastingeconomic repercussions.

10


In addition, last year’s temporary tax relief for Ameri-can subsidiaries abroad that repatriate profits is nowexpiring. These factors indicate that the 2002-2004decline in the dollar will resume after the sum-mer, following a pause in 2005 and early 2006. Weexpect the euro to be worth USD 1.20 at year-end2006 and USD 1.30 in December 2007. The weaken-ing of the dollar against the yen will be of about thesame magnitude.

There is some danger that the dollar slide may bemore dramatic, in a situation where the Fed stopsraising its key rate and the American current accountdeficit looks worse than ever. However, a collapse ofthe dollar does not seem likely. We expect Asiancentral banks to continue buying dollars on a largescale. Neither Japan nor China wants to see any rapidappreciation of the yen or the yuan. China has admit-tedly begun to diversify its foreign exchange reservesand to gradually reduce the percentage of dollars inthe mix. But there are no signs whatsoever of a desireto abandon China’s strategy of stable exchange raterelations. The “basket” that was introduced last


summer is, in practice, a crawling peg against thedollar — which presupposes a continued steady flowof US Treasury bond purchases.

We foresee Chinese yuan appreciation against thedollar of 5 percent per year, in small steps, both in2006 and 2007.

0706050403020100135

130

125

120

115

110

105

100 1.4

1.3

1.2

1.1

1.0

0.9

0.8

Source: SEB

Exchange rates USD/JPY and EUR/USD SEBforecast

USD/JPY (LHS)EUR/USD (RHS)

11

Nordic Outlook - February 2006The United States

Soft landingForces of growth will predominate in 2006High capacity utilisation puts pressure on FedHousehold savings adjustment on the way……but capital spending upswing will lead to softlanding

The low GDP growth in the fourth quarter of 2005,which reached only an annualised 1 per cent, raisesquestions about the strength of the US economy.However, signs of weakness culminated as early asOctober, whereas the final months of the year showedbetter momentum. Strong order bookings in manufac-turing and a clear recovery in household confidencepoint towards renewed vigour early this year. Thelow growth rate was also due to several factors of anonrecurring nature that will probably lead to arebound in early 2006, for example related to defenceexpenditures. We thus expect a strong first quarter,with growth close to 5 per cent.

Our assessment is that strength will predominateduring most of 2006. The Federal Reserve is nowapproaching the end of its rate-hiking cycle, a factthat may also re-energise the economy. The stockmarket is usually stimulated when Fed interest ratespeak, while bond yields are close to their peak. Inaddition, reconstruction work after last autumn’shurricane disasters will have a positive impact ongrowth in the first half of 2006. Thus, 2006 growthshould average 3¼ per cent, roughly in parity with thetrend level.

Worsened imbalancesHowever, the imbalances in the US economy haveworsened even further. The current account deficithas reached new record levels, and — contrary to allpredictions — the decline in household savings hascontinued, despite the Fed’s interest rate hikes.Housing savings are now a bit into negative territory,even after weak consumption during the fourthquarter led to a rebound. Rising home prices havedriven up the wealth position of households, and thishas obviously been more important to them thanhigher interest rates. One contributing reason has beenthat continued low mortgage loan rates and lag effectsin home loans have reduced the impact of the Fed’skey rate hikes. A relatively strong labour market hasalso contributed to reluctance by households to save.

Although we do not foresee a collapse in the housingmarket, obviously sooner or later a deceleration mustaffect the pace of economic growth. A certain coolingis already discernible: Price increases for newlyconstructed homes have slowed sharply, homes forsale are staying in the market longer, and affordability

has deteriorated as home prices have kept on rising. Atotal levelling off of home prices would slow GDPgrowth by 2-3 percentage points due to reducedconsumption capacity and construction (see NordicOutlook, November 2005). However, it is likely thatthis effect will be spread over a longer period than oneyear.

Growth will cool late in 2006Our conclusion is that expansive forces will keeptheir upper hand during most of 2006. After that, itis likely that due to a housing market slowdown, thehousehold consolidation process will begin. Since thesavings ratio has fallen below zero, there are risks of asharp adjustment.

On the other hand, offsetting counter-forces will easethe decline in GDP growth. So far, corporate capitalspending behaviour has been characterised by greatcaution. Although the economic recovery has beenunderway for some time, there is thus still majorpotential for a further upturn in capital spending.Rising capacity utilisation, strong balance sheets andgood profits point in the same direction.

Year-on-year percentage changeUS: Unit labour cost

Source: Bureau of Labor Statistics

Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q300 01 02 03 04 05

-2

-1

0

1

2

3

4

5

-2

-1

0

1

2

3

4

5

US: Household savings and home prices

Household savings, per cent of disposable income (LHS) Home prices (RHS)

Sources: US Department of Commerce, Office for Federal Housing Enterprise Oversight

90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 050.0

2.5

5.0

7.5

10.0

12.5

15.0

-2

-1

0

1

2

3

4

5

6

7

8

12


The United States

To some extent, foreign trade is another counter-force. International demand will remain strong, sinceChina and a number of other emerging markets willmaintain their rapid growth rates, while the economiesof Europe and Japan will slowly move in the rightdirection. A weaker dollar in the wake of graduallylooser Fed policy during 2007 will also benefit theexport outlook.

It thus looks as if the American economy has goodpotential for a soft landing in 2007. Our forecastimplies that GDP growth will slow to 2½ per cent in2007. This implies a slight upward revision for nextyear, among other things because we now foreseelower long-term interest rates during 2007. Our GDPforecast is below the consensus view, however.

Threat of inflation not written offThe inflation rate has fallen since last autumn’s spike,which was caused by energy prices. The underlyinginflationary outlook is also benefiting from strongproductivity growth, which is causing the increase inunit labour cost to decelerate again.

However, it is too early to write off the threat ofinflation. The producer price upturn is relativelybroad, underscored by the fact that companies inmost industries are expressing a belief in their abilityto raise prices. In addition, the labour marketsituation looks relatively tight. For this reason, anew upturn in unit labour costs cannot be ruled out.Traditional cyclical forces — entirely in line with thenormal course of economic events — will assertthemselves for another while. The Fed thus cannotcompletely relax with regard to inflation over the nextyear.

Looking further ahead, underlying competitive condi-tions will again make themselves felt. Given weakergrowth, global price pressures and the strong underly-ing productivity trend in the American economy willkeep inflation down once again.

Strained capacity utilisationAlthough job creation has been relatively modest,unemployment has continued to fall and is now below5 per cent. Leading indicators also point towards acontinued fall over the next six months or so. Ourshort-term forecast model tells us that we may seeunemployment figures below 4½ per cent by latespring. Historical experiences indicate that at suchunemployment levels, the economy is operating at fullcapacity utilisation. This justifies a watchful approachby the Fed.

The combination of modest upturn in employment andshrinking joblessness is due to the fact that the laboursupply has not climbed in the normal way. Theeconomic activity rate (percentage of working-agepeople in the labour force) fell during the 2001-2003slowdown but has not bounced back since. This issomewhat surprising, given the flexibility that the USlabour market usually shows. Naturally it cannot beruled out that the activity rate will finally reboundwhen the labour market becomes even hotter. On theother hand, a Fed working report has identifiedbehavioural and demographic trends that point to-wards a persistent downturn, for example a lowerdegree of part-time work by students and the fact thatfamilies with children are increasingly trying to get byon the income of one gainfully employed parent.

Fed will continue to 5 per centIn recent months, the Fed has announced that it isnearing the end of its rate hike cycle. The Fed hasstopped referring to its interest rate policy as accom-modative and has thereby gradually disconnected the“autopilot”. Instead, it has warned that high capacityutilisation in the economy may require further interestrate hikes. Thus traditional business cycle analysis –growth trend, labour market and inflation – will beeven more crucial in determining how far the centralbank’s rate hikes will continue.

USA: Employment and economic activity rate

Civilian economic activity rate, per cent (LHS) Non-farm payroll, million persons (RHS)

Source: BLS

80 82 84 86 88 90 92 94 96 98 00 02 04 0685

90

95

100

105

110

115

120

125

130

135

63.0

63.5

64.0

64.5

65.0

65.5

66.0

66.5

67.0

67.5

68.0

07060504

5.0

4.5

4.0

3.5

3.0

2.5

2.0

1.5

1.0

0.5

5.0

4.5

4.0

3.5

3.0

2.5

2.0

1.5

1.0

0.5

Sources: BLS, SEB

US: Inflation Year-on-year percentage change

SEB forecastCore inflationCPI

13


The United States

In the past, the Fed has ended its rate hiking andcutting cycles at around the same time as unemploy-ment has turned. Thus the Fed does not normallyseem to rely on its knowledge of lags in the economy.Instead it takes the time to wait for concrete signalsbefore regarding itself as having fulfilled its on-goingtask.

One special dilemma for the Fed will be to determinewhether a tight labour market and the inflationaryimpulses connected to it should be viewed as an after-effect of earlier economic vigour or as something thatcarries in itself the seed of a new dynamic upturn inconsumption and capital spending.

This uncertainty, combined with the strained capacitysituation, makes it likely that the Fed will choose tocontinue raising its rate by another 50 basispoints to 5 per cent. This implies somewhat largerrate hikes than the market currently expects. At thesame time, we should recall that 5 per cent is only themidpoint of the interval (4½-5½ per cent) that the Fedhas recently identified as its estimate of a neutral keyinterest rate.

Given our scenario of US economic deceleration inlate 2006 and early 2007, the period when the fedfunds rate is 5 per cent will be fairly brief. A rate-cutting cycle will begin early in 2007, in order toput a cushion under the downturn in the housingmarket and in the business cycle.

Who’s afraid of the yield curve? Our forecast implies that for a while, short-terminterest rates will be a bit higher than 10-year yields.Historically speaking, an inverted yield curve hasbeen a relatively certain predictor of a US recession.The pattern in such cases has been that the Fed hasbeen forced to drive up its funds rate to high levels tohalt inflation. The market has then assumed that theeconomy will be so severely damaged that the Fedwill soon have to slash interest rates. In some ways,the current situation deviates from this pattern:

The inversion that we now see before us isoccurring at a considerably lower key rate levelthan normal. In itself, the fact that this level isneutral instead of clearly contractive is oneargument against a recession risk.

Furthermore, the recent downturn in long-termyields has been driven to a greater extent bylower inflation forecasts than by a gloomiereconomic outlook.

Non-cyclical factors are also contributing to lowlong-term yields. The Fed’s high inflation-fightingcredibility, the large supportive purchases ofTreasury bonds by Asian central banks, the needfor insurance companies to reposition theirportfolios etc are also helping push down long-term yields.

Based on both the cyclical situation and the structuralfactors that have been part of the solution to the riddleof low bond yields, we thus dare conclude that thenegative yield curve does not foretell a recession.

Per centUS: Unemployment and fed funds rate

Fed funds (LHS) Unemployment (RHS)Sources: BLS, Fed

82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 053

4

5

6

7

8

9

10

11

0,0

2,5

5,0

7,5

10,0

12,5

15,0

Per centUS: Yield curve and fed funds

Fed funds (LHS) Interest rate differential 10-year minus 3-month (RHS)

Sources: Fed, EcoWin

82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05-1

0

1

2

3

4

5

6

0,0

2,5

5,0

7,5

10,0

12,5

15,0

17,5

US: Yield curve and GDP

Nominal GDP, year-on-year percentage change (LHS) Interest rate differential 10-year minus 3-month (RHS)

Sources: US Department of Commerce, EcoWin

86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05-1,0

-0,5

0,0

0,5

1,0

1,5

2,0

2,5

3,0

3,5

4,0

2

3

4

5

6

7

8

9

14


Japan

Upswing is consolidatingContinued surge in business optimismClear labour market improvementSlow farewell to deflation

The Japanese economy gained renewed expansivepower towards the end of last year, after a slightcooling during the third quarter. Exports were robust,and investments continued upward. The optimism ofthe business community became even stronger, whilehousehold confidence climbed to a 15-year high.

Japan’s adjustment following the burst bubble hasnow largely been completed, and growth has becomemore vigorous. Unlike previous cyclical upswings,households now also seem to have become bolder,decreasing the risk of a relapse into stagnation. Thegovernment’s extremely expansive economic policywill now begin to be normalised in a gentle way. Wethus predict that GDP will continue to grow aboveits trend of around 1½ per cent in the next couple ofyears. During 2006 GDP will increase by 2.5 per centand next year by 2.0 per cent.

Broad-based growthThe business sector finally seems on its way towardsresolving the lingering consequences of the excessesfrom the bubble years. According to the latest Tankanbusiness sentiment survey, for the first time since theearly 1990s a majority of companies are no longercomplaining of overcapacity or excess staffing inproduction. Debt levels have also fallen substantially.The healthier situation of the banking sector is appar-ent from a drop in problem loans and an upswing inlending.

Since the spring of 2005, exports have been in arecovery phase. The year ended strongly. The poten-

tial for prolonged good export growth is favourable,especially due to China’s economic expansion. Lastyear’s yen depreciation also provides an extra stimu-lus.

After several years of rising business investments, thedemand for labour is now also beginning to increase.As a result, wages and salaries have started to turnupward, and optimism has climbed significantly in thehousehold sector. The preconditions are thus in placefor a sustained economic upturn, though such sectorsas retailing have recently been less than convincing.

Because the upturn in the household sector is stillbarely beginning, the necessary government budgettightening will be carried out slowly and gradually.Some measures, such as broadening tax bases andeliminating temporary tax relief, have already beenimplemented. However, if the government is seriousabout its target of phasing out its primary budgetdeficit by 2010, the pace of tightening must acceleratetowards the end of this decade.

Zero interest rate policy for rest of 2006Deflation is relaxing its grip after prevailing for manyyears. Real estate prices are on the way towardsbottoming out, inflationary expectations have risensubstantially and the period of declining wages is over.Meanwhile there are factors that hold down prices,for example higher productivity growth is limiting theinflationary impact of accelerating pay hikes. TheJapanese price level also remains high in an interna-tional comparison.

The Bank of Japan (BoJ) wants to see positiveinflation figures for a number of consecutive monthsbefore beginning to normalise its monetary policy. InNovember, core inflation passed the zero level andJapan can probably avoid sliding back into deflationduring the next few months, among other things dueto base effects and rising energy prices.

Although the above-mentioned underlying factorsindicate an end to deflation, it is not at all certain thatthis will happen without occasional reversals. Adjustedfor energy prices, the price trend is still negative.Later this year, for example, certain temporary effectswill have a downward impact on inflation, which maycomplicate the BoJ’s timing. In our judgement, thecentral bank will begin to phase out its liquidityinjection policy in the second quarter, while the zerointerest rate policy will remain in place until year-end. During 2007, the BoJ will very cautiously raiseits key interest rate.

Net percentageJapan: Limitations on production

Production capacity LabourSource: Bank of Japan

80 82 84 86 88 90 92 94 96 98 00 02 04 06

-50

-40

-30

-20

-10

0

10

20

30

40

-50

-40

-30

-20

-10

0

10

20

30

40

15


China

Both strength and balanceContinued sheer strengthCalm stabilisation policyCurrency reform is progressing

The Chinese economy remains impressive. Afterrevisions in the national accounts, both the GDP leveland the growth of recent years have been adjustedsignificantly upward. Inflation remains low. China iscontinuing to reform its financial service sector and istaking a number of small steps to gradually allow botha stronger and a more flexible currency. In ourjudgement, GDP growth will reach 9.5 per centduring 2006 and 9 per cent in 2007.

New statistics confirm economic strengthNew calculations have boosted the 2004 GDP level(measured from the output side) by a full 17 per cent.Broken down over time, GDP growth in the pasttwelve years has averaged 0.5 percentage pointshigher annually than previously reported, with anacceleration in recent years. This means that poten-tial growth in China has been around 9 per centrather than the previously assumed 8.

The service sector accounts for nine tenths of theupward revision. Its share of GDP has thus risenappreciably, while the share of GDP represented bymanufacturing has declined. This makes the struc-ture of the Chinese economy less divergent in aninternational perspective.

Structural challengesFrom a stabilisation policy standpoint, the situationlooks bright. Inflation remains at a low level, and theauthorities thus need not resort to any severe tighten-ing. Inflation is slowly creeping upward, but slightlyhigher interest rates during 2007 plus a cautiouscurrency revaluation will help keep it in check.

Instead, the key tasks in Chinese economic policy arelong-term and concern the sustainability and allocationof growth.

Many capital spending projects are being subsidisedby politically fixed low interest rates. Credit lossesare large. By means of foreign ownership andstock market introductions, a few of the largestcommercial banks are now rapidly modernising.But reforming the banking system in its entirety, inorder to achieve a more rational allocation ofcapital, will take many years.

Growth must be of higher “quality”, that is,more environmentally friendly and more evenlydistributed geographically. In addition, bulk indus-trial production must give way to more knowledge-intensive service production. Simple serviceproduction aimed at households must also play alarger role in the country’s future growth profile. Anumber of initiatives will probably be unveiledwhen the next five-year plan is launched in March,for example tax incentives for selected economicsectors and regions, as well as major investmentsin education.

Continued revaluationThe yuan appreciated in trade-weighted terms during2005, since it followed the strengthening of the USdollar against other currencies. Apart from its small 2per cent revaluation against the dollar at the time oflast summer’s currency reform, the yuan has contin-ued de facto to be pegged to the dollar. Thus nocurrency “basket” is discernible in practice.

China’s large trade surpluses, rapid economic growthand continued need to support the service sector morethan manufacturing point towards a continued yuanrevaluation. The new, higher GDP figures will alsohelp to intensify political pressures from other coun-tries to revalue the currency.

During the past year, a number of minor technicalreforms have gradually opened the way for a moreflexible yuan. Tourists may take the currency out ofthe country, banks have expanded their exchangefacilities, etc. These small steps indicate that China istesting the yuan’s potential to cope with freer trading.Full convertibility is still some years away, but weanticipate that China will gradually let the yuan movein a broader range, and that a stepwise appreciationwill occur. We are sticking to our forecast of anannual revaluation of 5 per cent against the dollarin many small steps. But the possibility has increasedthat this revaluation may occur faster.

Yuan tnChina: GDP

GDP Revised GDPSource: National Bureau of Statistics of China

78 79 80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 040,0

2,0

4,0

6,0

8,0

10,0

12,0

14,0

16,0

0,0

2,0

4,0

6,0

8,0

10,0

12,0

14,0

16,0

16


The euro zone

Things are falling into placeBrighter growth outlookBut low capacity utilisation and falling inflationECB will proceed cautiously

In recent months, leading euro zone indicators havepointed upward, which means greater dynamism inthe economy. Consequently, were revising ourforecast upward and now expect GDP growth to endup at around 2¼ per cent this year, a bit abovetrend. But next year, growth will fall below 2 per centdue to tighter economic policies and a stronger euro.This growth forecast implies that the output gap willdecrease only marginally during our forecast period.Capacity utilisation will thus remain low. HICP infla-tion will fall during the spring, despite continued highenergy prices. The European Central Bank will thusproceed cautiously with its interest rate hikes in ordernot to risk interrupting the economic upturn too early.

Economic recovery on firmer groundThere are a number of indications that the on-goingcyclical upswing will be more sustainable than thesignals that generated false hopes of better times in2002 and 2004. In Germany, judgements concerningthe current economic situation have become moreoptimistic, following several years of wide gapsbetween rosy expectations and more disillusionedperceptions of current conditions.

Another important difference is that domestic demandis now a more important part of the overall picturethan previously. An upturn in capital spending is inprogress. The brighter labour market situation alsoprovides hope of boosting the otherwise gloomyfuture expectations of European households — andthus consumption — to levels that we have not seenfor a long time.

The upturn also seems geographically broader. Apartfrom Germany, the main economic engine of the eurozone, things look brighter in the other large countries.In France, the upturn is continuing, driven by opti-mistic households to a greater extent than in Germany.In Italy, too, recent economic signals have beenpositive, especially on the export front.

Italy’s underlying problems related to its product mixand cost situation have hardly eased, but the countryseems to be taking advantage of the positive dynamicthroughout the euro zone. As more countries andsectors are pulled into the upturn, this creates apositive spiral. This self-generating cyclical upswingwill dominate 2006 more than the structural andpolitical problems lurking in the background.

Greater obstacles to growth next yearThe current positive dynamic will carry into 2007.Capital spending is still at a low level, and oncehousehold optimism gets a foothold, high savings andstrong balance sheets will provide considerablepotential for increased consumption.

On the other hand, the preconditions for growth willbecome tougher in various respects next year. TheECB’s interest rate policy will be less expansive, whileexports will be hampered by a stronger euro andsomewhat weaker international demand, especiallyfrom the United States.

Fiscal policy will also be tighter, especially in Germa-ny. Prophets of doom have drawn parallels to the1997 consumption tax hike in Japan, which smoth-ered a nascent economic recovery. Germany’s 3percentage point VAT increase in 2007 will undoubted-ly slow consumption, since it will cut into disposableincome. In addition, the VAT hike makes it advanta-geous to accelerate capital goods purchases to thisyear. At the same time, it is easy to exaggerate theseeffects. Households are of course aware of thechanges that are underway; consequently they have a

Net balanceEuro zone: Confidence indicators

Manufacturing sector HouseholdsSource: DG ECFIN

96 97 98 99 00 01 02 03 04 05-25

-20

-15

-10

-5

0

5

10

-25

-20

-15

-10

-5

0

5

10

IFO Index 2000=100Germany: Business climate

Current situation Expected situationSource: IFO

96 97 98 99 00 01 02 03 04 0582.5

85.0

87.5

90.0

92.5

95.0

97.5

100.0

102.5

105.0

82.5

85.0

87.5

90.0

92.5

95.0

97.5

100.0

102.5

105.0

17


The euro zone

chance, in a forward-looking and rational way, tosmooth out their consumption over the next couple ofyears. Our forecast thus implies that German con-sumption growth will indeed slow down in 2007, butthat this effect will be modest.

Taken together, our forecast implies that euro zonegrowth will slow from 2.2 per cent in 2006 to justbelow 2 per cent next year. Viewed over the fore-cast period as a whole, GDP will thus rise nearly halfa percentage point faster than potential. In our judge-ment, the initial output gap is wider than this. Thusthe euro zone will still be working below normalcapacity utilisation at the end of 2007.

Structural problems will persistOur forecast implies that unemployment will fall from8.6 to 8.1 per cent this year. This is due to cyclicalfactors. The structural problems hampering the eurozone are still unsolved. It will take many additionalsteps to make the labour market more flexible.

Public sector deficits will also persist. The low publicsavings level in the euro zone is reflected by the factthat the current account has already moved intodeficit, though the capital spending and consumptionupturn has just begun. A euro zone current accountdeficit at this early stage reinforces global savingsimbalances to some extent, making the global recov-ery increasingly dependent on Asian capital.

Inflation continuing to fallThe rate of inflation has fallen since peaking lastautumn, although it is still stuck at above 2 per cent.HICP inflation will fall sharply during the secondquarter of 2006 as last year’s upturn in oil and otherenergy prices disappears from the 12-month figures.Towards the end of the year, the opposite base effectwill again drive up the HICP.

In 2007, the German VAT hike will push up inflationby almost half a percentage point. Excluding thiseffect, HICP inflation will be only around 1½ per cent.

Merkel effect in GermanyAngela Merkel’s starting position was not the bestwhen she took over as chancellor, succeedingGerhard Schröder. Schröder’s attempts to reform theGerman economy, for example with Agenda 2000,had stagnated. Due to weak growth and risingunemployment, the German people were sceptical ofhis reform policy.

The mood of economic crisis exerted heavy pressureon Chancellor Merkel to quickly launch reforms in thelabour market and social insurance systems. Mean-while there was a major risk that the difficulties ofholding together the new grand coalition governmentmight undermine the content and effectiveness ofsuch economic policies.

The government’s programme included a largeausterity package aimed at bringing the public budgetdeficit below 3 per cent of GDP. Important elementsincluded raising Germany’s value-added tax from 16

to 19 per cent in 2007, increasing marginal tax onhigh-income earners and curbing deductions. Theproposal that will have the greatest impact on growthin a longer perspective is a multi-year programmeaimed at stimulating greater capital spending inGermany. There are also plans to lower the corporatetax in a couple of years.

The government’s focus on budget tightening createdworries that the economic recovery might be interrupt-ed. To date, however, the change of chancellor hashelped fuel greater optimism in Germany. Merkel’ssuccess at the most recent EU summit meeting hasstrengthened her at home, giving the corporate sectorhopes of a better investment climate. However, in ouropinion what has happened is not enough to entirelyoffset the tightening effects of the 2007 VAT increase.German GDP growth will thus decelerate slightly nextyear.

Year-on-year percentage change, EUR bn, rolling annual rateEuro zone: GDP and current account

GDP (LHS) Current account (RHS)Source: Eurostat

97 98 99 00 01 02 03 04 05-100

-75

-50

-25

0

25

50

75

0.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5

4.0

4.5

5.0

070605040302

3.0

2.5

2.0

1.5

1.0

0.5

0.0

3.0

2.5

2.0

1.5

1.0

0.5

0.0

Sources: Eurostat, SEB

Euro zone: HICPYear-on-year percentage change

HICPAdjusted for VAT hike in Germany

18


The euro zone

The rate of pay hikes has again fallen. As a result,increases in unit labour cost remain at a very lowlevel. This supports our conclusion that the outputgap is still significant. Combined with mountinginternational competition, this indicates that inflation-driving pay hikes seem distant.

Nor do we see any worrying signs of rising inflation-ary expectations. On the contrary, expectations havefallen somewhat in recent months. Market expecta-tions, as evidenced by break-even inflation in index-linked bonds, is relatively consistent with the ECB’sinflation target.

Monetary expansion — which the ECB portrays as athreat to price stability — is continuing, although thepace of increase in the money supply has slowedsomewhat in recent months.

Cautious ECB rate hikesIn December, when the ECB took the first step ofraising its key interest rate from 2 to 2.25 per cent,the economic upturn was still in its infancy. The ECB

instead justified its rate hike by saying it wanted toprevent HICP inflation from getting stuck at a highlevel, which would lead to rising inflationary expecta-tions and second-round effects on wage and priceformation.

The ECB has subsequently toned down the hawkishrhetoric that preceded its December rate hike. ECBPresident Jean-Claude Trichet has repeatedly empha-sised that the bank has no plans to carry out a seriesof rate hikes. As a result, the market’s previouslyrather aggressive rate hike expectations have softened,though economic signals have been predominantlypositive.

Given the euro zone’s brighter growth prospects,unused capacity will be placed in service to a some-what greater extent. This indicates that the ECB cancontinue its normalisation of interest rates.However, we are sticking to our view that the ratehikes will occur at a gentle pace. The ECB willcontent itself with a 25 basis point hike this spring —probably in conjunction with its inflation report inMarch — and another in the autumn. At year-end, thebank’s refi rate will thus stand at 2.75 per cent.

During 2007 we believe that the ECB’s rate hikes willbe limited to 25 basis points. There are several rea-sons for this slow increase:

Any tendency towards second-round effects isdifficult to discern. The rate of pay increases hasagain fallen, after an upturn during the second halfof 2005. Inflationary expectations are undercontrol. Although a new wave of oil price hikeswould slow the downturn in inflation, most indica-tions are that such a downturn is imminent.

The ECB can, with some justification, bask in theglory of its December rate hike. By showing itsmuscles at an early stage, it has helped to steminflationary tendencies, while low interest rates stillsupport growth. It is unlikely that the ECB wantsto risk smothering the economic upturn at an earlystage through a series of rate hikes in 2006. Earliercriticism from influential organisations like the IMFand OECD has undoubtedly played some part inthis context.

Like ours, the ECB’s growth forecast is relativelyclose to trend both this year and next. After arather long period of growth below trend, it wouldbe a powerful signal of distrust of the way theeconomy functions if the bank were to see supply-side restrictions as imminent at this early stage.

Year-on-year percentage changeEuro zone: Money supply and credit growth

Credit growth (LHS) Money supply, M3 (RHS)Source: ECB

99 00 01 02 03 04 051

2

3

4

5

6

7

8

9

10

11

12

13

14

2

3

4

5

6

7

8

9

10

11

12

13

14

15

Year-on-year percentage changeEuro zone: Hourly wage costs and ULC

Unit labour costs (LHS) Hourly wage costs (RHS)Sources: Eurostat, ECB

Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3 Q197 98 99 00 01 02 03 04 05

-1.5

-1.0

-0.5

0.0

0.5

1.0

1.5

2.0

2.5

3.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5

4.0

4.5

5.0

19


The United Kingdom

Levelling off after soft landingConsumption growth will remain below trendInflation lower than 2 per cent targetTemporary housing market resurgence

The British economy is going through a soft landing.GDP growth ended up below trend last year, mainlybecause the previously rapid growth in consumptionfell. The labour market has also begun to weaken,which means wage and inflation risks have faded.Due to rising exports and capital spending, however,growth will recover somewhat ahead. We project thatGDP will increase by about 2 per cent both in 2006and 2007; i.e. below 2½ per cent, which is both thepotential growth rate and the prevailing consensusforecast.

Short-term indicators point towards continued stagna-tion in manufacturing. Some improvement willgradually occur, since export growth will shift slightlyupward to an average of 5½ per cent in 2006-2007,somewhat above the average for the past 25 years.Greater demand from the euro zone will help, andtowards the end of 2006 so will a weaker pound.

A squeezed investment ratio and high company profitspoint towards higher capital spending, but the upturnwill be slowed by modest capacity utilisation.

Private consumption growth will stay at around 2 percent, clearly below trend. Household optimism seems

to have stabilised, and purchasing power will indeedrise at a somewhat faster pace ahead. However, dueto concerns about a weakening labour market, thesavings ratio will rise. Households are in a vulnerableposition, with a historically low savings ratio of 5 percent and high indebtedness. Despite earlier tighteningof interest rates and a calmer housing market, house-hold debts are still rising by nearly 9 per cent year-on-year, only marginally lower than a year ago.

Unemployment has begun to creep upward afterbottoming out at 4.8 per cent last autumn. Signalsfrom companies about lower hiring needs and fewerjob openings indicate that the same trend will continuethis spring. Given GDP growth below trend, thelabour market will continue to weaken.

Wage and salary growth (excluding bonuses) hasalready slowed and is now just below 4 per cent.Given a weaker labour market, the pace of wageincreases will remain below the 4½ per cent that theBank of England (BoE) usually regards as criticalfrom an inflation standpoint.

Inflationary pressure has also recently eased. TheHICP increase fell to 2 per cent in December. Thiswas not only due to lower energy prices. Underlyinginflation (HICP adjusted for energy and food) hasplunged below 1½ per cent. Due to pressure on retailprices and modest GDP growth, inflation will staybelow the BoE’s target of 2 per cent; we predict 1.8per cent inflation in 2006 and 1.7 per cent in 2007.

Housing market a headache for the BoE For a long time, the Bank of England’s series ofinterest rate hikes in 2003-2004 looked like a careful-ly weighted dose of cooling for the overheatedhousing market. The downshift in the pace of homeprice increases since late 2004 from about 20 percent to a low of 1.5 per cent last summer was animportant element of the economy’s successful softlanding. But during the autumn, home prices againtook off, while the number of mortgages approvedturned upward. This raises questions about futureinterest rate policy.

In our judgement, this housing market resurgenceis temporary. The interest rate cut of August 2005kindled hopes that a series of rate cuts was immi-nent. Home prices were also stimulated by fallingreal interest rates (from about 3 per cent at the short-term end downward towards 2 per cent in the courseof 2005) in the wake of higher inflation.

However, households cannot count on further stimu-lation from falling real interest rates. The pause ininterest rate cuts will be lengthy, while economicrecovery will be delayed; the housing market is thuslikely to weaken again.

Since the housing and credit markets have beenstronger than the BoE outlined in its Novemberinflation report, the Bank will wait until this summerbefore making its next interest rate cut (from 4.50 to4.25 per cent). We anticipate that a further interestrate cut will be needed in late 2006.

United Kingdom: House prices and repo rate

House prices, Halifax, year-on-year percentage change (LHS) Repo rate (RHS)

Sources: BoE, Halifax/Bank of Scotland

95 96 97 98 99 00 01 02 03 04 053.5

4.0

4.5

5.0

5.5

6.0

6.5

7.0

7.5

-5

0

5

10

15

20

25

30

20


Central and Eastern Europe

Broad economic strengthGerman upswing will boost exportsComing elections mean expansive fiscalpoliciesDivided inflation picture

The economies of Central and Eastern Europe willcontinue to grow at a good pace. The main drivingforce will be domestic demand, but due to a brighteroutlook for the important German market for exports,we are raising our growth forecast somewhat.GDP in the region including Russia will increase by anaverage of 5½ per cent annually in 2006-2007.

The three Baltic countries will continue to growfastest, at 6½-8 per cent this year. Exports remaingood. The very rapid pace of lending is stimulatingdomestic demand. This trend is causing some con-cern, since fixed exchange rate systems leave thecentral banks without an interest rate weapon. Otherattempts to slow credit expansion, such as Estonia’sdecision in December to tighten the banks’ capitalcoverage requirements for home mortgages, will havelittle effect. Nor are signs of fiscal tightening discerni-ble.

Russia will continue to grow at 5-6 per cent a year,aided by high oil prices. The parliamentary andpresidential elections of 2007 and 2008, respectively,will lead to an expansive fiscal policy that sustainsstrong private consumption. Underlying uncertaintyabout political developments nevertheless constitutes arestraining factor for investments.

Last year, political turbulence contributed to economicdisappointments in Ukraine. A gradual economicrecovery is expected. Much will depend on whetherthe government that takes office after the Marchelection can improve the investment climate.

In Central Europe, consumption and investmentswill increase on a broad front, fuelled by rising realwages and lower interest rates. Credit demand willgrow. Fiscal policy will be expansive, among otherthings due to autumn parliamentary elections inSlovakia, the Czech Republic and Hungary. In Poland,domestic demand will accelerate too. A new electionwill be avoided. The minority government (Law andJustice) will form a stability pact together with twosmall parties. The political uncertainty will disappear,at least until the local elections in the autumn. Howev-er, the prospects for reforms and fiscal tightening willnot improve. Hungary’s rating has been lowered.Current fiscal policy may lead to slight turbulence infinancial markets.

Central Europe’s exports were relatively strong lastyear and will get an extra push in 2006 due to Ger-man recovery. Poland, Slovakia, the Czech Republicand Hungary all send much of their exports to Ger-many, 30-40 per cent. There is a strong connectionbetween their exports and German economic per-formance. A good leading indicator is the IFO Index.

Continued inflation divergenceIn Central Europe, inflation remains low. In Poland,the Czech Republic and Slovakia, the rate of priceincreases is around 1-3 per cent. Hungary is movingdown to the same level. In the short term, a new waveof energy price hikes may admittedly spawn higherinflation. In the longer term, however, appreciatedcurrencies combined with keener competition willpreserve low inflation.

In Russia and Ukraine, inflation will be stuck ataround 10 per cent. In Ukraine, gas prices willcontribute to continued high inflation, while Russia’sFX policy, aimed at limiting the real appreciation of therouble despite large oil revenue, will help drive upinflation. An expansive fiscal policy in both countriesalso plays a role.

Strong domestic demand and high wage growth areleading to continued price pressures in the Balticcountries. Rising energy prices are also a factor.Inflation in Lithuania remains below 3 per cent in2006. Estonia’s will decline to 3.5 per cent. Latvia’sinflation will slowly move downward from far higherlevels. This will have implications for the eurotimetable.

The first applications will be evaluated this year.Lithuania and Slovenia will stick to their schedulesand become euro zone members in 2007. Estoniaand Lithuania will be forced to delay accession byone year, until 2008 and 2009, respectively. Such adelay will not threaten fixed exchange rate regimes,since these countries are well placed to fulfil all otheraccession criteria, including public finances.

IFO and exports from Central Europe

Czech exports (LHS) Polish exports (LHS)

IFO (RHS)

Sources: IFO, Czech Statistical Office, Central Statistical Office of Poland

96 97 98 99 00 01 02 03 04 05In

dex

2000

=100

82,5

85,0

87,5

90,0

92,5

95,0

97,5

100,0

102,5

Year

-on-

year

per

cent

age

chan

ge

-20

-10

0

10

20

30

40

50

60

21


Sweden

Sustained upturnStronger labour marketLow capacity utilisation will allow good growthin 2007 as wellInflation target still core of monetary policy —Riksbank will raise its key rate slowlyStrong public sector finances, uncertainelection outcome

After a brief slowdown early in 2005, the economyhas bounced back more vigorously than expected.Growth will be strong, driven mainly by domesticdemand. GDP will climb 3.3 per cent this year,equivalent to more than 3½ per cent after adjustingfor the number of working days. Low capital spend-ing, high household savings and low capacity utilisa-tion indicate that the wave of growth can continue.We thus expect GDP growth of around 3 per cent in2007 as well: an upward revision since our lastforecast.

The economy may actually grow even faster. House-holds may open their wallets and become more eagerconsumers than we anticipate, and strong publicsector budget figures combined with a close electioncampaign may trigger additional fiscal stimuli. Weakerinternational expansion and continued uncertaintyabout the capital spending plans of the manufacturingsector are downside risks.

The upturn is finally starting to have an impact on thelabour market. We expect employment to grow by 1.6per cent this year, equivalent to 70,000 new jobs, butmore than one third are the result of government-financed labour market policy programmes. Capacityutilisation is relatively low, so the risks of inflation-driving pay hikes will be small in the next two years.

Inflation will remain low throughout 2006. Modestpay increases, cheap imports and low rent increaseswill keep prices down. The Riksbank’s UND1X

underlying inflation index will average 1.4 per cent in2006.

Despite all the talk about home prices, interest ratepolicy will be determined primarily by the inflationforecast. Continued low inflation will thus mean thatthe Riksbank’s interest rate hikes will comeslowly. We are sticking to our forecast of a 100 basispoint total increase this year; most will come duringthe first half of the year. In 2007, capacity utilisationwill gradually climb and eventually continued ratehikes will be needed to ease inflationary pressure. Buteven at the end of our forecast period, in December2007, the repo rate will only be 3.25 per cent.

The improvement in public sector finances has beendramatic in recent months. The national budgetbalance in 2005 was a full SEK 40 billion (1.6 per centof GDP) stronger than the government expected asrecently as September. Financial saving in the publicsector will presumably end up close to the officialtarget, 2 per cent of GDP, during our forecast period.

Strong central government finances will increasethe likelihood of additional election “pork”. Weexpect the spring budget bill to represent an additionalfiscal expansion equivalent to SEK 10 billion.

Because of a narrower gap between the public sup-port enjoyed by the non-socialist opposition and bythe ruling minority Social Democrats plus their alliesthe Greens and Left Party, the outcome of the Sep-tember 2006 parliamentary election has become moreuncertain. However, the non-socialist alliance enjoys alead in most surveys. We thus continue to expect achange of government. The result will be a somewhatless expansive fiscal policy in 2007.

Uncertainties in manufacturing sectorGood international economic conditions will mean abright export outlook. Better growth in the euro zone,strong expansion in Nordic markets and better sales

060504030201009998

7

6

5

4

3

2

1

0

-1

7

6

5

4

3

2

1

0

-1

Sources: Statistics Sweden, SEB

Sweden: SEB's GDP indicatorYear-on-year percentage change

IndicatorGDP

060504030201

20

15

10

5

0

-5

-10

20

15

10

5

0

-5

-10


Sweden: Merchandise exportsYear-on-year percentage change

Euro zoneNordic countries

22


Sweden

opportunities in Asia and Eastern Europe will offsetweaker US demand.

There are a number of uncertainties, however. Short-term indicators are not entirely convincing, and signsof weakening are visible in such key sectors as thevehicle and telecom industries. A degree of hesitationis also evident in the investment behaviour of themanufacturing sector. Last year’s upturn in capitalspending seems to have reached only 10-15 per cent,considerably less ambitious than the plans previouslyreported. In addition, companies actually showedfalling investment plans for 2006 in Statistics Swe-den’s October survey.

We cannot draw far-reaching conclusions from thisunwillingness to spend, however. Companies usuallyunderestimate their capital spending at such an earlystage. Thus most indications are that high capacityutilisation, a low investment level and good profits willfinally lead to a continued upturn in capital spend-ing.

Continued low interest rates and rising production willalso stimulate capital spending elsewhere in theeconomy, although growth will gradually decelerate.Housing construction, which rose nearly 20 per cent

in 2005, will slow to about a 10 per cent rate both thisyear and next. However, public sector investments,which have largely been unchanged in the past twoyears, will rise. Total capital spending will climb 8 percent this year and 4 per cent in 2007.

Consumption boom on the wayHousehold consumption will speed up further. Growthaccelerated during 2005, when retailing gained mo-mentum at the same time as service consumptionrecovered. Although the household confidence indica-tor is still a bit below the levels of the 1999-2000boom and new car sales remain listless, the potentialfor continued acceleration seems good:

Disposable household income will grow rapidly.Because of high real wage increases and risingemployment, as well as tax cuts and increasingtransfer payments, purchasing power will increaseby 3½ per cent this year and 3 per cent in 2007.

A brighter labour market and continuing balancesheet improvements due to the upturn in share andhome prices point towards strong consumtion.

Economic situation of householdsYear-on-year percentage change

2004 2005 2006 2007Disposable income 1.3 2.6 3.6 2.9Consumption 1.8 2.6 3.4 3.3Savings ratio level, % 8.3 8.4 8.4 8.8Sources: Statistics Sweden, SEB

Rising interest rates will restrain the consumptionincrease. However, the upturn in the householdinterest burden will remain below one percentage pointin the next couple of years. In 2007, interest expenseswill be equivalent to only 4½ per cent of income.

The Riksbank’s rate hike signals have already begun tocool off the hot housing market. Meanwhile risingincome and increased employment are important

060504030201009998979695

25

20

15

10

5

0

-5

-10

-15

25

20

15

10

5

0

-5

-10

-15


Sweden: Capital spending in businessYear-on-year percentage change

Planned, according to October surveyActual

0604020098969492908886848280

140

130

120

110

100

90

80

12

10

8

6

4

2


Sweden: Household debt and interest expensesPer cent of disposable income

Debts (LHS)Interest expenses after taxes (RHS)

Per centSweden: Capacity utilisation in manufacturing

Source: Statistics Sweden

94 95 96 97 98 99 00 01 02 03 04 0586.5

87.0

87.5

88.0

88.5

89.0

89.5

90.0

90.5

91.0

86.5

87.0

87.5

88.0

88.5

89.0

89.5

90.0

90.5

91.0

23


SwedenSweden

counter-forces. In Sweden as a whole, home priceswill probably continue to climb in the next couple ofyears, albeit at a clearly declining pace. The risks ofprice slides apply mainly to the overheated markets incentral areas of major cities.

Overall, we expect that household consumption willincrease by 3-3½ per cent annually in 2006 and2007. This forecast implies that the savings ratio willremain historically high, which may be interpreted asan upside risk in our consumption forecast.

How much can employment grow?After a long period of disappointments, job creationgained momentum during the autumn. According toStatistics Sweden’s Labour Force Survey (LFS), theyear-on-year upturn was more than 1 per cent or50,000 people. However, measurement problemsconnected to the EU harmonisation of the LFS lastspring risk overestimating the upturn. The estimate inthe National Accounts that the employment upturntotalled only 35,000 people is probably more reliable.

The upturn will accelerate further this year. We expect70,000 new jobs in 2006 and more than 40,000next year. They will appear mainly in the construc-tion sector and in private service sectors such as thedistributive trades and consulting. The public sector isalso expanding, but labour market policy programmesare the main explanation here.

Now that employment is finally rising, questionsrelated to the output gap, the labour reserve and thenon-accelerating inflation rate of employment(NAIRU, or equilibrium unemployment) are pivotal indetermining how long the expansion can continue —and thus also how monetary policy will be shaped. Abroad approach is necessary, both in order to analysethe question in different time dimensions and to getaround a number of methodological problems thathave muddied the economic policy debate.

Our analysis below consists of three stages, withthree different time perspectives: 1) short-termcapacity utilisation measures, 2) medium-term analy-sis of equilibrium unemployment and labour supplyunder given rule systems and 3) the long-term poten-tial for economic policy to boost labour force partici-pation.

1) Resource gap indicatorsIt is difficult to quantify output gaps and sparecapacity in the economy. Different methods ofestimation often lead to widely varying results. Evenmore worrying is that the same method does not yieldstable results over time.

Given the major problems of advanced output gapestimates, we see the need for an indicator thatweighs together a number of measurements, forexample job opening statistics from the NationalLabour Market Administration (AMS) and the ques-tions in the Swedish Institute of Economic Research(NIER) Business Tendency Survey about shortagefigures and capacity utilisation. With the help of alarge number of series from these sources, combined

070605040302

9

8

7

6

5

4

9

8

7

6

5

4


Sweden: UnemploymentPer cent

Registered unemployment

Registered unemployment +labour market programmes

SEB forecast

06050403020100999897969594939291

130

120

110

100

90

80

70

130

120

110

100

90

80

70

Sources: NIER, Statistics Sweden, SEB

Sweden: SEB's resource indicatorIndex

050403020100999897969594939291

3

2

1

0

-1

-2

3

2

1

0

-1

-2

Sources: NIER, SEB

Sweden: Resource utilisation indicatorsIndex

NIER Business Tendency SurveyAMS statistics

24


Sweden

with simple estimates of trend deviations for employ-ment and GDP, we have sought to construct anindicator of resource restrictions in the Swedisheconomy. Different sources can be weighed togetherin different ways, but our calculations show that ourcapacity indicator is robust in relation to how varioussub-components are weighted.

At present, resource utilisation is relatively low. Itis approximately in parity with conditions in 1995-98,i.e. the period when tough government budget-tightening held back Sweden’s economic recovery.

The connection with wage inflation is far fromunambiguous. This connection is especially absentduring the economic boom of 1998-2000, when thecredibility of low inflation was established in earnest.Yet we believe that this measure has good potential tosummarise how the capacity situation will be per-ceived by the Riksbank and others in the future.

2) Equilibrium unemployment and labour supplyin the next two yearsEquilibrium unemployment and labour supply are ofcentral importance to the medium-term forecast. Onestarting point is that the current equilibrium level(NAIRU) for unemployment is 4.5 per cent (whichis equivalent to 4.0 per cent using the old LMSdefinition).

Our analysis of the labour supply contains variousstages. The working-age population will increase by0.6-0.7 per cent annually in the next couple of years.This increase will be largest among the youngest andoldest age categories, where labour market participa-tion is substantially below the average. Taking thisinto account, the contribution of population change toincreased labour supply will be only 0.4 per centannually.

Labour market Year-on-year percentage change

2004 2005 2006 2007Employment -0.4 0.7 1.6 1.0Population aged 16-64 0.6 0.6 0.7 0.6Labour supply 0.3 0.7 0.8 0.8Unemployment, level 6.0 5.9 5.2 5.0Hours worked 0.9 0.4 1.3 0.9Productivity, GDP 2.9 2.3 2.0 1.9Sources: Statistics Sweden, SEB

But the labour force may grow more than this.Labour force participation usually increases whenemployment rises. This is mainly due to higherparticipation by younger age categories. Furthermore,the clear trend since the mid-1990s towards higherlabour force participation in the 55-65 age range isexpected to continue.

We therefore expect the labour supply to grow by 0.8per cent annually, in historical terms not especiallymuch during a recovery. Given these assumptions,unemployment will not fall all the way to 4½ per centduring our forecast period, which is illustrated by thefact that the employment gap in the chart below willnot close. In other words, both our resource indicatorand this analysis seem to end up concluding that theeconomy can grow at a good pace without theresource situation becoming especially strained.

3) Long-term potentialThe two stages thus far in our analysis concern thenext couple of years. In such a perspective, it isreasonable to apply the existing rule systems for taxes,benefits etc. But in a longer perspective, the mostimportant issues have to do with challenges posed byglobalisation and demographics.

This is too large an issue to discuss in detail here, butthe chart above illustrates the potential. Perhaps labourmarket participation in the late 1980s was unsustaina-bly high — which was illustrated by extremely highabsenteeism. But labour market participation remainsabout 4 percentage points below the level of the mid-

04020098969492908886848280

86

84

82

80

78

76

86

84

82

80

78

76


Sweden: Labour supplyAs percentage of working-age population

070605

4450

4400

4350

4300

4250

4200

4450

4400

4350

4300

4250

4200


Sweden: EmploymentThousands

Potential employment

Actual employment

25


Sweden1980s. In other words, reforms in the tax and benefitsystem — for the purpose of lowering the marginaleffect and boosting the relative income from work —have a good chance of markedly increasing futurelabour supply and labour force participation.

Low inflation — balanced risks this yearThe rate of pay increases has shown a weak down-ward trend since 2001. However, because of thestronger labour market, combined with the fact thatexisting collective agreements will provide somewhathigher increases in the near future, this trend will nowbe interrupted. No major acceleration in wages andsalaries is likely, though.

The agreements in the coming wage round will besigned during the spring of 2007. As usual, varioussources of tension might create demands for wagecompensation: for example the fact that salaries ofwhite-collar employees have increased faster thanblue-collar wages, or that manufacturing wages havefallen behind. Politically inspired demands for higherwomen’s wages and salaries in the public sector mayalso help drive up average pay increases. However,dark clouds of this type are constantly appearing andare normally not strong enough to disrupt the patternof low pay agreements established by the first Agree-ment on Industrial Development and Wage Formationin 1998.

UND1X inflation has been creeping upward since itbottomed out last spring. For a long time, energyprices were the only thing behind this, but late in 2005UND1X excluding energy also began to climb faster.However, several factors point towards continuedlow inflation. Imports of consumer goods from low-price countries and a continued price squeeze onfoods, due to increased competition, will dampeninflation. In addition, rent increases will slow frommore than 2.5 per cent in 2005 to 1 per cent this year.This alone will decrease the rate of inflation by 0.2percentage points.

There are, however, other factors that indicate thatcore inflation — UND1X excluding energy — has alsobottomed out. A cyclical slowdown in productivitygrowth will lead to rising unit labour costs, thoughfrom a very depressed level. The effects of a weakerkrona exchange rate during 2005 are also makingthemselves felt. Prices of consumer goods at theimport and producer levels have begun to climb. Suchincreases usually show up in consumer prices with alag of a few months. On the other hand, the situationwill be the opposite in 2007, when the effects of akrona appreciation during 2006 will dominate thepicture. The latest surge in energy prices also indi-cates that in the short term, inflation will be highercompared to the path described by the Riksbank in itslast Inflation Report.

We have adjusted our UND1X forecast for this yearto an average of 1.4 per cent. UND1X inflation in2007 will average 1.6 per cent. One upside risk is thepossibility that higher commodity prices are finallypassed on, interrupting the trend towards a pricesqueeze on consumer goods in the world market. Asthe box in our International Overview indicates,however, there is no sign of this yet. In our judge-

070605040302010099989796

7

6

5

4

3

2

1

0

7

6

5

4

3

2

1

0

Sources: NIER, SEB

Sweden: Wages and costsYear-on-year percentage change

SEB forecast

Wages/salaries per hourUnit labour cost

070605040302010099989796

6

4

2

0

-2

-4

6

4

2

0

-2

-4


Sweden: UND1X, imported goodsYear-on-year percentage change

consumer goods (5-month lag)

UNID1X, imported goods excl. energyPrice of domestic supply, durable

0706050403

3.5

3.0

2.5

2.0

1.5

1.0

0.5

0.0

-0.5

3.5

3.0

2.5

2.0

1.5

1.0

0.5

0.0

-0.5


Sweden: UND1XYear-on-year percentage change

UND1X

UND1X excl. energy and food

Prognos SEB

26


Sweden

ment, the inflation forecast for 2006 is symmetri-cal, while downside risks will be somewhat morepredominant in 2007.

Due to higher interest rates and indirect taxes, theConsumer Price Index will increase faster thanUND1X both this year and next. Higher energy taxesand the introduction of congestion fees on carsentering and leaving central Stockholm will affect CPIby 0.2-0.3 per cent. However, the contribution of thiscongestion fee will disappear when the trial periodends in August. Next year, energy taxes will continueto be raised, but a non-socialist election victory wouldprobably mean a cut in alcoholic beverage taxes. Thecontribution of indirect taxes to CPI is thereforeprojected to be near zero in 2007.

Modest Riksbank rate hikesThe Riksbank has begun to raise its key interest rate.The message has been that the Bank intends to hikeits repo rate approximately in line with market expec-tations. The risk-adjusted UND1X path in the latestInflation Report ended at 2 per cent in December2007 and assumed that the repo rate had been raised

to 2.5 per cent in December 2006. The economicupturn and the employment picture have been some-what of an upside surprise, while higher energyprices will push up inflation in the short term. Webelieve that this is enough to persuade the Riksbank toraise the repo rate by another 25 basis points inFebruary.

Our main scenario, however, is still that inflationarypressure will remain low and that GDP growth in thenext two years will occur without any significantsupply restrictions emerging. After the first phase inthe rate-hiking cycle is completed, the underlyingeconomic picture will thus lead the Riksbank toproceed more slowly. We anticipate another 50 basispoints of rate hikes during the rest of the year. Thusat the end of 2006, the repo rate will be 2.5 per cent,for a total of 100 points in increases this year.This is somewhat below current market expectations.

If we are correct in our business cycle forecast, in2007 the economy will be characterised by continuedgood growth in production and employment. Supplyrestrictions will then become evident to a greaterdegree than during 2006. We thus anticipate that

Inflation target with optimal pathIn recent years, a number of the drawbacks in usingan inflation target have attracted attention. Continu-ous downside inflation surprises, combined with aweak labour market, have pushed down the Riks-bank’s key interest rate. This, in turn, has driven uphome prices and stimulated a rapid credit expansion.Last autumn, it also became clear how powerfulcurrency movements can arise when the Riksbankand the ECB are out of synch. This debate reachedits peak in December, when credit market worriesand currency turbulence affected the mood of theRiksbank Executive Board. The Riksbank leadershipalso stimulated market speculation about newstrategies by announcing that work was under wayon a broader analytical framework that would allowgreater room for asset prices.

This trend is likely to cool. Given rising inflation andincreased capacity utilisation, the goal conflicts inSwedish monetary policy will ease. In such a situa-tion, there is hardly any reason for the Riksbank toventure out on the slippery ice that Alan Greenspanhas constantly warned about. The Riksbank alsoapparently wants to avoid fuelling criticism that itweighs in exchange rates and asset prices in asomewhat arbitrary way in its monetary policy scales.After all, the task of meeting the inflation target is thefoundation of the Riksbank’s independence vis-à-visthe government. Our conclusion is thus that the ratehikes ahead will be dominated by the inflationoutlook and by resource gap analysis.

Likely to adopt optimal interest rate pathThe Riksbank is likely to gradually change its analyti-cal framework in various ways, with Norges Bank asone source of inspiration. There are many indicationsthat the Bank will replace the market’s interest rateexpectations (so-called implicit forward interest rates)with an “optimal interest rate path” as the basis for itsforecasts. The introduction of an optimal interest ratepath of its own will mean that the Riksbank itself willpoint out the path it considers the most suitable at themoment, given the available information.

By using such a path, the Riksbank can avoid theproblems that arose when it published its InflationReport in December. The dilemma of whether to citethe market interest rates on which the forecast isbased (but which are not entirely up to date) or morecurrent expectations (but which do not have anythingdirectly to do with the forecast scenario) is fundamen-tally insoluble. We therefore believe the Riksbanksees reasons to speed up its work with an optimalinterest rate path and that the transition may comeeven before this summer.

One factor, however, that may lead the Riksbank tohesitate before committing itself to such a change ofmethodology is that the Executive Board faces adiffifficult task. It must rally around a whole interestrate path, not just decide a current change in the keyinterest rate. The system of six independent ExecutiveBoard members would thus be put to a tougher test.

27


Swedensome time in early 2007 the Riksbank will again speedup its pace, carrying out another 75 points in ratehikes to a level of 3.25 per cent by the end of theyear. The gap in relation to market pricing willthereby diminish during the latter part of 2007.

Slow upturn in bond yieldsThe prospect of lower bond yields around the worldwill also cause a downward revision in the level ofSwedish long-term yields. In the past quarter, 10-year government bond yields have mostly been belowtheir German counterparts. The most importantdriving force behind this is that the Riksbank hasmaintained a lower key interest rate than the ECB, butSweden’s strong central government finances havealso been of importance. Bond issue volumes havedecreased, while Sweden’s creditworthiness is firmlyanchored in the highest category according to interna-tional rating institutions. Also of importance has beenlife insurance companies’ demand for long-termbonds in order to meet the requirements of theSwedish Financial Supervisory Authority’s new“traffic light” system.

The motives for the negative long-term yield spreadwill gradually weaken. The Riksbank will raise its key

interest rate at a faster pace than the ECB, while theinflation differential will largely be erased. Our modelfor estimating bond yield spreads, which is based ondifferentials in key rates, inflation and growth, indi-cates a yield spread of about 30 basis points in 2007.This may be an overestimate, however, since themodel does not take into account Sweden’s strongcentral government finances. Our forecast is thus thatthe yield spread will be positive in the second half ofthis year, but that the differential next year will notexceed 10 points. Swedish long-term yields will thusclimb from today’s 3.50 per cent to 3.70 per cent atthe end of this year and 4.10 per cent at the end of2007.

Krona will continue upwardThe fate of the krona, like that of other currencies,has been closely linked to key rate differentials withother countries. The appreciation of the krona beganas soon as the Riksbank started to signal that ratehikes were imminent. This change of course wasobviously more important than the actual key ratedifferential against the ECB around the end of 2005,which was as large as 75 points.

Sweden’s large trade surpluses indicate that the kronais undervalued in a longer perspective. In an environ-ment of low capital spending in Sweden, savings havebeen channelled abroad. Given our forecast of acontinued upturn in capital spending, combined with aturnaround in the interest rate margin, this might bethe catalyst that triggers the oft-predicted strengthen-ing of the krona.

The interest rate differential against the euro willdecrease somewhat this year, and this will support thekrona. We are therefore stubbornly continuing tomaintain that the krona will appreciate. We anticipateexchange rates of SEK 9.00 per euro at year-end andSEK 8.70 at the end of 2007. The krona will graduallystrengthen even more against the dollar. We expect thedollar to stand at SEK 7.50 at the end of 2006 andSEK 6.70 at the end of next year.

Public sector savings 2 per cent of GDPThe final central government budget outcome for2005 showed a surplus of SEK 13 billion. It is thuslikely that the official target of a surplus equivalent to2 per cent of GDP for overall public finances will beachieved. As recently as in its budget bill last autumn,the Ministry of Finance underestimated the outcomeby SEK 41 billion or 1.6 per cent of GDP.

The task of the forecaster is to determine how muchof the 2005 budget improvement was temporary.Certain factors will help reduce the surplus in 2006.

Tax revenue in 2005 was inflated because newrules for tax allocation reserves led to extra tax

07060504030201009998

5.0

4.0

3.0

2.0

1.0

5.0

4.0

3.0

2.0

1.0

Source: SEB

Key ratesPer cent

forecastSEB

Sweden: Repo rateEuro zone: Refi rate (Germany until 1999)

07060504030201009998

1.5

1.0

0.5

0.0

-0.5

-1.0

-1.5

1.5

1.0

0.5

0.0

-0.5

-1.0

-1.5

Sources: EcoWin, SEB

Sweden: Interest rate spread vs. GermanyPer cent

forecastSEB

10-year government bond yieldKey rate

28


Sweden

payments. These payments will disappear, pushingdown corporate tax revenue on the margin by SEK10-15 billion (0.3-0.4 per cent of GDP) in the nextcouple of years.

Tax cuts, higher benefit levels etc will burden thebudget by a gross amount equivalent to SEK 40billion in 2006.

On the other hand, rapid growth and a strong labourmarket will create the potential for further revenueenhancements. The surplus in public sector financ-es is thus likely to be around 2 per cent of GDPfor the next couple of years. The risks in thisforecast are actually that the strength of the budgetmay continue to surprise.

Expansionary on fiscal policyRapid budget improvement has created confusionabout how expansive Sweden’s fiscal policy actuallyis. The National Institute of Economic Researchinterprets a number of forces behind the improvement— especially rising tax revenue — as implicit austeritymeasures. This leads to the conclusion that thegovernment’s fiscal policy for 2006 is only weaklyexpansive.

Looking at the actual budget decisions, however, thepicture is different. The budget bill for 2006 containedproposals to boost expenditures and cut taxes bymore than SEK 20 billion. Adding previous proposals,we end up with around SEK 30 billion, equivalent to1.2 per cent of GDP. The fiscal policy approved todate adds a total of more than 1 percentage point tothe real purchasing power of households in 2006,while local government consumption may rise bymore than 1½ per cent.

In our opinion, it is reasonable to describe such afiscal policy as clearly expansive. Strong central

government finances also imply a temptation forfurther fiscal stimuli, especially if the ominous publicopinion situation of the government persists. To date,government statements have reflected an awarenessof the risks of pouring even more fiscal policy fuelinto the economy. Our forecast is still based on theassumption that the spring budget bill will containlabour market policy programmes (discounts onemployer payroll fees, mainly to local governments)as well as higher transfer payments and tax cuts tohouseholds worth another SEK 10 billion in 2006.

The non-socialist opposition still has a slight lead inpublic opinion surveys as the autumn parliamentaryelection approaches. Our forecast for 2007 there-fore assumes that there will be a change ofgovernment and that after the non-socialist coalitiontakes office, it will cut both income taxes and benefitlevels.

However, given the pattern of previous elections —with strong last-minute surges of support for theSocial Democrats — the election outcome remainsuncertain. The Social Democrats have presentedproposals for a dental care reform, higher ceilings forunemployment insurance and more money for pen-sioners and students. The economic forecast in thisNordic Outlook will probably also favour the incum-bent government.

If the SDP and their parliamentary allies should onceagain win a majority in the election, the Greens andthe Left Party will demand seats in the government.Such a request may trigger some uncertainty infinancial markets. But we doubt that the SocialDemocrats want to let others into the government.Such worries should thus subside rather quickly.

07060504030201

2.0

1.0

0.0

-1.0

-2.0

2.0

1.0

0.0

-1.0

-2.0

Sources: NIER, SEB

Sweden: Fiscal policy stancePer cent of GDP

SEB forecast

0706050403020100999897

8

6

4

2

0

-2

-4

8

6

4

2

0

-2

-4


Sweden: Public sector financial savingsPer cent of GDP

forecastSEB

TotalLocal government

29


Denmark

Strong and broad-basedConsumption boom will gradually fadeSlower GDP growth – but above trendCapacity shortages lurking around the cornerFiscal tightening necessary

For the past two years, the Danish economy has beenin a positive spiral. A fiscal policy expansion in 2004reawakened slumbering private consumption andcaused unemployment to decline. GDP growth shiftedupward, reaching 3 per cent last year. The economicupturn was based on good fundamentals: the nationalbudget and current account have shown stablesurpluses and underlying inflation has remained low.

Growth will slow down but remain above its potentiallevel of about 2 per cent. We have raised our GDPforecast to 2.7 per cent in 2006 and 2.4 per cent in2007. The reasons are increased export demand fromthe euro zone and stronger employment. We don´texpect the ongoing anti-Danish protests in part of theMuslem world to cause any measurable dent inDanish exports.

Broader growthEconomic growth is becoming more broad-based,after having been highly dependent on consumptionfor a few years. Export growth has accelerated andwill remain a annual pace of 6-7 per cent in the nextcouple of years.

Capital spending began to rise last year, after havingbeen weak for many years. A historically low invest-ment ratio, continued low interest rates and highconstruction activity point towards growing capitalspending. Residential construction will remain at ahigh level for at least another year.

Danish consumers’ eagerness to spend is backed byrecord-high confidence in the future — sustainedby growing employment, low interest rates and highhome prices. Total bank lending has accelerated inrecent years; at the end of 2005 it was growing at anannual pace of 20 per cent, and it will climb further inthe near future. Yet looking ahead, some factorsindicate that the rapid growth in consumption willcool. Income growth will slow when the effects ofearlier fiscal stimulation measures fade. Higher interestrates will eventually slow credit expansion as well asthe price increases in the housing market.

A few bottlenecks, despite “flexicurity”Unemployment is on its way down below 5 per cent,which is regarded as an equilibrium level. Ordinarily,this would fuel inflation. But in recent years Denmarkhas successfully re-defined the framework of itslabour market policy. The system is called “flexicuri-ty” — both flexibility and security — and repre-sents a significant commitment to an active labourmarket policy combined with liberal labour marketlegislation. Efforts to increase the labour supply,especially among young people, may possibly lead to aslight decline in the non-accelerating inflation rate ofemployment (NAIRU), thereby reducing the acute riskof inflation.

Nevertheless, in our judgement a tighter fiscal policywill eventually be necessary in order to avoid over-heating problems and a deterioration in Denmark’scompetitiveness. To date, mainly construction compa-nies have cited labour shortages as an obstacle toincreased production, but in the months ahead occa-sional bottlenecks are expected to emerge in othersectors as well.

Wage and salary growth has been calm in the pastfew quarters. This also applies to the hot constructionsector, where the rate of pay increases shifted mod-estly upward after the 2003 slump. In the overalleconomy, hourly wage hikes will accelerate fromabout 3 per cent last year to nearly 4 per cent in 2007.HICP inflation will drift upward from 1.7 per centin 2005 to 2.2 per cent in 2007, due to acceleratingpay hikes as well as high domestic demand.

Because of Denmark’s fixed exchange rate, monetarypolicy is tied to the interest rate decisions of the ECB.Since the ECB – and thus the Danish central bank –will be proceeding cautiously with interest rate hikes,fiscal policy must bear a larger burden in thefuture tightening that we regard as necessary. Howev-er, the risks of general overheating in the labourmarket are beyond the horizon of our forecast.

0706050403020100999897969594

14

12

10

8

6

4

14

12

10

8

6

4

Sources: Statistics Denmark, SEB

Denmark: UnemploymentPer cent

forecastSEB

30


Norway

The good times will continueOil will further stimulate growthTighter labour marketNorges Bank will raise its key rate cautiouslyKrone will regain its strength

High oil prices and expansive economic policy willremain important driving forces behind Norway’supswing. Growth is broad-based and is now having aclear impact on the labour market. Employmentclimbed and the jobless rate fell last autumn. Weexpect GDP growth to slow only modestly in the nextcouple of years. This year’s growth will be 3.1 percent and next year’s 2.7 per cent.

One central question in gauging the duration of theupswing is to what extent the tighter labour marketwill lead to higher pay hikes. We expect this spring’swage round to result in modest wage and salaryincreases, but pay hikes will accelerate somewhatnext year. Norges Bank will have to weigh this againstan inflation level that is far below its target and acontinued downturn in import prices. Our assessmentis that the interest rate upturn will be modest, butwe see some upside risk towards the end of ourforecast period, which might lead to a strongerappreciation of the krone.

Broad growth in domestic demandConsumption is continuing to grow at a rapid pace.Year-on-year, there was admittedly a certain slow-down late in 2005. However, this was mainly becauseextremely strong autumn 2004 car sales could not bematched; it is hardly a matter of a genuine interruptionin the upward trend. The buying plans of householdsremain at a high level, and good underlying incomegrowth in the form of rising real wages and higheremployment will provide continued support. Con-sumption growth will thus slow only modestly, from3½ per cent last year to 3 per cent this year and next.

Mainland (i.e. non-oil) capital spending is also contin-uing to increase at a rapid pace. The manufacturingconfidence indicator is at a historically high level. Bothprofitability and capacity utilisation point towardscontinued upturn in capital spending. In other busi-ness sectors, too, we foresee an expansive invest-ment climate. The exception is residential construc-tion; housing starts fell during most of 2005.

Higher capital spending in the oil sectorIn keeping with oil futures, we have revised our crudeoil price forecast upward from an average of USD 58per barrel to USD 67 for the next two years. This willstimulate growth via fiscal policy and will mean

further capital spending in the oil sector. Thelatest investment survey also confirms an upwardrevision of plans for 2006. Capital spending in the oilsector will climb by 10 per cent this year, thenstabilise at a high level next year. This levelling-off isthe main reason why GDP growth will slow in 2007.

The robust commodities market will also lead to afavourable price trend for other portions of Norway’scommodities-heavy manufacturing sector. Norwaywill thus benefit in different ways from the effects ofglobalisation. The increased role of China and otherAsian countries in the world market will push downconsumer goods prices, but drive up commodityprices at the same time. Norway can thus exportexpensive products and import cheap ones. As aresult, this year the current account surplus willset a new record of around 18 per cent of GDP.

Labour market improvementThe economic upswing of recent years has not hadsuch a large impact on job creation and unemploy-ment. Productivity has risen rapidly, while averagehours worked have climbed due to reduced sickleaves and increased overtime. At the same time,Norway has attracted labour from the new EUcountries.

Some of these processes are now showing signs ofending. The downturn in sick leaves has come to ahalt, and productivity growth is about to slow forcyclical reasons. These factors have contributed toacceleration in the number of jobs, a growing labourshortage and an increase in the number of job open-ings. Taken together, the resulting picture is a clearimprovement in the labour market, althoughunemployment according to the LFS remains at ahistorically high level.

The spring 2006 collective bargaining negotiations willthus take place in an environment where companiesare earning record profits and unemployment is on its

NOK billionNorway: Current account

Source: Statistics Norway

80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05-20

-10

0

10

20

30

40

50

60

70

80

90

-20

-10

0

10

20

30

40

50

60

70

80

90

31


Norway

way down. This could result in an upward shift in therate of pay increases from the low levels of recentyears. However, there are a number of indications thatwage and salary agreements will again be modestthis year. Inflation remains very low, allowing roomfor good real wage growth even with modest nominalpay hikes. During 2005, for example, there were noclear signs of higher wage drift. The introduction ofmandatory occupational pensions is also a restrainingfactor, though it pushes up expenses at companies.Wages and salaries are not an inflation risk in the shortterm, but they will remain an upside risk ahead as thelabour market continues to improve.

Inflation target still distantThe upward trend in inflation ended last autumn. InDecember the underlying rate of price increases (CPI-ATE) fell below 1 per cent. One important reason forthis was that the decline in prices of imported goodsgrew larger in the wake of krone appreciation during2005. We foresee that import prices will continue tomake a clearly negative contribution to inflation, sincethe krone will resume its upward path while thesqueeze on consumer goods prices in the worldmarket will continue.

Working in the opposite direction is the fact thathigher capacity utilisation will lead to rising unit labourcosts, both via decelerating productivity growth andhigher pay increases. However, this is not enough tomake inflation reach Norges Bank’s 2½ per centtarget by the end of 2007. Average CPI-ATE will be1.5 per cent in 2006 and 2.0 per cent in 2007. CPIinflation will be clearly higher this year, due to value-added tax hikes on foods and certain services andrising prices on electricity.

Strong krone will limit interest rate hikeSince Norges Bank’s last inflation report, there havebeen mixed signals about the bank’s main scenario.On the one hand, the decline in registered unemploy-ment may indicate a tighter labour market thanexpected. Home prices have also surged and creditgrowth has accelerated further. On the other hand,inflation has been below the bank’s forecast.

In our judgement, Norges Bank will stick to itsstrategy of raising the sight deposit rate by 75basis points this year. We have admittedly adjustedour ECB key rate forecast upward by 25 points thisyear, which allows room for further Norwegian hikeswithout excessive pressure on the krone. However,we believe that low inflation will weigh more heavilyfor Norges Bank. The consequence of this will be asomewhat weaker krone than in our previous fore-cast.

In our forecast, the ECB will only raise its key rate by25 points next year. This limits Norges Bank’s roomfor manoeuvre. Meanwhile we expect graduallyhigher inflation pressure from rising pay increases,which will intensify the goal conflict between thwart-ing early tendencies toward overheating, on the onehand, and avoiding excessive appreciation of thekrone, on the other. In our assessment, Norges Bankwill continue to hike rates at a slow pace, out ofconcern for the krone and the competitiveness ofNorwegian manufacturers. At the end of 2007, thesight deposit rate will be 3.75 per cent.

In the short term the krone will suffer, since the ECBand the Riksbank will boost their key rates earlier thanNorges Bank. However, the underlying strength of thekrone will gradually take the upper hand, as it be-comes clear that the ECB has ended its rate hikes. Atyear-end 2007, the krone will have appreciated toNOK 7.60 per euro.

The budget proposal by the new centre-left coalitiongovernment implies that government spending of oilmoney will remain above the 4 per cent of the Petro-leum Fund the “fiscal activity rule” prescribes. Weforesee substantially higher oil prices than the NOK350 per barrel the government assumes, which willlead to further expansive fiscal policy ahead.

Per cent of labour forceNorway: Unemployment

According to Labour Force SurveySource: EcoWin

98 99 00 01 02 03 04 050,0

0,5

1,0

1,5

2,0

2,5

3,0

3,5

4,0

4,5

5,0

0,0

0,5

1,0

1,5

2,0

2,5

3,0

3,5

4,0

4,5

5,0

070605040302

3.0

2.5

2.0

1.5

1.0

0.5

0.0

-0.5

3.0

2.5

2.0

1.5

1.0

0.5

0.0

-0.5

Sources: Statistics Norway, SEB

Norway: CPI-ATEYear-on-year percentage change

forecastSEB

32


Finland

Modest upswingHigher export growthStrong consumption will gradually decelerateModest pay hikes despite lower unemploymentInflation will climb slowly from low level

The Finnish economy is back on its growth trackafter the paper industry strike last spring. But there isno sharp upswing. Our GDP forecast – which islargely unchanged compared to Nordic Outlook inNovember – implies that GDP growth will climbfrom 1.8 per cent last year to 3.8 per cent thisyear and 2.9 per cent next year. However, underly-ing growth — adjusted for the effects of the strike —is close to 3 per cent in all three years.

Broad upturn in manufacturingThe forest industry strike contributed to a loss ofmarket share by Finnish manufacturers last year. Butthe favourable global situation for basic industries,especially metal producers, as well as for the telecomindustry, points towards a gradual rise in manufactur-ing output. Exports will consequently grow somewhatfaster this year.

Capital spending will grow at a modest pace. Dueto low interest rates, even after the ECB’s hikes,residential and other construction activity will remainlively for at least one year. However, capital spendingby manufacturers will increase slowly due to sparecapacity, among other things.

In recent years, private consumption has increased by3-4 percent annually. Lower income taxes, lowinflation, and since last year accelerating employmentgrowth, have led to good increases in real income.Tax cuts remain a key element of the earlier incomespolicy agreement. However, local tax increases, higher

pension provisions and higher inflation will mean thatincome growth will slow in the future. As a result,consumption growth will gradually cool to 2.9 percent this year and 2.2 per cent in 2007.

Employment will expand on a broad front. Unlikeother Nordic countries, the number of jobs is alsoincreasing in Finnish manufacturing. Unemploymentwill continue to fall, from an average of 8.4 per centin 2005 to 7.2 per cent in 2007. As in other Nordiccountries, capacity utilisation will thus also rise.

Nevertheless, in our judgement the risks of over-heating are small during our forecast period. Thereis still spare capacity in manufacturing. Pay increasesare being kept in check, among other things, by long-term wage and salary agreements that expire only inSeptember 2007. The combination of income tax cutsand low inflation will also lower the risks of wagedrift.

Lowest inflation in the EULast year, inflation in Finland was the lowest in theEU: 0.8 per cent. Higher import prices, includingenergy, and the longer-term impact of a tighter labourmarket are among the reasons why inflation willclimb to an average of 1.4 per cent this year and1.7 per cent in 2007. Continued low price increasesfor services as well as a price squeeze in retailing willslow the inflation upturn.

Fiscal policy will remain mildly expansive in thecoming year. The public sector budget surplus, whichis the largest in the euro zone, will shrink marginallyfrom about 2 per cent of GDP last year. However, theentire surplus is attributable to the pension system,while central and local governments will continue torun deficits this year.

07060504030201009998

6

5

4

3

2

1

0

-1

6

5

4

3

2

1

0

-1

Sources: Eurostat, Statistics Finland, SEB

Finland: GDP and inflationYear-on-year percentage change

GDP

HICP

forecastSEB

Year-on-year percentage change, 3-month moving averageFinland: Exports

Pulp and paper Radio, TV, communication equipment and devices Total exports

Source: EcoWin

Jan Mar May Jul Sep Nov Jan Mar May Jul Sep04 05

-60

-50

-40

-30

-20

-10

0

10

20

30

40

-60

-50

-40

-30

-20

-10

0

10

20

30

40

33


Nordic key economic data

DENMARKYearly change in per cent

2004 2005 2006 2007Gross domestic product 2.0 3.0 2.7 2.4Private consumption 3.9 4.2 3.1 2.3Public consumption 2.0 1.2 0.7 0.5Gross fixed investment 3.1 3.9 5.3 3.5Stockbuilding (change as % of GDP) 0.2 0.0 0.0 0.0Exports 3.3 8.6 6.8 6.0Imports 6.5 9.9 7.7 5.8

Unemployment (%) 6.4 5.7 4.8 4.7Consumer prices, harmonised 0.9 1.7 2.0 2.2Wage cost 3.1 3.0 3.5 3.9Current account, % of GDP 2.9 2.9 2.9 3.2Public sector financial balance, % of GDP 2.3 2.9 2.4 2.2Public sector debt, % of GDP 43.2 37.0 33.0 31.0

FINANCIAL FORECASTS Feb 1 Mar 06 Jun 06 Dec 06 Jun 07 Dec 07Deposit rate 2.40 2.65 2.65 2.90 2.90 3.1510-year bond yield 3.44 3.40 3.50 3.60 3.80 4.0010-year spread to Germany, bp -2 0 0 0 0 0USD/DKK 6.15 6.42 6.42 6.21 5.96 5.73EUR/DKK 7.46 7.45 7.45 7.45 7.45 7.45

NORWAYYearly change in per cent

2004 2005 2006 2007Gross domestic product 2.8 2.3 3.1 2.7Gross domestic product (Mainland Norway) 3.4 3.3 3.1 2.7Private consumption 4.7 3.6 3.1 3.0Public consumption 2.2 1.9 2.4 3.0Gross fixed investment 7.8 10.4 7.1 2.9Stockbuilding, (change as % of GDP) 0.8 0.4 0.0 0.0Exports 0.8 0.6 3.6 3.4Imports 8.9 7.0 5.8 4.2

Unemployment (%) 4.5 4.5 4.1 3.7Consumer prices 0.4 1.6 2.6 2.3CPI-ATE 0.3 1.0 1.5 2.0Wage cost 3.5 3.5 4.1 4.3Household savings ratio (%) 10.0 9.5 5.0 4.0Current account, % of GDP 13.5 16.1 17.9 15.9Public sector debt, % of GDP 11.4 15.3 17.0 17.0

FINANCIAL FORECASTS Feb 1 Mar 06 Jun 06 Dec 06 Jun 07 Dec 07Sight deposit rate 2.25 2.50 2.75 3.00 3.50 3.7510-year bond yield 3.76 3.70 3.80 3.90 4.10 4.3010-year spread to Germany, bp 30 30 30 30 30 30USD/NOK 6.64 6.81 6.72 6.42 6.08 5.85EUR/NOK 8.07 7.90 7.80 7.70 7.60 7.60

34


Nordic key economic data

SWEDENYearly change in per cent

2004 2005 2006 2007Gross domestic product 3.7 2.7 3.3 3.0Private consumption 1.8 2.6 3.4 3.3Public consumption 0.1 0.2 1.6 1.2Gross fixed investment 5.1 9.0 8.0 4.0Stockbuilding (change as % of GDP) -0.3 0.2 0.2 0.1Exports 10.8 5.2 5.6 5.3Imports 6.4 7.4 8.3 5.9

Unemployment (%) 6.0 5.9 5.2 5.0Employment -0.4 0.7 1.6 1.0Industrial production 9.1 4.0 5.3 5.1Consumer prices 0.4 0.5 1.7 1.9UND1X 0.8 0.8 1.4 1.6Wage cost 3.3 3.4 3.7 3.8Household savings ratio (%) 8.3 8.4 8.4 8.8Real disposable income 1.3 2.6 3.6 2.9Trade balance, % of GDP 6.9 5.6 4.6 4.8Current account, % of GDP 6.6 6.3 5.6 5.5Central government borrowing, SEK bn 51 -13 5 14Public sector financial balance, % of GDP 1.6 2.1 1.9 2.1Public sector debt, % of GDP 51 52 50 47

FINANCIAL FORECASTS Feb 1 Mar 06 Jun 06 Dec 06 Jun 07 Dec 07Repo rate 1.75 2.00 2.25 2.50 2.75 3.253-month interest rate, STIBOR 2.09 2.40 2.65 2.90 3.15 3.5010-year bond yield 3.46 3.30 3.50 3.70 3.90 4.1010-year spread to Germany, bp 0 -10 0 10 10 10USD/SEK 7.60 8.10 7.93 7.50 7.08 6.69EUR/SEK 9.23 9.40 9.20 9.00 8.85 8.70TCW 127.9 131.5 128.8 125.2 122.1 119.2

FINLANDYearly change in per cent

2004 2005 2006 2007Gross domestic product 3.6 1.8 3.8 2.9Private consumption 3.2 3.4 2.9 2.2Public consumption 1.6 1.3 2.0 1.4Gross fixed investment 5.0 -0.9 3.7 4.0Stockbuilding (change as % of GDP) 0.3 0.0 0.0 0.0Exports 5.6 5.4 7.2 6.0Imports 6.0 6.8 5.7 5.4

Unemployment (%) 8.8 8.4 7.6 7.2Consumer prices, harmonised 0.1 0.8 1.4 1.7Wage cost 3.8 3.3 2.8 2.8Current account, % of GDP 4.2 2.9 3.2 3.0Public sector financial balance, % of GDP 2.1 2.1 1.8 1.7Public sector debt, % of GDP 45.1 43.0 42.0 41.0

35


International key economic data

EURO ZONEYearly change in per cent

2004 2005 2006 2007Gross domestic product 1.8 1.5 2.2 1.9Private consumption 1.4 1.4 1.8 1.8Public consumption 1.1 1.3 1.5 1.6Gross fixed investment 1.7 2.6 4.0 3.1Stockbuilding (change as % of GDP) 0.3 0.0 -0.1 0.0Exports 5.9 4.4 6.5 4.4Imports 6.1 4.8 6.5 4.9

Unemployment (%) 8.9 8.6 8.1 8.0Consumer prices, harmonised 2.1 2.2 1.8 2.0Household savings ratio (%) 11.1 10.8 10.5 10.3

USYearly change in per cent

2004 2005 2006 2007Gross domestic product 4.2 3.4 3.2 2.6Private consumption 3.9 3.6 2.5 1.9Public consumption 2.2 1.7 1.6 1.2Gross fixed investment 9.7 8.0 6.2 6.1Stockbuilding (change as % of GDP) 0.4 -0.3 0.2 0.0Exports 8.4 6.7 5.8 5.9Imports 10.7 6.2 4.4 3.7

Unemployment (%) 5.5 5.1 4.6 5.0Consumer prices 2.7 3.3 2.7 2.0Household savings ratio (%) 1.2 -0.5 0.5 1.6

LARGE INDUSTRIAL COUNTRIESYearly change in percent

2004 2005 2006 2007GDPUnited Kingdom 3.2 1.8 2.0 2.1Japan 2.6 2.5 2.5 2.0Germany 1.6 1.1 1.8 1.7France 2.1 1.7 2.1 2.1Italy 1.2 0.1 1.5 1.5

InflationUnited Kingdom 1.3 2.0 1.8 1.7Japan 0.0 -0.2 0.1 0.4Germany 1.8 1.9 1.6 2.2France 2.3 1.9 1.7 1.5Italy 2.3 2.2 2.0 1.7

Unemployment (%)United Kingdom 4.7 4.9 5.2 5.4Japan 4.7 4.4 4.1 3.9Germany 10.6 11.7 10.7 10.4France 10.0 9.9 9.5 9.3Italy 8.0 7.7 7.4 7.3

36


International key economic data

CENTRAL AND EASTERN EUROPE

2004 2005 2006 2007GDP, yearly change in per centCzech Republic 4.4 5.0 4.8 4.5Estonia 7.8 9.2 6.4 6.4Hungary 4.2 4.2 4.5 3.8Latvia 8.3 10.2 8.0 7.0Lithuania 6.9 6.8 6.5 6.2Poland 5.4 3.2 4.7 4.5Russia 7.2 6.4 5.8 5.2Slovakia 5.5 5.7 6.0 6.5Ukraine 12.1 2.4 4.0 4.5

Inflation, yearly change in per centCzech Republic 2.8 1.9 2.5 2.8Estonia 3.0 4.2 3.6 3.0Hungary 6.8 3.6 1.7 3.2Latvia 6.2 6.7 5.8 4.5Lithuania 1.1 2.6 2.5 2.7Poland 3.5 2.1 1.5 2.1Russia 10.8 12.4 11.0 10.0Slovakia 7.6 2.7 3.5 2.2Ukraine 9.0 13.5 11.0 9.0

FINANCIAL FORECASTS

Feb 1 Mar 06 Jun 06 Dec 06 Jun 07 Dec 07Official interest ratesUS Fed funds 4.50 4.75 5.00 5.00 4.50 4.00Japan Call money rate 0.00 0.00 0.00 0.00 0.50 0.75Euro zone Refi rate 2.25 2.50 2.50 2.75 2.75 3.00United Kingdom Repo rate 4.50 4.50 4.25 4.00 4.00 4.00

Bond yieldsUS 10 years 4.52 4.60 4.60 4.50 4.40 4.30Japan 10 years 1.56 1.60 1.80 2.00 2.30 2.50Germany 10 years 3.46 3.40 3.50 3.60 3.80 4.00United Kingdom 10 years 4.15 4.10 4.00 4.00 4.15 4.30

Exhange ratesUSD/JPY 117 120 114 112 108 105EUR/USD 1.21 1.16 1.16 1.20 1.25 1.30EUR/JPY 143 139 132 134 135 137GBP/USD 1.78 1.73 1.68 1.71 1.74 1.78EUR/GBP 0.68 0.67 0.69 0.70 0.72 0.73

GLOBAL KEY INDICATORSYearly percentage change

2004 2005 2006 2007GDP OECD 3.3 2.7 2.9 2.6GDP world 5.1 4.4 4.5 4.2CPI OECD 2.2 2.4 2.1 1.9Export market OECD 10.0 7.1 8.5 7.7Oil price Brent (USD/barrel) 38.3 54.0 67.0 66.0

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