NEWS FROM DANMARKS NATIONALBANK

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1 1ST QUARTER 2015 N0 1 NEWS FROM DANMARKS NATIONALBANK PROSPECT OF HIGHER GROWTH IN DENMARK Danmarks Nationalbank adjusts its forecast of growth in the Danish economy this year and next year upwards. GDP is now forecast to grow by 2.0 per cent in 2015, which is 0.3 percentage point more than in the projection from December last year. The forecast for 2016 is 2.1 per cent, representing a marginal upward adjustment compared with the previous projection. Growth is stimulated by the continued fall in oil prices, lower interest rates and a weaker effective krone rate. Each of these three factors contributes to boosting the economy. The relatively inexpensive oil and the low interest rates both increase disposable income and hence the households opportunities to consume. And the lower effective krone rate improves Denmark s competitiveness. The effective krone rate is a weighted average of the krone s rate against the currencies of Denmark s trading partners. For Chart 1 Growth is set to be higher than previously assumed, especially in Higher growth in 2015 and 2016 Chart 1 Per cent, year-on-year GDP growth Of which upward adjustment since December

2 2 example, when the US dollar rises vis-à-vis the euro, and thus also the krone, it becomes cheaper to buy Danish goods in the USA. A NEED FOR RESTRAINT These positive contributions to the Danish economy from external factors place demands on fiscal policy. Danmarks Nationalbank recommends that the fiscal easing introduced in order to cushion the impact of the crisis be rolled back over the next couple of years. It is time for restraint, and e.g. public investment should return to a more normal level. With private sector demand set to pick up, fiscal policy should be designed to prevent the economy from accelerating too much. It is necessary for the labour force to grow at a steady pace in the coming years. The reforms of, inter alia, the unemployment benefit and pension systems in recent years should be reflected in an increase in the number of people able and willing to take on some of the new jobs created. Otherwise there will soon be a shortage of labour, and the upswing will come to a halt. question of increasing the housing tax burden, but merely of ensuring that taxes follow prices, whether they go up or down. Throughout 2014, the housing market was characterised by rising prices. The upward trend was seen not only in the large cities, but with a few exceptions all over Denmark. The general pattern is that time on market is decreasing slightly and that more homes are sold. The reason why it is important to keep a vigilant eye on the housing market is that there is a risk of a new housing bubble if the low interest rates trigger self-reinforcing price increases. Political instruments are available that can counter such fluctuations. If taxation follows prices, so that rising prices result in higher taxes and falling prices lead to lower taxes, taxes help to stabilise prices. But since 2002 there has been a freeze on property value taxes and a ceiling on the rate at which land tax can rise. Danmarks Nationalbank recommends that this policy be abandoned so that taxes will contribute to stabilising housing prices in future. RISKS IN THE HOUSING MARKET Danmarks Nationalbank calls for caution in relation to the housing market and recommends that the housing tax scheme be amended. It is not a For further information see the article Current Economic and Monetary Trends in the Monetary Review, 1st Quarter FALLING OIL PRICES WILL NOT LEAD TO DEFLATION The falls in oil prices seen in previous months will not lead to actual deflation in Denmark, i.e. to general and sustained price falls. While the lower oil prices do curb inflation here and now, the overall effect will be positive for the Danish economy. That is the main conclusion of a new analysis by Danmarks Nationalbank that looks at the consequences of the halving of oil prices within a few months. As Chart 1 shows, the fall in oil prices has had a major impact on consumer price inflation in Denmark. The immediate effect is an average price fall of 1.2 per cent because petrol, gas and oil have become cheaper. In the slightly longer term there will also be a downward impact on electricity and heating prices, and many other goods and services may also become a little cheaper. That is because the lower oil price reduces production costs.

3 3 Falling oil prices are reducing consumer prices markedly Chart 1 Percentage points Per cent, year-on-year jan-14 apr-14 jul-14 okt-14 jan-15 Energy Other goods and services Overall consumer price index, HICP (right-hand axis) - Chart 1 The oil price halved from June 2014 to January 2015, which reduced consumer prices substantially. NO DEFLATION Inflation has been marginally negative in the first months of It was -0.3 per cent in January and 0 per cent in February, but deflation is still a long way off. In certain situations, large price falls may give cause for economic concern. Such concerns would also affect Danmarks Nationalbank since one of its tasks is to ensure price stability in Denmark. These concerns would arise if prices in general fell for a protracted period, and at the same time collective bargaining resulted in wage reductions. Those two factors in combination could trigger a negative spiral: wages fall, leading to price falls, leading to lower wages, etc. in other words deflation. But the analysis shows that this is by no means the situation in Denmark. Private sector wage growth is positive and accelerating slightly, and the recently concluded collective agreements for the public sector, which generally mirror wages in the private sector labour market, certainly do not operate with negative wage growth. Typically, the wage increases agreed are around 6.5 per cent in total over the next three years. UNDRAMATIC PRICE FALLS The pronounced falls in oil prices seen over the last few months are not epoch-making. They may be dramatic for those who are dependent on and have invested in the oil market, but for society as a whole their significance is much smaller. Oil prices have dropped by just as much on many previous occasions, cf. Chart 2. They have fallen sharply and abruptly six times since the mid-1980s. Since the millennium rollover, they have dived three times. During 2001 the price of oil fell by 45 per cent, and in the 2nd half of 2008 it fell by 64 per cent. For further information see the article Falling Oil and Consumer Prices in the Monetary Review, 1st Quarter 2015.

4 4 Large oil price falls have been seen before Chart 2 Kr. per barrel per cent -48 per cent -53 per cent -45 per cent -64 per cent -50 per cent Oil price Note: Monthly price of a barrel of Brent oil stated in kroner. The most recent observation is from February The shading indicates periods when oil prices plummeted. Source: Danmarks Nationalbank and EcoWin. Chart 2 Over the last 25 years, the price of oil has fallen sharply and abruptly on six occasions. PRESSURE ON THE KRONE CAME PRIMARILY FROM DOMESTIC SOURCES When the Danish krone came under pressure from mid-january, the underlying purchases of kroner were mainly made by domestic investors. Danmarks Nationalbank s compilation shows that almost two thirds of the inflow of foreign capital and the resultant purchases of Danish kroner in both January and February came from domestic institutional investors, including pension and insurance companies, while non-resident investors accounted for just over one third. The event that triggered it all was the decision by the Swiss central bank to abandon the ceiling on the exchange rate of the franc against the euro on 15 January. Only a few hours after this announcement, the krone began to strengthen. And further interest built up one week later when the European Central Bank announced an extensive programme to purchase European government bonds. Both these announcements caused parts of the market to turn their attention to the krone.

5 5 Some investors did so to hedge themselves against risks of losses. Others including non-resident investors did so on the assumption that if it could happen in Switzerland, it could probably also happen in Denmark. However, there is one very significant difference between Denmark and Switzerland: the Central Bank had has made it clear that the ceiling vis-àvis the euro was a temporary measure. In contrast, Denmark has conducted a fixed exchange rate policy for decades, first against the D-mark, then against the euro. This policy enjoys broad support in the Danish society and from political parties across the Folketing (parliament). The pressure on the krone was strong Box 1 Sales of kroner by Danmarks Nationalbank have been historically large in early They reached kr. 106 billion in January and kr. 169 billion in February. This means that the volume sold within just over one month totalled kr. 275 billion. By comparison, sales totalled kr. 90 billion over one year (mid-2011 to mid-2012) last time it was necessary to take such measures (the sovereign debt crisis in a number of euro area member states). Back in 2008, when the financial crisis escalated, Danmarks Nationalbank had to purchase (not sell) kroner. Purchases in September and October of that year totalled around kr. 65 billion. NO CEILING ON THE FOREIGN EXCHANGE RESERVE When the krone came under pressure in mid- Janu ary, Danmarks Nationalbank applied its usual reaction function. This means that it initially sought to counter the increase in demand for kroner by intervening in the market. Depending on the volume and speed of demand for kroner, the next step is to reduce interest rates. The first reduction took place on Monday, 19 January. Subsequently, Danmarks Nationalbank continued to sell kroner and also implemented three more interest rate cuts. Other instruments were also Chart 1 Domestic investors accounted for almost 2/3 of the krone purchases, while non-residents accounted for 1/3 in January and February Who purchased kroner? Chart 1 Share January February Domestic insurance and pension sector Domestic firms and investment associations Non-residents Source: Danmarks Nationalbank.

6 6 used, including suspension of sales of government bonds. When there is upward pressure on the exchange rate of the krone, Danmarks Nationalbank keeps it stable by selling kroner and purchasing foreign exchange. Danmarks Nationalbank has access to unlimited amounts in kroner so there is no ceiling on the foreign exchange reserve when Danmarks Nationalbank sells kroner. Consequently, intervention is used more in the current situation than when there is downward pressure on the krone. During January and February, the foreign exchange reserve increased by kr. 275 billion, and it is free to expand much more if needed. In the present situation, Danmarks Nationalbank profits from selling kroner, which accrue interest at a lower Danish rate of interest, and purchasing euro, which can be invested at a higher European rate. SPECULATION AGAINST THE KRONE IS COSTLY The opposite applies to investors who sell euro in order to purchase kroner whether to hedge risks or in the hope of making a profit if the fixed exchange rate policy is abandoned. They pay a price twice. The first price to be paid relates to the interest rate spread. Interest rates are higher in the euro area than in Denmark. Holding on to euro could have given the investors a higher return. The second price is paid in the form of the exchange rate. When investors who have sold euro at relatively low exchange rates in order to purchase kroner need to sell their kroner again, they will have to pay a relatively high price per euro. This means that investors have sold euro for kroner cheap and must purchase them at a higher cost. Under the fixed exchange rate policy, Danmarks Nationalbank ensures that it should not be profitable to speculate against the krone. Both the lower Danish interest rates and the exchange rate development mean that speculation against the krone involves considerable losses. Investors taken together lose, while Danmarks Nationalbank makes a profit. For further information see the article The Danish Krone under Pressure in January-February 2015 in the Monetary Review, 1st Quarter PUBLISHING, DESIGN AND LAYOUT: DANMARKS NATIONALBANK DANMARKS NATIONALBANK HAVNEGADE 5 DK-1093 COPENHAGEN K

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