Monetary Review 3rd Quarter

Danmarks Nationalbank Monetary Review 3rd Quarter 2000 D A N M A R K S N A T I O N A L B A N K 2 0 0 0

Danmarks Nationalbank Monetary Review 3rd Quarter 2000

The Monetary Review is published by Danmarks Nationalbank and is issued quarterly. Managing Editor: Jens Thomsen Editor: Anders Møller Christensen The Monetary Review can be ordered from: Danmarks Nationalbank, Information Desk, Havnegade 5, DK-1093 Copenhagen K. Telephone +45 33 63 70 00 (direct) or +45 33 63 63 63. E-mail: info@nationalbanken.dk www.nationalbanken.dk Schultz Grafisk A/S, Copenhagen ISSN 0011-6149 (Online) ISSN 1398-3865

Contents Recent Monetary Trends... 1 Comparison of Goods Trade and Goods Payments... 19 Macroeconomic Costs and Benefits of Price Stability... 23 Erik Haller Pedersen and Tom Wagener, Economics Theoretical considerations as well as practical experience indicate that stable prices provide the best framework for achieving a high degree of affluence in the economy. However, reducing inflation may be associated with certain immediate costs. Denmark's External Debt 1960-99... 45 Tom Nordin Christensen and Jens Hald, Statistics Denmark's external debt is mainly the result of current-account deficits over many years. Value changes due to fluctuations in stock-market prices and exchange rates have also played a central role in certain years. The Danish Export Finance Corporation... 57 Henning Dalgaard, former Assistant Governor The Danish Export Finance Corporation was established in 1975 and dissolved in 2000. History shows that interest in borrowing from DEFC declined in step with the reduction of interest subsidies as from the mid-1980s. Option Prices and Interest-Rate Expectations... 67 Klaus Jensen, Market Operations, and Tom Wagener, Economics Against the background of registered option prices the article describes a method to determine the distribution of the parties' expectations of future interest rates. Press Releases... 79 Tables and Graphs Section Vol. XXXIX/No. 3

1 Recent Monetary Trends This review covers the period from the middle of May to the end of August 2000. INTERNATIONAL ECONOMIC BACKGROUND A number of key indicators point to slightly lower growth in the US economy. In particular, since March industrial confidence has shown a clearly falling trend, cf. Chart 1. Furthermore, the retail sales index indicates more moderate growth in private consumption, despite record-high consumer confidence. The dampening follows strong growth in the 2nd quarter of 2000, when GDP was 6.0 per cent above the level a year before, according to preliminary national accounts. In line with the sustained boom in the US economy, investments showed strong growth in the 2nd quarter, accompanied by a considerable increase in labour productivity. Against the background of low unemployment, which was 4.0 per cent of the labour force in July, a precondition for continued high growth is MANUFACTURED OUTPUT AND INDUSTRIAL CONFIDENCE IN THE USA Chart 1 Per cent, year-on-year 8 Index 65 6 60 4 55 2 50 0 45-2 40-4 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 35 Growth in manufactured output (left-hand axis) Industrial confidence index (right-hand axis) Note: Industrial confidence is measured in terms of the NAPM Purchasing Managers Index. Source: Ecowin.

2 an equivalent increase in productivity or in the labour force. In August the consensus among economic forecasters was that the growth rate of the US economy will be more than 5 per cent in 2000, and just below 3.5 per cent in 2001. The trend for increasing consumer-price inflation in the USA continues. In July, the annual rate of price increases was 3.5 per cent, against just over 2 per cent one year before. The higher rate of inflation is primarily attributable to the higher oil price, although the rate of underlying inflation has also increased a little. The Federal Reserve has left the official interest rates unchanged since they were raised by 0.5 per cent in mid-may. This should be viewed against the background of the considerable tightening in May and the release of rather soft key indicators for the US economy, cf. above. The prospects of more moderate growth also affected the financial markets. The yield on the 10-year US government bond fell by approximately 0.75 per cent in the period from the beginning of May to the end of August, when it was just below 5.75 per cent, cf. Chart 2. For a period in May and June the dollar weakened against the yen and the euro, but strengthened again in July. In August the dollar weakened against the yen, but continued to strengthen against the euro. In Japan an increasing number of indicators point to an upswing in the economy. Private consumption is on the increase, employment is rising and industrial confidence is improving. However, the upswing is still tentative. One of the consequences of the preceding prolonged reces- 10-YEAR YIELDS IN GERMANY, USA AND JAPAN Chart 2 Per cent p.a. 7 6 5 4 3 2 1 Sep Oct Nov Dec Jan Feb Mar Apr May Jun Jul Aug 1999 2000 Germany USA Japan

3 GROWTH AND INDUSTRIAL CONFIDENCE IN THE EURO AREA Chart 3 Per cent, year-on-year 7 Percentage balances 9 6 6 5 3 4 0 3-3 2-6 1-9 0 1997 1998 1999 2000-12 GDP growth Growth in manufactured output Industrial confidence index (right-hand axis) Source: Ecowin. sion is that many business enterprises were forced to close down. In mid-july the large retail chain Sogo filed for compulsory liquidation with a debt that had escalated to JPY 1,870 billion. This is the largest compulsory liquidation ever outside the Japanese banking sector. Apart from reflecting the weak economy of the preceding years, the growing number of company failures indicates appropriate structural adjustments of the conditions to which the Japanese business community is subject. On 11 August the Bank of Japan decided to end the "zero-interest policy" pursued for the previous one and a half years by raising the benchmark interest rate to 0.25 per cent. In the subsequent weeks the yield on the 10-year government bond increased by approximately 0.25 per cent to around 2 per cent. The background to the increase in the long-term interest rates was the more positive prospects for the Japanese economy, as well as discussion of yet another supplementary budget, and thereby a greater supply of central-government securities. In the euro area the economic upswing now appears to have taken a firm hold. In the 1st quarter of 2000 GDP was approximately 3.5 per cent above the level of the preceding year. The upswing which commenced in the 2nd half of 1999 has been in step with the expansion of global growth, with exports from the euro area supported by the depreciation of the euro vis-à-vis especially the dollar and the yen. The course of manufacturing output and industrial confidence indicate continued

4 strong growth in the euro area's economy during the spring and summer months, cf. Chart 3. At the same time unemployment continued to fall and was in July 9.1 per cent of the labour force. Available capacity in the labour market appears to be higher in the euro area than in the USA or the UK. However, from a low level in recent years the rate of wage increases has risen in step with the upswing. In the 1st quarter of 2000 hourly labour costs rose by 3.5 per cent against the previous year. A part of the wage increase has been attributed to especially high wage levels in connection with the millennium rollover. The rate of inflation measured by the Harmonised Index of Consumer Prices, HICP, rose to 2.4 per cent in June and July. This is higher than the ECB's definition of price stability as an annual rate of increase in HICP in the range of 0-2 per cent in the medium term. However, inflation is still significantly lower than in the USA, despite the weakening of the euro against the dollar. The higher inflation rate is primarily attributable to the oil price, cf. the section on the impact of oil prices on consumer prices. However, since the autumn of 1999 there has also been a tendency for the rate of growth in prices for goods and services not immediately related to energy to increase. The annual rate of increase in HICP excluding energy and food was thus 1.3 per cent in July, against 0.9 per cent in October 1999. In terms of activity and consumer prices the development in the euro area taken as one conceals considerable variations among the individual countries. A characteristic feature of the cyclical situation in the euro area is that small and medium-sized member states such as Luxembourg, Ireland, Finland, the Netherlands and Spain are furthest into the business cycle. In these member states the average annual growth in GDP exceeded 3.5 per cent in 1997-99, compared to 2.5 per cent for the euro area as a whole, cf. Table 1. These member states also have the highest inflation, and a few of them, especially Ireland, where the inflation rate was almost 6 per cent in July, show signs of overheating. The rate of growth in the second largest economy in the euro area, France, was close to the average for the overall euro area, while growth in Germany and Italy was considerably lower. For both Germany and Italy higher growth in 2000 is expected. Economic activity in Germany is supported by an expansionary tax reform. Over a number of years as from 2001 the marginal tax rates will be lowered and personal deductions increased. On 8 June the European Central Bank, ECB, raised the official interest rates by 0.5 per cent. The rate of interest for the main refinancing operations, the refi-rate, thus reached 4.25 per cent, while the rates of interest for the deposit facility and the marginal lending facility were respectively 3.25 per cent and 5.25 per cent.

5 GDP, UNEMPLOYMENT AND INFLATION IN THE EURO AREA Table 1 GDP growth Unemployment HICP Average 1997-99 2000 1 July 1999 July 2000 July 2000 Per cent, year-on-year Per cent of labour force Per cent, year-on-year Germany... 1.7 3.0 8.8 8.4 2.0 France... 2.6 3.7 11.3 9.6 2.0 Italy...... 1.6 3.0 11.3 10.7 2 2.6 Spain... 3.9 4.2 15.4 14.2 3.7 Netherlands... 3.7 4.1 3.4 2.6 3 2.8 Belgium... 2.9 3.6 9.1 8.4 3.1 Luxembourg... 6.6 2.4 2.2 3 4.7 Austria... 2.0 3.2 3.7 3.2 2.0 Finland... 5.3 4.7 10.0 9.4 2.9 Portugal... 3.4 3.4 4.6 4.3 3.3 Ireland... 9.7 8.4 5.7 4.5 5.9 Euro area... 2.5 3.4 9.9 9.1 2.4 Sources: Eurostat and Consensus Forecast. 1 Estimate from Consensus Forecast, August 2000. 2 April 2000. 3 June 2000. The background to the decision to raise interest rates was the threat to the future price stability of the euro area as a consequence of rising import prices in a period of strong economic growth and expansionary credit conditions. The high oil prices and the euro's depreciation were reflected in import prices. As from 28 June the ECB adjusted the procedure for the weekly main refinancing operations from fixed rate tenders to variable rate tenders. Liquidity is now supplied according to an American auction principle, whereby the counterparties offer bid rates as well as bid amounts. The bids at the highest interest rate are accommodated first and the ECB then accepts successively lower interest rates until the desired allotment is reached. The new auction principle is a reaction to the very high bid amounts and thereby low allotment ratios which were the result of the previous fixed rate tender principle. At the same time the ECB fixed a minimum bid rate of 4.25 per cent. The marginal rate, i.e. the lowest rate of interest at which liquidity is allotted, was around 4.30 per cent up to and including the auction on 8 August, cf. Chart 4. In the following three auctions the monetary-policy counterparties submitted bids at interest rates somewhat higher than the minimum bid range. Against this background the ECB's marginal rate was increased steadily. At the auction on 29 August the marginal rate was 4.68 per cent. On 31 August the ECB again raised the official interest rates by 0.25 per cent on the grounds of the development during the summer in the factors which were the basis for the interest-rate increase in June. The

6 INTEREST RATES AND BIDS IN THE ECB'S MAIN REFINANCING OPERATIONS Chart 4 Per cent p.a. 5 4.75 4.5 4.25 4 3.75 3.5 3.25 3 Euro billion 9,000 8,000 7,000 6,000 5,000 4,000 3,000 2,000 1,000 2.75 Jan Feb Mar Apr May Jun Jul Aug 0 Refi rate/minimum bid rate Marginal rate Bid amount (right-hand axis) minimum bid rate was raised to 4.50 per cent, while the rates of interest for the deposit facility and the marginal lending facility were raised to respectively 3.50 per cent and 5.50 per cent. In the following auction on 5 September the marginal rate was fixed at 4.55 per cent. Against the background of an expected tightening of monetary policy by the ECB the money-market interest rates in the euro area rose by approximately 0.5 per cent in the period from mid-may to the end of August. In the same period the long-term interest rates showed a slightly declining trend. At the end of August the yield on the 10-year German government bond was thus approximately 5.3 per cent, compared to 5.4 per cent in mid-may. The drop in long-term interest rates in the euro area was slightly less pronounced than in the USA, but their level is still somewhat lower than in the USA, cf. Chart 2. In a number of European countries the future government borrowing requirement and thereby the supply of government bonds will be affected by extraordinary revenue from the sale of UMTS (Universal Mobile Telephone System) licences. Pursuant to an EU directive these licences must be allocated to operators before 2002. In Germany the licences were allocated at an auction from which the central government realised revenue of approximately 51 billion euro or around 2.5 per cent of Germany's GDP. A similar auction allocation principle was applied in the UK, from which the proceeds were slightly higher as a ratio of GDP, and in the Netherlands where the proceeds were somewhat lower.

7 INFLATION AND EFFECTIVE EXCHANGE RATE IN THE UK Chart 5 Per cent, year-on-year 3.5 January 1997 = 100 120 3 115 2.5 110 2 105 1.5 1997 1998 1999 2000 RPIX inflation (left-hand axis) Inflation target (left-hand axis) Effective exchange rate (right-hand axis) 100 Note: An increase in the effective exchange rate implies appreciation. At the meeting of the European Council in Portugal in June it was decided that Greece should join EMU as of 1 January 2001. The conversion rate will be 340.75 drachma per euro, equivalent to the central rate in the current ERM II. At the end of June, and again at the beginning of September, the Bank of Greece lowered the official interest rates as an element of the adjustment to the monetary policy of the euro area. The most recent adjustment was the lowering of the rate of interest for 14-day money-market transactions by 0.75 per cent to 7.5 per cent. The convergence towards the ECB's interest rates was accompanied by equivalent convergence of the money-market interest rates, while at the same time the exchange rate approached its central rate. The sustained upswing in the UK economy continued in the 2nd quarter of 2000 when GDP was more than 3 per cent above the level in 1999. The improvement was strongest in the service sectors, but the gap to other sectors was less pronounced than before. With an unemployment rate of only 3.7 per cent of the labour force the UK's labour market is tight. During the spring consumer prices showed a tendency to accelerate in step with minor depreciation of the pound sterling, cf. Chart 5, and rising oil prices. The annual rate of increase in the RPIX index, on which the Bank of England's inflation target is based, was 2.2 per cent in July. The Bank of England stated in its inflation report of August 2000 that it expected the rate of price increase to exceed the target of 2.5 per cent during the next year, despite expectations of a dampening of growth.

8 The Bank of England's official interest rates have remained unchanged in the period covered by this Monetary Review. The Bank of England's Monetary Policy Committee has stated openly that on making its interest-rate decisions it faced a dilemma between a tight labour market and an overvalued currency. The Swedish economy continues to be characterised by strong growth and low inflation. The annual increase in GDP was 4.0 per cent in the 2nd quarter of 2000, according to preliminary national accounts, while in July consumer prices were 0.9 per cent higher than in 1999. The low inflation rate should be viewed in the light of such factors as strongly declining prices for telecommunication services. In its inflation report for June Sveriges Riksbank expected GDP growth of almost 4.5 per cent in 2000 and 3.5 per cent in 2001. Up to mid-2001 the inflation rate is expected to be below the target of 2 per cent. Yields on 10-year government bonds in the UK and Sweden have taken a generally similar course, reaching around 5.25 per cent at the end of August, despite great variation between the official interest rates, cf. Chart 6. For short periods the long-term interest rates in both countries were slightly lower than the corresponding German rate. In Sweden this could be attributed to the announcement of the government's buyback of government bonds in connection with the Telia liberalisation. Norges Bank raised its interest rates by 0.5 per cent on 15 June and by a further 0.5 per cent on 10 August. After the raising of interest rates in INTEREST RATES IN THE UK AND SWEDEN Chart 6 Per cent p.a. 6.5 6 5.5 5 4.5 4 3.5 3 Jan Feb Mar Apr May Jun Jul Aug Repo rate, UK Repo rate, Sweden 10-year yield, UK 10-year yield, Sweden

9 August the deposit and lending rates were respectively 6.75 and 8.75 per cent. The background to the tightening measures was the weakening of the Norwegian krone and capacity problems in the Norwegian economy. In connection with the most recent raising of interest rates Norges Bank also stated that the next interest-rate adjustment would probably be another increase. The Icelandic krone came under pressure for a period in June, and again in July. To avoid a sharp depreciation of the Icelandic currency the Icelandic central bank intervened in the foreign-exchange market and raised the interest rate. The foreign-exchange unrest followed the release of poor key economic indicators for Iceland, but the Icelandic central bank found that speculative attacks also played a role. The upswing in Latin America and Asia continues after the crisis in 1997-98. The development has been driven by exports, but domestic demand has also begun to increase. However, the overall picture conceals great variations among the countries. Especially in certain Latin American countries economic growth is hindered by political unrest. THE IMPACT OF OIL PRICES ON CONSUMER PRICE INFLATION After a drop in March and the beginning of April the oil price rose to extremely high levels in July and August. At the end of August the price of crude oil was around 35 dollars per barrel. Oil price fluctuations have a direct impact on consumer prices via the sub-index for energy products. A rule of thumb for the euro area is that an oil price increase of 10 per cent raises the sub-index for energy products in HICP by 1 per cent, cf. the relationship between the axes in Chart 7. Since the energy index accounts for approximately 10 per cent of the total consumer price index an oil price increase of 10 per cent will increase the consumer price index by approximately 0.1 per cent. However, this is not a mechanical correlation. Firstly, energy tax adjustments have affected the sub-index for energy products and thereby the overall consumer price index, even though the oil price remained unchanged. Secondly, higher energy prices will tend to increase the costs of domestic processing, including transport costs. Whether these costs spill over to consumer prices will depend on factors such as the competitive situation and capacity utilisation. Thirdly, higher energy prices erode consumer purchasing power. This can lead to a demand for compensation via wage increases which do not reflect a corresponding increase in labour productivity, thereby increasing underlying inflation. OPEC has agreed to increase output should the price of an "oil basket" from various producers exceed 28 dollars for more than 20 days. On the

10 GROWTH IN OIL PRICE AND HICP FOR ENERGY PRODUCTS IN THE EURO AREA Chart 7 Per cent, year-on-year 250 Per cent, year-on-year 25 200 20 150 15 100 10 50 5 0 0-50 -5-100 1997 1998 1999 2000-10 Oil price (left-hand axis) HICP, energy products (right-hand axis) Note: The rate of increase in oil prices is measured by the price for Brent oil in euro. HICP is the Harmonised Index of Consumer Prices. The most recent observation is July 2000 for the consumer price index and 1 September for the oil price. GROWTH IN GDP OF THE OECD COUNTRIES AND IN COMMODITY PRICES Chart 8 Per cent, year-on-year 6 Per cent, year-on-year 40 5 30 4 20 3 10 2 0 1-10 0-20 -1 1985 1990 1995 2000-30 GDP (left-hand axis) Commodity price index, excluding energy (right-hand axis) Note: The commodity price index measured in dollars. Source: OECD Economic Outlook no. 67.

11 other hand, output will be reduced should the price drop below 22 dollars. In so far as this agreement functions in practice energy prices can be expected to fall in the immediate future. There are, however, other factors that indicate rising inflation in both the USA and the euro area. The key factor in the USA is high capacity utilisation, while in the euro area it is the general increase in import prices as a consequence of the euro's depreciation. Moreover, the spillover of energy prices to the rest of the economy may be subject to a certain time lag in both economies. Finally, higher global growth may lead to a further increase in commodity prices, and thereby greater pressure on costs, cf. the normal relation between global activity and commodity prices in Chart 8. DEVELOPMENT IN INTEREST AND EXCHANGE RATES IN DENMARK Danmarks Nationalbank raised the discount rate and the current-account rate by 0.5 per cent to 4.25 per cent following the ECB's raising of interest rates on 8 June. The lending rate and the rate of interest for certificates of deposit were increased by a little more i.e. by 0.6 per cent to 4.7 per cent since on the days around 1 June the Nationalbank sold foreign exchange for approximately kr. 10 billion. From mid-may until mid-july the money-market interest rates in Denmark rose by almost 1 MONEY-MARKET INTEREST RATES AND BOND YIELDS Chart 9 Per cent p.a. 9 8 7 6 5 4 3 Jan Feb Mar Apr May Jun Jul Aug The Nationalbank's deposit rate 3-month CIBOR 2-year government bond 10-year government bond 30-year building bond Note: The yield on 30-year building bonds is the weighted yield of the Association of Danish Mortgage Banks. The increase of approximately 0.5 per cent at the beginning of July is attributable to a shift towards issues with a coupon rate of 8 per cent.

12 INTEREST-RATE DIFFERENTIAL TO THE EURO AREA AND OPINION POLLS ON DENMARK'S ENTRY TO EMU Chart 10 Per cent p.a. 1.4 Percentage points 4 1.2 2 1 0 0.8-2 0.6-4 0.4-6 0.2-8 0 Apr May Jun Jul Aug 3-month interest-rate differential (left-hand axis) Difference between "no" and "yes" (right-hand axis) -10 Note: The difference between a "no" and a "yes" is the average of opinion polls conducted by Megafon/TV2, Greens, Gallup, BG-Bank, Vilstrup, Sonar and IFKA. The curve shifts in step with opinion polls from the individual institutes. per cent, cf. Chart 9. The increase was particularly pronounced at the turn of the month from June to July when the Nationalbank also sold foreign exchange for kr. 5 billion to cushion the fluctuations in the krone rate. In the period covered by this Monetary Review the krone rate was close to its central rate of kr. 7.46038 per euro. The increase in short-term interest rates up to mid-july is partly a consequence of the raising of interest rates in June. The opinion polls prior to Denmark's referendum on the adoption of the euro on 28 September also have an effect, cf. Chart 10. The interest-rate differential to the euro area thus widened with the decrease in support for EMU in June and the beginning of July, and then narrowed as support for the euro returned. Against the background of the aforementioned development in the ECB's marginal rate for allotment of liquidity the lending rate and the rate of interest on certificates of deposit were raised by 0.2 per cent on 23 August and again on 30 August, and lowered by 0.1 per cent on 6 September. After the most recent adjustment both interest rates were 5.0 per cent. The discount rate and the current-account rate were raised by 0.25 per cent to 4.5 per cent on 1 September as a direct consequence of the ECB's raising of the minimum bid rate by 0.25 per cent. The increase in short-term interest rates from May led to a generally flat yield curve in the range from 3 months to 10 years, cf. Chart 9.

13 DOMESTIC ACTIVITY AND THE BALANCE OF PAYMENTS The preliminary national accounts indicate a decline in economic activity in Denmark in the 1st quarter of 2000. The seasonally adjusted gross domestic product was 0.6 per cent lower than in the 4th quarter of 1999, but 1.7 per cent higher than one year before. The background was a decrease in both private consumption and exports. The drop in consumption concerned car sales, which fell by almost 20 per cent against the 4th quarter of 1999. Car sales decreased by a further 5 per cent in the 2nd quarter, when nonetheless there were indications of stronger growth in the other components of consumption. The retail sales index thus continued to indicate a rising trend, and lending by banks to households rose steadily in May and June. The strong growth in consumption was supported by increased consumer confidence. The rate of growth in lending to the business sector continues to be higher than in lending to households. The borrowing requirement reflects factors such as expanding investment. However, the trend shown by borrowing is not reflected in the money supply, which has increased only moderately. Prices for houses and owner-occupied flats have generally risen to very high levels after strong growth for a number of years. However, the annual rate of increase has been diminishing since the autumn of 1997, while the number of transactions has fallen, cf. Chart 11. In this respect the housing market has been subject to a certain dampening, but in terms of the annual rate of increase, however, house prices have risen more strongly than prices for consumer goods. Employment increased by approximately 35,000 persons in the first two quarters of 2000, according to statistics from ATP (the Danish Labour Market Supplementary Pension Fund). The improvement was particularly strong in the 1st quarter, which should be viewed against the background of a decline in the 4th quarter of 1999, and a strong increase in the construction sector to handle repairs after the hurricane which swept across Denmark in December 1999. Manufacturing industry, which is driven by exports, accounted for a large part of the increase in employment in the 2nd quarter. Unemployment ceased to decline in the spring, but the labour market is still tight. In July the rate of unemployment was 5.4 per cent of the labour force. In the first 5 months of 2000 the current-account surplus was by and large equivalent to the surplus in the same period in 1999, i.e. an annual surplus of kr. 15-20 billion. The improvement achieved in 1999 is thus maintained. This improvement reflects the dampening of domestic demand, but also factors which are unequivocally external. These include

14 CASH HOUSE PRICES AND NUMBER OF TRANSACTIONS Chart 11 Per cent, year-on-year 14 1.000 transactions 58 12 56 10 54 8 52 6 50 4 1996 1997 1998 1999 2000 48 Growth in house prices (left-hand axis) Number of transactions (right-hand axis) Note: Sales as the sum of 4 quarters. Source: Statistics Denmark. increased activity on Denmark's export markets, improved competitiveness against the background of the depreciation of the effective krone rate, and higher oil prices. Denmark's energy output has accelerated in terms of volume, and especially in value terms, in step with the higher oil prices, and energy products account for a large proportion of the improvement in the trade balance. In mid-2001 Denmark is expected to allocate UMTS licences by auction, as in the UK, Germany and other countries. In view of the experience from these countries the sale of licences can be expected to yield considerable revenue. This extraordinary revenue should contribute to a further reduction of the government debt, which totalled kr. 640 billion in 1999, or more than half of GDP. If the debt is reduced, the burden of interest expenditure on the government budget balance will also become lighter. In view of an increased elderly dependency ratio it is important to increase the scope of future fiscal policy. The government's draft Finance Bill for 2001 includes a minor relaxation of fiscal policy due to increased expenditure on education and health in the local government service sector. In view of the prospects of continued growth in the economy the government finance surplus is expected to be kr. 31 billion or 2.4 per cent of GDP, on a par with 2000.

15 WAGES AND PRICES DEVELOPMENT IN CONSUMER PRICES AND NET RETAIL PRICES Table 2 Consumer price index Index of net retail prices Energy Imports Total In July consumer prices in Denmark were 2.8 per cent higher than in 1999, measured in terms of HICP. As in other countries inflation has increased in view of rising oil prices, but the development in rent and food prices also contributed to higher inflation in 2000. On the other hand, underlying inflation has decreased, cf. Table 2. "Other factors" fell to below 0.5 per cent in the 2nd quarter, reflecting a lower rate of wage increases and pressure on profit margins from a combination of weaker demand and strong increases in import and oil prices. Consumer prices are still increasing at a faster rate than in the euro area, although the inflation differential has narrowed during 2000. In July the annual rate of increase in HICP in Denmark was thus 0.4 percentage point higher than in HICP in the euro area, compared to 1.3 percentage point at the end of 1999. The narrowing is attributable par- Foodstuffs Domestic prices Rent Public services Other factors Weights HICP CPI 1.000 0.088 0.143 0.769 0.144 0.250 0.039 0.335 Year-on-year growth, per cent 1993... 1.3 1.4-0.9 0.0 1.9-0.2 2.1 1.7 2.7 1994... 2.0 1.6-3.1 2.1 2.0 3.0 1.6 2.4 1.6 1995... 2.0 2.1 1.9-2.5 2.5 2.2 3.1 1.8 2.5 2.0 1996... 2.1 2.1 2.0 6.6 0.1 1.9 1.7 1.6 1.1 2.4 1997... 1.9 2.2 2.2 2.7 0.9 2.4 3.6 2.8 2.2 1.8 1998... 1.3 1.9 1.5-2.8 0.6 1.9 1.8 2.1-0.9 2.3 1999... 2.0 2.5 2.1 2.1-0.3 2.5 0.6 2.7 3.5 3.0 1998 1st qtr.... 1.6 2.0 1.8-1.7 1.4 2.1 4.1 2.5-0.4 1.6 1998 2nd qtr... 1.4 2.0 1.7-0.7 0.9 2.0 2.5 2.1-1.5 2.3 1998 3rd qtr.... 1.2 1.7 1.2-4.0 0.4 1.7 0.6 1.9-1.9 2.6 1998 4th qtr... 1.1 1.7 1.2-4.7-0.1 1.9 0.1 2.0 0.4 2.8 1999 1st qtr.... 1.4 2.0 1.5-7.0-0.7 2.4 0.3 2.8 2.1 3.1 1999 2nd qtr... 1.8 2.3 1.8-1.4-0.8 2.4-0.2 2.5 4.5 3.1 1999 3rd qtr.... 2.3 2.6 2.3 5.7-0.2 2.5 0.7 2.8 3.8 2.8 1999 4th qtr.... 2.8 3.0 2.8 11.5 0.4 2.6 1.7 2.7 3.6 2.7 2000 1st qtr.... 2.8 3.1 3.4 24.1 2.1 2.1 2.6 3.1 3.6 1.0 2000 2nd qtr... 2.9 3.2 3.5 21.6 4.1 2.0 3.4 3.5 3.6 0.3 Note.: Weighting basis as of December 1999. The index of net retail prices is the consumer price index adjusted for indirect taxes, duties and subsidies for general price reductions. "Other factors" is a measure of domestic market-determined inflation. "Other factors" normally increases faster than the index of net retail prices due to an overweight of services for which the price development is typically stronger than for other commodities. HICP is the Harmonised Index of Consumer Prices.

16 INFLATION AND THE INFLATION CRITERION OF THE MAASTRICHT TREATY Chart 12 Per cent, year-on-year 2.8 2.6 2.4 2.2 2 1.8 1.6 1.4 1.2 1998 1999 2000 Danish inflation Threshold value Note: Inflation relates to the average annual rate of increase in HICP in the last 12 months, rounded to one decimal place. Most recent observation July 2000. The threshold value is the average for the three member states with the lowest inflation rates, with the addition of 1.5 per cent. ticularly to energy prices, while the actual differential is related to such factors as higher rent increases in Denmark. In more general terms, recent years' higher inflation in Denmark can be attributed to a somewhat higher rate of wage increases in Denmark than in the euro area. On the other hand, during 2000 so far the rate of wage increases has declined in Denmark and increased in the euro area. In the 1st quarter the annual rate of increase in hourly wage costs was thus around 3.5 per cent in both Denmark and the euro area, and it remained at this level in Denmark in the 2nd quarter. The continuation of this trend is particularly positive with regard to price stability and competitiveness. However, the apparent convergence of the rates of wage increases is subject to some uncertainty since, as stated, the development is registered for only one quarter. In January 2000 and again in May, June and July Denmark exceeded the inflation criterion for entry to EMU. According to the criterion inflation in an applicant country may not exceed a threshold value which is the average for the 3 EU member states with the lowest inflation rates, with the addition of 1.5 per cent. The applied measure of inflation is the most recent 12-month average of the annual rate of increase in HICP. The calculation convention applied is that rates of increase are rounded to one decimal place, so that the difference between inflation in an applicant country and the threshold value of the criterion will always be

a rounded number of points per thousand, cf. Chart 12 which shows that Denmark exceeded the criterion by 0.2 percentage point in July 2000. The threshold was based on price trends in France, the UK and Sweden. In July alone the UK had the lowest inflation rate in the EU, i.e. an annual rate of increase in HICP of 1.0 per cent. The UK was followed by Sweden at 1.3 per cent and Germany, France and Austria at 2.0 per cent. The gap between Denmark's inflation rate of 2.8 per cent and the inflation rates of the 3 EU member states with the lowest inflation was thus less than 1.5 per cent. The fact that Denmark nonetheless exceeded the criterion in July is due to the criterion's focus on the development over a longer term. This makes the criterion robust to extreme observations in certain months, but on the other hand, it gives little indication of the most recent development. In view of the recent wage and price trends Denmark is expected to meet the inflation criterion in the course of a few months. 17

19 Comparison of Goods Trade and Goods Payments Since summer 1999 Statistics Denmark and Danmarks Nationalbank have compared the compilation of trade in goods in the external trade statistics with the compilation of goods payments in the settlement statistics 1. The comparative survey was instigated by the Ministry of Economic Affairs and took advantage of the particulars in the new reporting system for settlement statistics launched by the Nationalbank in October 1998. The reason for the survey was a considerable discrepancy between the official current account and current account of payments in 1998, cf. Chart 1. Since then the discrepancy between the two compilations has narrowed, and during the period covered by the survey the official current account generally accorded with the current account of payments in the settlement statistics. However, the parallel course of the two compilations covers substantial level differentials between the two statistical compilations, especially with regard to trade in goods, where revenue and expenditure in the settlement statistics exceed exports and imports 2 of goods in the external trade statistics by kr. 20-30 billion on an annual basis. The aim of the investigation was to compare the goods trade and goods payments reported by a number of enterprises to respectively the external trade statistics and the settlement statistics for selected periods of 1999 and the beginning of 2000. It goes without saying that it was impossible to investigate and thereby explain the significant difference between the two compilations for 1998. During the period of the investigation both the number of enterprises and the periods of comparison were successively increased. At the time of conclusion, slightly more than 170 enterprises had participated in the comparative survey. 1 2 The external trade statistics are prepared by Statistics Denmark. It is the main element of good compilation in the official current account published by Statistics Denmark. The settlement statistics are prepared and published by the Nationalbank as statistics of external payments. The official goods payments net of payments concerning repairs and bunkering, net of trade in ships and aircraft and transactions of the Faroe Islands and Greenland with rest-of-world countries. In the external trade statistics exports and imports are compiled at FOB value.

20 CURRENT ACCOUNT OF PAYMENTS AND CURRENT ACCOUNT OF THE BALANCE OF PAYMENTS Chart 1 Kr. billion 25 20 15 10 5 0-5 -10-15 -20 Jan Mar May Jul Sep Nov Jan Mar May Jul Sep Nov Jan Mar May 1998 1999 2000 Current payments (Danmaks Nationalbank) Current account (Statistics Denmark) Note: Accumulated over 12 months. The provisional results were published in December 1999 1. They showed a tendency for over-reporting of both export and import payments in the Nationalbank's settlement statistics, primarily as a consequence of erroneously reporting by enterprises of merchandise payments. The comparative survey was concluded on the publication of the final report in June 2000 2. Overall, the comparison of the external trade statistics with goods payments in the settlement statistics has explained only a minor part of the level differentials between the two compilations, and the result does not affect the current account of payments. The result of the survey is a downward adjustment of goods payments by approximately kr. 3 billion on expenditure as well as revenue reporting during the period January 1999 to February 2000. Nevertheless, the very greatest part of the present level differentials between goods revenue and goods exports and between goods expenditure and goods imports remains unexplained. Moreover, the reporting of goods payment for some enterprises covers offsetting payment, so called netting payments. In addition an adjustment for this will also tend to widen the level differentials between the two statistical compilations with regard to goods. 1 2 Report on the Project to Improve the External-Trade and Balance-of-Payments Statistics (in Danish) published by Statistics Denmark in December 1999. Report on Improvement of the External-Trade and Balance-of-Payments Statistics (in Danish) published by Statistics Denmark in June 2000.

All in all it is more likely, the reason for the level differentials is that the two statistics are based on different concepts with different methods of collection and compilation. The settlement statistics are based on data on external payments reported by banks, which in principle covers all external payments. Errors are typically related to an incorrect statement of the payment purpose. On the other hand, the external trade statistics are based on cross-border trade in goods reported by export and import enterprises. Data is collected on the basis of surveys and does not necessarily give a full picture of goods imports and exports. Finally, it must be borne in mind that the two statistical compilations will always deviate if compared on a monthly basis due to the time lag between the time of payment and the time of transaction. A discrepancy between the two sets of statistics' in the range of kr. 5-10 billion should therefore be seen as a consequence of the abovementioned differences. Even though the comparison fails to explain the current differentials it has provided valuable input for improving the quality of information on both the goods payments as well as goods imports and exports. The cooperation between Statistics Denmark and the Nationalbank on the comparative survey of goods trade and goods payments will continue as part of the general cooperation between Statistics Denmark and the Nationalbank. In the spring this cooperation was formalised by a cooperation agreement in the statistics area. In respect of the Nationalbank the investigation has brought the reporting of goods payments in focus. The Nationalbank has thus initiated its own survey of merchandise payments in settlement statistics. This thematic survey comprised almost 50 enterprises selected on the basis of their unbalanced reporting of revenue and expenditure of merchandise payments. Processing the results of this thematic survey is not yet concluded, but preliminary results indicate overestimation of goods revenue by almost kr. 2 billion for the period from January 1999 to mid-march 2000, and underestimation of goods expenditure by just over kr. 1 billion. Although this will have an impact on the goods payments, the current account of payments is not affected since the payments for goods and services are merely redistributed. The results of the survey will be included in data releases when they are finalised. The survey is still being followed up by systematic monitoring of the reporting of merchandise payments. Furthermore, in the near future a new thematic survey on reporting by enterprises using netting in the settlement of goods transactions will be initiated. The thematic surveys are expected to reduce the extent of reporting errors with regard to goods payments. 21

22 The Nationalbank also compares data from the settlement statistics with reports for the compilation of Denmark's international investment position and with the monthly money and banking statistics. This is an ongoing effort to improve the quality of the settlement statistics. However, there are continuous shifts in settlement instructions for both current and financial transactions. From time to time this can lead to errors in reports to the settlement statistics. It is sought to prevent actual systematic reporting errors through ongoing dialogue with the reporting banks.

23 Macroeconomic Costs and Benefits of Price Stability Erik Haller Pedersen and Tom Wagener, Economics INTRODUCTION Today price stability is an objective of most central banks in the western world. The central banks of many countries have also been given considerable independence from policy-makers to determine monetary policy. Price stability is regarded as a central element of the framework for a sound and affluent economy. The notion that it is possible in the longer term to reduce unemployment permanently and stimulate economic growth by maintaining a higher rate of inflation no longer applies in theory or in practice. However, it is recognised that in the very short term, under certain circumstances, stronger growth can be achieved by inflating the economy, while the costs will not affect the economy until later. The literature describes an "inflation bias" in economic policy. In recent years this has led to an explicit division of labour in the economic policies of many countries, including Sweden, the UK and the euro area member states, whereby an independent central bank concentrates on maintaining price stability. It is important to emphasise that a central bank's pursuance of price stability must be considered together with the rest of economic policy. An overall objective to maintain stable prices does not in itself mean that other social objectives such as employment or distribution policy are given lower priority. Meeting these objectives is the task of especially fiscal and structural policy, and thereby of the government and parliament. Monetary policy contributes to achieving these objectives mainly through the maintenance of price stability. The costs and benefits of inflation, including the costs and benefits of pursuing price stability as a principal monetary-policy objective, are described in the following 1. The theoretical arguments in favour of and against price stability are considered, before turning to an account of Danish experience, with focus on the last 30 years. 1 In recent years extensive theoretical and empirical literature on monetary-policy objectives and strategies has been published. See the overview in Journal of Monetary Economics (1999), Special Issue and Lyngesen (1999).

24 PRINCIPAL CONCLUSIONS Inflation defined as a sustained increase in the general price level in excess of a few per cent per annum has numerous negative consequences for a market economy. They include unintended redistribution of wealth between various groups in society, aggravation of imbalances in the economy and in the longer term, lower employment. The higher the inflation rate, and the stronger its fluctuation, the greater the negative effects will be. Inflation, and not least uncertainty concerning the future inflation rate, tend to increase the element of uncertainty underlying the financial decisions of households and business enterprises with regard to savings, consumption, investments, etc., and thereby the utilisation of society's resources. Inflation generally encourages "short-sighted" economic decisions. It also complicates the planning of economic policy. Unexpected changes in the level of the rate of price increases lead to random redistribution as capital gains/losses between creditors (lenders) and debtors (borrowers), unless index-linking is applied to contractual undertakings. In the housing market inflation reinforces the differences in the terms applying to various groups of buyers. High inflation, combined with the taxation system, in particular the taxation value of deductible interest payments, was a significant factor contributing to the imbalances in the Danish economy in the 1970s and the first part of the 1980s. The subsequent development is an example of how a credible economic policy can reduce the rate of price increases without imposing high real costs such as higher unemployment and a shortfall in growth. A key precondition was to eliminate the close correlation between wage and price increases via the automatic costof-living adjustments. Danish experience shows that the indexation of the economy did not solve the inflation problem, as is often described in the textbooks, but was actually part of the problem. Price formation has strong inherent dynamics since inflation, via wage formation, is dependent on the expectations of future inflation. To avoid this self-amplifying effect it is vital that economic policy and the authorities' willingness to maintain price stability are credible. A change in general attitudes was required to dispose of the notion that high nominal wage increases automatically implied higher real wages. Chart 1 shows the development in inflation and real wages in Denmark over the last 30 years. It supports the conclusion that a low inflation rate is an excellent safeguard against erosion of real wages. There are weighty arguments against setting the inflation target at exactly zero, so in practice a low inflation objective is the most appropriate.

25 INFLATION AND GROWTH IN REAL WAGES IN DENMARK Chart 1 Per cent p.a. 16 14 12 10 8 6 4 2 0-2 -4 1970 1972 1974 1976 1978 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 Growth in real wages Inflation Note: Real wages are calculated as hourly wages in manufacturing industry deflated by the consumer price index. Inflation is the increase in the consumer price index. EXPECTED INFLATION In the theoretical literature on the costs of inflation to the overall economy a distinction is normally made between the effects on the economy of respectively predicted and unpredicted inflation. In the first group of studies the channels through which inflation as an economic phenomenon affects the economy are analysed, while the focus of the second group is more specifically on the effects due to uncertainty concerning inflationary development. Bailey (1956) is a classical reference with regard to the costs of completely expected inflation. The argument is that inflation is like a tax on the cash funds of the citizens, since via its impact on the nominal interest rate inflation increases the loss on holding non-interest-bearing cash rather than investing in interest-bearing securities, e.g. bonds. This is an incentive for the general public to reduce their holdings of cash funds, so that they have to make more frequent cash withdrawals for current transactions. It implies "shoe-leather costs" whereby the citizen has to go to the bank more frequently. Lucas (2000) presents a more recent overview of this literature. Predicted inflation also entails macroeconomic costs in so far as collecting information on price trends and changing price tags, sales brochures, etc. require resources and time. These costs are termed "menu

26 costs", see Ball (1994). The costs also arise in the case of fully predicted inflation, but increase if the inflationary development cannot be predicted. The higher the rate of inflation, the higher the "menu costs". The complex interaction between inflation and the tax system affects the economy, but it is difficult to separate the effects of inflation from the effects of the tax system itself, which has its own distorting effect. This effect should naturally be viewed in conjunction with the contribution of tax revenues to upholding the welfare state. The interaction between taxation and inflation has a distorting effect on the financial decisions of households and business enterprises, which can be avoided if price stability is maintained. The problem can be divided into two elements. On the one hand, inflation and the interest-rate level, and on the other inflation and the tax wedge, i.e. the difference between real interest rates before and after tax. Regarding the influence of inflation on the interest-rate level, the question is how an expected price-increase rate spills over to the nominal interest rate. This issue was already discussed by Fisher at the end of the 19th century; Fisher (1896). The argument here is that inflation expectations affect the nominal interest rate in a 1:1 ratio, giving the Fisher equation. In a small open economy this mechanism means that expectations of 1-per-cent higher inflation spill over into expectations of currency depreciation at 1 per cent p.a. which again is transmitted into lifting the nominal domestic interest rate. If taxes are introduced in the system it must be considered how inflation affects real interest rates. In a small open economy it is reasonable to assume that the real interest rate before tax is constant, corresponding to growth in the nominal interest rate on a par with inflation expectations, i.e. in accordance with the Fisher equation. This spillover mechanism implies that the real interest rate after tax declines in step with inflation, cf. Box 1. The same applies to the required yield on investments, thereby stimulating business investments. In a small open economy with a fully credible exchange-rate objective such as Denmark's it can be argued that the nominal level of interest rates rather than the real interest rate before tax is determined by external factors. In this case an inflation rate which deviates from that of the outside world for a certain period will have a direct impact on the domestic real interest rates both before and after tax. In a large closed economy such as the US the opposite is often assumed, i.e. that the real interest rate after tax is kept constant by the households' required return on savings. Therefore the nominal interest rate increases faster than inflation expectations. This implies that 1-per-cent higher inflation requires a 1.5-per-cent higher nominal interest rate before tax, if