In the United States, concern about the health of the financial system continues to hold centre stage. In particular, Fannnie Mae and Freddie Mac, two federal agencies that refinance mortgage loans, saw their stocks nose-dive once again (their market capitalisation has plummeted by around 95% in a year). However, their role is crucial, since they hold directly or guarantee, between the two of them, close to 45% of outstanding US mortgage credit, i.e. an amount of USD 5,300 billion. The two companies have been badly hit by the slump in the real estate market and are facing an increasingly tough situation with respect to refinancing their own debt. The latest data from the US real estate market, in fact, showed its correction is still under way, with a fresh annualised 11% m/m decline in housing starts. Down to 965k (in annualised monthly data) they have sunk to their lowest level since March 1991. Moreover, building permits plummeted by more than 17%. Admittedly, a more reassuring message was sent by existing house sales (nearly 90% of total sales) as they may have rebounded in July (data to be released next week), after declining in June, confirming an incipient stabilisation. Nonetheless, the market might not bottom out before the end of the year. Furthermore, the latest data on producer prices merely worsened the dilemma facing the Fed, caught between the slowdown in growth and financial strains, on the one hand, and inflation on the other. Producer prices jumped 1.7% m/m in July, their fastest pace since 1981, with their year-on-year growth coming close to 11%, i.e. their highest level since the early 1980s. Excluding food and energy products, the twelve-month rise in core inflation was admittedly far weaker at 3.6%, although this was a 17-year high. The most recent statements by Fed policymakers, in fact, reflect the uncertainty within the FOMC as to when a tightening in monetary policy should start, since it is now virtually certain that the Fed’s next move will be an increase in its key intervention rates. The Fed is likely to wait until 2009, as an increase in key intervention rates is unlikely before signs of a levelling off appear in the real estate sector and the labour market. However, Jeffrey M. Lacker, the President of the Federal Reserve Bank of Richmond argued that the Fed may have to raise its interest rates even before the economy rebounds and the ongoing correction in the financial markets is ended. For his part, Robert Fisher, the President of the Federal Reserve Bank of Dallas, does not believe that the slide back in commodity prices has been significant enough to stem inflation risks, any more than the slowdown in the economy will be – he expects anaemic, or even zero, growth in the second half and does not forecast an upturn in economic activity before next year. Worried about the risk of increases in producer costs (in particular labour costs), he also pointed out that a rate hike could not be ruled out, before the cycle hit its trough and financial markets calmed down. True, Jeffery Lacker is not currently a voting member of the FOMC and Richard Fisher, for his part, was the only voting member of the FOMC to oppose, at its June and August meetings, the decision to leave interest rates on hold and he was already calling for a rate hike. The minutes of the 5 August meeting that will be published next week will provide a better view of the debate within the FOMC. In the euro zone, the fact that GDP declined in the second quarter, shedding 0.2% q/q according to Eurostat’s preliminary estimate, after it grew 0.7% in the first quarter was noteworthy: this was the first quarterly contraction in activity since the early 1990s, and confirmed the severity of the slowdown under way. All the zone’s major economies are affected, with a 0.5% fall in Germany, where this correction followed an exceptional first quarter with 1.3% q/q growth, although the downturn was less substantial than expected; while French GDP shrank for the first time since Q4 2002, dropping 0.3%, as was the case in Italy. Lastly, while Spain’s GDP did not contract, it barely inched up, gaining 0.1% q/q, while the meltdown in Spanish growth was perfectly reflected by the fall in year-on-year growth from 4.0% to 1.8% in twelve months. For the euro zone as a whole, year-on-year growth in fact slowed to just 1.5%, as average GDP growth did not top 0.3% q/q in the first two quarters. All surveys and leading indicators show that the risk of a recession has increased. In these conditions, even as inflation could begin to ebb gradually thanks to the favourable base effects related to food and energy prices, the ECB will likely maintain its monetary status quo (refi at 4.25%) for a quite lengthy period. Lastly, in the UK, GDP stagnated in Q2, due to a fall in manufacturing and construction output, while services activity growth slowed. Household consumption, investment and exports contracted. This was offset by a sharp decline in imports. The economic climate is worse than assumed by the Bank of England. This could persuade the majority of the Monetary Policy Committee members to soften the monetary stance. The most likely date is November at the update of the Committee’s inflation and growth forecasts.

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