Publications

• The past decade has seen a huge expansion in the kinds of risks that can be traded on global financial markets
• Nowhere is this more true than in the global credit and credit derivatives markets
• The creation of these markets is a good example of what economists call ‘market completion’ 
• But they also display unmistakeable signs of what economists call ‘market failure’ 
• ‘Market completion’ is a good thing in that it allows more real investments to be made than would otherwise be possible 
• But ‘market failure’ is a bad thing and could mean that the total quantity of risk in the market may now be sub-optimally high 
• Despite the current turmoil, our guess is that market completion is the bigger story.  So a ‘full-blown’ credit crunch is unlikely.  

Full note attached.

• The decline in unemployment across the euro area in recent years has been very impressive, and now appears to have taken it below estimates of the NAIRU 
• We expect that trend to continue, but not to lead to significant wage pressures      
• A standard economic model suggests that labour is currently very cheap across the euro area as a whole. Hence there may be room for demand for labour to rise significantly, without igniting wage pressures      
• Moreover, there may also be grounds for arguing that the euro area NAIRU could fall further, towards estimates for the US and UK 
• Substantial progress has been made in bridging the structural gap with the US and UK, though there is plenty of scope for further improvement 
• In the meantime, the ECB has room to give euro area growth a chance.

The attached slide presentation goes through our updated CPI and RPI forecast, and includes a breakdown of the 17 April data into news and noise. It shows that we continue to believe that despite yesterday's shock, UK inflation is set to drop dramatically over the rest of 2007, with CPI inflation reaching 1.5% and RPI falling to 3% in the final quarter, respectively.

• Over the past decade, demand for US assets has been underpinned by a belief in its superior productivity performance
• But last year US productivity growth slowed to its slowest rate since 1995, and per capita GDP growth was lower than the euro area’s rate of growth
• We ask if the ‘New Economy’ miracle is over, or whether this is just a cyclical blip around a still solid trend?
•  In order to unravel the source of the slowdown, we describe an extension to the standard growth accounting framework, recently developed by economists at the NY Fed. This extension allows us to examine the role of ICT investment explicitly
• One's conclusions depend on what rate of ICT investment is assumed to take place in the future, but there are grounds for arguing that the underlying trend rate of productivity may have slowed
• We use a simple dividend discount model to illustrate the potential impact a re-rating of US trend growth could have on the fair value of the S&P 500

• During the slowdown of 2005, it was fashionable to try to predict the size and scale of the housing market correction that most including the Governor of the Bank of England seemed to agree was inevitable
• Today few commentators including the MPC deem the housing market worthy of more than a passing comment 
• What has changed? If the housing market was overvalued in 2005, why is it not today?
• During 2005 the MPC saved the housing market with a well-timed cut in rates. 
• But this year, falling inflation will deliver sharply higher real, ex-post, interest rates, providing the housing market with its sternest test since 1990.

• Oil prices have dropped by around 35% since their peak in 06
• It is tempting to see this as reflecting weaker demand, especially in the US. In that case, we should expect to see them rebound as concerns for a housing-led recession ease
• But the decline in oil prices probably reflects easing of potential supply concerns more than demand
• Our SVAR model backs up this interpretation. In that case, in the absence of new adverse supply shocks (e.g. widening of Iraq war), oil prices will remain lower
• That will continue to boost consumer confidence and spending

• After serial disappointment, euro area growth surprised on the upside during 2006. This has occurred against the background of an appreciating euro and fiscal consolidation. 
• Germany’s resurgent economy was the driving force behind that surprise. Germany has shown the path to redemption with disciplined control of wage costs. A more flexible real wage response to rising oil prices has allowed for jobs growth and a decline in unemployment below levels previously regarded as inflationary. 
• Across the region as a whole, the NAIRU appears to have declined. Participation rates are rising and the average working week has lengthened. But this is not true for every country.
• Therein lies the potential downside. A number of  countries have failed to control unit wage costs but have benefited from low euro zone interest rates as Germany’s economy has struggled. They are now facing a combination of higher real rates, and a significant loss of competitiveness.
• This raises the risk that the problem of underperformance will now revolve from Germany to Italy and Portugal, where unit wage costs have continued to rise. Spain too looks vulnerable to a Portuguese-style boom and bust.

The dollar has fallen by 12% against the euro since the start of the year, and by nearly 4% in the past month alone. Against sterling, the dollar has fallen by 14% since the start of the year, pushing sterling to its highest level against the dollar since the 1992 ERM debacle, and ever closer to the magic $2 mark. By contrast, it has fallen only slightly against the yen, by just 1.6% since the end of 2005.   Notwithstanding the relatively small move against the yen, the markets have been taken by surprise by both the extent and the brutality of the dollar's slide in recent weeks.  

Naturally, the questions on everyone's mind are: why now? And how much more is there to come? We apply a standard UIP methodology to try to explain the dollar's fall. The attached presentation summarises our results.