The State of the Business Cycle

Frankfurt, 13 April 2005

Dr Holger Schmieding

European EconomicsBank of America, London+44 20 7174 4924

2

Longer-term Themes: From Worker to Consumer Power

Globalisation spreading to more countries, more sectors, more workers

Rise of Emerging Eurasia, from Bratislava to Bangalore and Beijing

Shift from labour to profit income

Helped by the information technology revolution, productivity growth remains high in US, despite some signs of a slowdown

IT revolution strengthens consumer choice

Increased pace of supply growth and reduced wage pressures constrain inflation risks

The demographic challenge: Germany and Japan vs the US and France

3

US Productivity Growth Still Strong

Remember the “new economy”? There was some kernel of truth in the notion.

Labour productivity in US business sector, annualized change in %. Source: BLS

-2

0

2

4

6

8

Mar-52 Mar-62 Mar-72 Mar-82 Mar-92 Mar-02

Productivity in US business sector 5-year average

4

Erosion of Union Power Paves the Way for Reforms

Would Hartz IV have been possible 10 years ago?

Source: DGB; DAG

Union Members in % of German Workers

20

24

28

32

36

Dec-90 Dec-92 Dec-94 Dec-96 Dec-98 Dec-00 Dec-02 Dec-04

Unionisation Rate

5

Cyclical Themes: US Healthy - Europe Vulnerable

US is removing its extraordinary monetary and fiscal stimulus.

Inflation Outlook: Globalisation and technological advances augment the pace of supply growth, the erosion of union power reduces the risks of wage inflation, increased consumer choice enhances competitive pressures. Inflation risks now look more subdued than in the last 3 decades.

US outlook: Sound fundamentals. We expect only a slight growth deceleration in 2005 as consumers gradually raise their savings rate in response to more normal interest rates. Worries about the US twin deficits are overdone.

Eurozone: A modest pick-up in domestic demand will be largely offset by a reduced external stimulus in 2005. Growth below trend until late 2005.

Japan: Structural progress, but Japan’s upswing is too vulnerable to bear a slowdown in Chinese demand and a strong Yen at the same time. BoJ rates on hold until mid-2006.

Oil: The renewed surge in oil prices will hit global growth in Q2 and Q3, in the Eurozone slightly more so than in the more flexible US. Expect a modest fall in oil prices later in 2005.

Asset bubbles?

6

US Corporate Health Restored

5%

6%

7%

8%

9%

10%

11%

12%

Mar-60 Mar-65 Mar-70 Mar-75 Mar-80 Mar-85 Mar-90 Mar-95 Mar-00 Mar-05

Corporate Profits in US GDP

US corporate profits have recovered back to normal.

Share of pre-tax profits in US nominal GDP. Source: BEA

7

US Households Are Rich – Not Overindebted

US Household Wealth Back on Trend

10

20

30

40

50

Mar-60 Mar-70 Mar-80 Mar-90 Mar-00

Real Net Worth of US Households in $ trn

US households are more heavily indebted than before. However, they are also more wealthy. Real wealth adjusted for debt is back on trend.

Source: Fed

8

US Consumers: Excessive Debt Burden?

US Households: Debt Service and Interest Income

10

12

14

16

18

20

Mar-80 Mar-85 Mar-90 Mar-95 Mar-00 Mar-05

Debt Service Interest Income

In line with lower nominal interest rates, interest income has fallen. Many households would benefit from higher interest rates.

In % of disposable income. Source: Fed; BEA

9

US Consumer: Help from the Labour Market

Although higher interest rates will be a burden for some households, extra income from an improving labour market should offset this even for lower-income groups who are not major recipients of interest income.

Yoy change in %. Source: BLS

Strong Rebound in US Employment

-2

-1

0

1

2

3

4

5

6

Jan-80 Jan-84 Jan-88 Jan-92 Jan-96 Jan-00 Jan-04

Employment Growth in %

10

Fiscal Deficits – Signs of Improvement in US

The US fiscal balance has started to improve, helped by a rebound in tax revenues. Tax cuts are over. Capital gains tax receipts are recovering. We expect US tax revenues to rise by at least 6% per year.

Yoy change of 12-month rolling sum, in %. Source: US Treasury; BEA

US Federal Tax Revenues: Growing Again

-15

-10

-5

0

5

10

15

Jan-92 Jan-94 Jan-96 Jan-98 Jan-00 Jan-02 Jan-04

US Federal Tax Revenues

11

House Prices: Spot the Bubble

House Prices Relative to Earnings

0.8

1

1.2

1.4

1.6

1.8

Mar-74 Mar-79 Mar-84 Mar-89 Mar-94 Mar-99 Mar-04

US UK

The UK has a serious house price problem – the US does not. In a fast-growth economy such as the US, real estate prices should rise in real terms over time. In the UK, supply constraints add to the volatility of house prices.

Average earnings for UK; average weekly earnings for US; rebased to 1974-2003 average = 1. Source: ONS; ODPM; BLS; Bloomberg

12

Japan: The China Factor

Japanese export growth has started to falter. A slowdown in Chinese demand for investment goods will likely dampen Japanese GDP growth to around 1% in 2005.

Yoy change in Japanese exports to China, 3-month average. Source: MoF

Losing Momentum: Japanese Exports to China

-20

-10

0

10

20

30

40

50

Jan-92 Jan-94 Jan-96 Jan-98 Jan-00 Jan-02 Jan-04

Exports to China

13

Eurozone Outlook

The big external stimulus already faded last summer

Leading indicators have turned down again

Investment: Only a modest upturn likely

Consumption: Higher oil prices restrain growth in disposable income

Technical rebound in Q1 GDP likely to be followed by weaker Q2; expect some strengthening back to trend growth in late 2005 if oil prices and the euro decline.

Huge disparities within the Eurozone

Real estate boom in “Club Med”: Liquidity-driven bubble - or sustainable adjustment to EMU-related permanent decline in interest rates?

14

Eurozone Leading Indicators Turning South Again

Industrial confidence has fallen sharply, the halting rebound in consumer confidence has stalled.

Source: EU Commission survey

Cyclical Rebound in Confidence Already Over

-35

-30

-25

-20

-15

-10

-5

0

5

10

Jan-92 Jan-94 Jan-96 Jan-98 Jan-00 Jan-02 Jan-04

Consumer confidence Industrial confidence

15

Eurozone Export Outlook: Mediocre at Best

The rate of demand growth among trading partners and the lagged impact of exchange rate changes drive Eurozone exports. A deceleration of global demand has started to reduce export growth.

Yoy changes in %; Bank of America forecasts for trading partner growth from 1Q05 onwards. Source: Eurostat; BoA

Export Growth Has Peaked

-2

0

2

4

6

8

10

12

14

Q1 1994 Q1 1996 Q1 1998 Q1 2000 Q1 2002 Q1 2004

0.5

1.5

2.5

3.5

4.5

Eurozone export growth

Trading partner GDP growth (RHS)

16

Eurozone Domestic Demand: Investment Outlook

Buoyant profits support investment.

Yoy change in %, gross fixed capital formation and gross operating surplus including mixed income. Source: Eurostat

Profits Recovery Points to Stronger Investment

-8

-4

0

4

8

12

Mar-92 Mar-94 Mar-96 Mar-98 Mar-00 Mar-02 Mar-04

Profits

Investment

17

Eurozone Consumption: A German Problem

Real Private Consumption

100

110

120

130

140

Mar-95 Mar-97 Mar-99 Mar-01 Mar-03 Mar-05

US Eurozone ex Germany Germany

The weakness in German consumption is weighing on the Eurozone as a whole.

Consumption levels, 1Q95=100. Source: Eurostat

18

German Outlook

Regaining cost competitiveness within the Eurozone thanks to wage restraint

Hoping for the lagged impact of recent labour market reforms

Leading indicators have turned down again

Significant decline in household savings rate unlikely

No support from the housing market

Decline in working age population and continuing transfers to East Germany will make further benefit cuts inevitable

19

The Demographic Burden

Germany: Working Age Population Shrinking

-0.3

0

0.3

0.6

0.9

1.2

1.5

1980 1983 1986 1989 1992 1995 1998 2001 2004

yoy change in %

Is Germany reforming fast enough to cope with the demographic challenge?

Source: OECD; OECD forecasts for 2004-05

20

The Demise of Wage Inflation?

Wage inflation has fallen sharply in the Eurozone, following years of weak domestic demand. We look for headline inflation to drop below the ECB’s 2% pain threshold again in June.

Total hourly labour costs in whole economy, advanced by one year; service CPI and service CPI excluding German health care charges on right-hand scale; yoy in %. Source: Eurostat

Labour Cost Pressures Receding

1

2

3

4

Mar-97 Mar-98 Mar-99 Mar-00 Mar-01 Mar-02 Mar-03 Mar-04 Mar-05

1

2

3

4

Euro Labour Costs, 1yr fwd

Euro Service CPI

21

Eurozone Inflation: Oil Matters

Oil Price Scenarios: Inflation Impact

-1.0

-0.5

0.0

0.5

1.0

Jan-04 May-04 Sep-04 Jan-05 May-05 Sep-05 Jan-06 May-06

Brent at €35 €30 €40

We expect oil prices to moderate to €35 per barrel Brent crude by end-2005. Near-term, oil prices pose the greatest risk to our inflation forecast.

Direct and indirect impact of oil prices on headline inflation. Source: Eurostat; BoA forecasts from April 2005 onwards

22

Global Economic ForecastsIMF GDP Unemployment CPI Current Account Budget Balance

WEIGHT % change (%) % change % of GDP % of GDP2004 2005 2006 2004 2005 2006 2004 2005 2006 2004 2005 2006 2004 2005 2006

WORLD 100.00 3.8 3.0 3.3THE AMERICAS 37.55 4.4 3.7 3.7United States 29.42 4.4 3.8 3.7 5.5 5.2 5.0 2.7 2.9 2.6 -5.7 -5.9 -5.4 -3.6 -3.3 -2.8Canada 2.44 2.8 2.6 3.2 7.2 7.2 7.0 1.8 2.3 2.5 2.6 1.6 1.2 0.7 0.5 0.2Latin America 4.68 5.3 3.8 3.6

Brazil 1.36 5.3 4.1 4.3 9.8 9.5 9.2 7.5 5.6 5.2 1.5 0.8 0.3 -2.8 -3.2 -3.0 Mexico 1.73 4.4 3.8 3.7 3.8 3.6 3.7 5.2 4.2 3.9 -1.3 -1.7 -2.0 -2.7 -2.9 -3.2 Argentina 0.35 8.8 3.7 1.3 15.6 14.3 14.0 3.1 8.9 12.1 4.3 3.7 2.1 2.5 2.1 1.9 Chile 0.20 5.7 5.3 5.0 9.1 8.8 8.1 2.8 3.0 3.1 1.7 3.0 0.8 1.5 1.3 1.0

EUROPE 34.50 2.6 2.0 2.4

Eurozone 23.09 1.8 1.4 2.1 8.8 8.9 8.5 2.1 1.9 1.6 0.6 0.3 0.2 -2.7 -2.7 -2.1

Germany 6.64 1.0 0.8 1.8 9.6 9.8 9.4 1.7 1.7 1.4 -3.7 -3.5 -2.9

France 4.87 2.4 1.9 2.2 10.0 9.9 9.7 2.3 1.9 1.8 -3.7 -3.0 -3.5Italy 4.06 1.0 0.8 1.9 8.1 8.0 7.9 2.3 1.8 1.8 -3.0 -3.8 -3.0

Other Western Europe 7.90 2.9 2.3 2.2 United Kingdom 5.23 3.1 2.3 2.0 4.8 4.7 4.9 1.3 1.7 1.6 -2.2 -1.7 -1.0 -3.6 -3.5 -3.6

Switzerland 0.88 1.7 1.3 1.8 3.9 4.0 3.6 0.8 1.4 1.5 11.4 10.1 9.7 -1.0 -0.6 -0.2 Sweden 0.83 3.0 2.9 3.2 5.5 5.3 5.0 0.4 0.5 1.6 8.1 7.6 6.7 -0.5 0.0 0.5 Norway 0.61 3.4 3.5 2.7 3.9 4.2 4.2 0.5 1.5 2.1 13.7 12.2 10.9 6.0 5.0 5.0Other Europe 3.93 6.2 5.0 4.3 Russia 1.19 6.3 6.1 4.6 7.7 7.5 7.0 10.9 12.1 9.5 10.8 5.2 2.0 3.6 1.5 0.2

Turkey 0.66 9.9 5.4 4.7 10.1 9.5 9.1 10.7 8.6 9.3 -4.8 -4.5 -4.0 -7.5 -6.0 -5.4

Poland 0.58 5.4 3.8 3.7 19.6 19.0 18.5 3.5 2.6 2.7 -2.1 -2.4 -2.8 -6.4 -6.7 5.9 Czech Republic 0.25 4.3 3.3 3.1 9.4 8.9 8.4 2.9 2.0 2.9 -5.9 -5.5 -5.2 -5.8 -5.1 -4.6 Hungary 0.23 4.0 3.5 3.4 6.1 5.9 5.3 6.8 3.6 3.7 -8.4 -7.8 -7.0 -5.5 -5.3 -4.8ASIA & PACIFIC 24.21 4.7 3.4 4.1

Japan 12.00 2.6 1.1 2.6 4.7 4.4 4.1 -0.1 -0.2 0.1 3.7 3.5 3.7 -7.0 -6.5 -6.3

China 3.90 9.5 8.0 7.5 8.5 8.0 7.5 3.9 3.0 2.5 2.5 3.0 2.6 -3.0 -2.0 -1.0Other Asia 6.81 5.8 4.9 5.0Oceania 1.64 3.4 2.9 3.6 Australia 1.50 3.2 3.0 3.7 5.6 5.2 5.4 2.3 2.7 2.9 -6.4 -6.1 -5.4 0.8 0.6 0.6AFRICA / MID EAST 3.76 3.9 4.3 3.8