The Federal Reserve left its key target for the Fed funds rate unchanged at 2% following its 5 August meeting. This widely expected decision was not in the least surprising given the current economic environment. The most recent activity statistics tended to show that the economy was holding up better than feared to the various pressures of recent months: the drop-off in the housing market, rising unemployment, tighter credit conditions, soaring oil and commodity prices, the weak dollar and financial market instability among others. In the end, Q2 growth was rather solid at an annualised quarterly rate of 1.9%, though still below the potential rate, mainly driven by household consumption and exports. Yet this solidity is likely to be short lived. At his half-yearly speech before Congress, Fed Chairman Ben Bernanke had already warned that growth would slow sharply in the second half. The non-manufacturing index taken from the ISM survey in this sector held below 50 for the second consecutive month in July. In the manufacturing sector, the ISM new orders index dropped sharply in July to 45, the lowest score since 2001, and the eighth consecutive month below 50. Job market pressures are also growing. Non-farm payroll employment contracted for the seventh consecutive month in July, and the jobless rate rose to 5.7% from 5.5% in June. Yet, inflationary pressures are still a key concern for the FOMC. In June, the consumer price index rose 1.1% m/m, lifting inflation to 5%. The recent decline in oil prices had suggested that inflation would gradually ebb if oil prices continued to fall. The FOMC’s press release underscored that “Inflation has been high, spurred by the earlier increases in the prices of energy and some other commodities, and some indicators of inflation expectations have been elevated.” Apparently, the Fed no longer fears that inflation will continue to rise as fast as it did in June. It now looks like a better balance has been reached between the risks of growth and prices: “Although downside risks to growth remain, the upside risks to inflation are also of significant concern.” The FOMC has clearly adopted a neutral bias. Under this environment, the Fed should maintain its key rates at least through the end of the year. In the Euro zone, the ECB’s decision to maintain the refi rate at 4.25% was no surprise either given the growing downside risks to growth in recent weeks while pricing pressures are still high. It is almost certain now that economic activity in Europe contracted in the second quarter. In Germany, which only recently looked like an exception when compared to the other euro zone big countries already experiencing economic slowdown, the government confirmed rumours that GDP contracted by about 0.8% qoq in Q2 after rising a hefty 1.5% qoq in Q1, the strongest growth in twelve years. Moreover, the manufacturing and services PMI surveys and the European Commission’s business climate index all showed that economic activity continued to deteriorate in July and that short-term prospects were hardly any brighter. ECB chairman Jean-Claude Trichet acknowledged that the Q2 slowdown would be more than a simple correction of the strong rebound in Q1 GDP (+0.8% qoq). In his opinion, the downside risks to growth are taking shape and growth will be also particularly weak in the third quarter. Nonetheless, the ECB chairman esteems that for some time inflation will hold much higher than levels consistent with price stability. Inflation hit 4.1% in July, the highest level since the introduction of the euro. Moreover, Mr. Trichet still worries about second round effects and will attentively monitor the wage talks to be held this fall in the Eurozone. In the end, Jean-Claude Trichet’s well-balanced message mirrors the complexity of the current situation that he has to cope with: economic slowdown coupled with rising inflation. The ECB should wait for economic activity to rebound (next year) to justify monetary tightening or for inflationary pressures to ease (toward the end of this year) before cutting rates, if further economic slowdown requires it. All options are still open. This is what the chairman meant by reiterating that the ECB did not have a monetary bias. Under these conditions, we expect the ECB to opt for the monetary status quo over the long term. Nonetheless a 25 basis points rise in the Refi rate before the end of this year can not be totally excluded either. Caroline Newhouse-Cohen

Last week, the collapse of the Doha round of trade negotiations, seemed to entail the Doha cycle would be shelved for many months. The end of the talks decided on 29 July by Pascal Lamy, Director General of the World Trade Organisation (WTO), after the compromise he put forward on 25 July(1) nearly led to an agreement, admittedly, was deplored by all the negotiators. However, the progress made with respect to subsidies and customs duties on agricultural products masked significant disagreements in other fields such as the opening of emerging countries to industrial goods(2) and services of developed countries. Ultimately, the disagreement between the United States and India, which voiced with China the demands of emerging countries during the meetings gathering the seven main negotiating powers (the European Union, the United States, Japan, Brazil, China, India and Australia) about safeguard clauses in agriculture(3); led to the breakdown of the talks. Regrets probably all resulted from the fact that everybody would lose, to a varying extent in net terms, from a definitive failure of the Doha Round. For instance, Europe (in particular Germany as it is the world’s largest exporter) and the United States were expecting the borders of emerging countries to be opened to their factory goods (more than 70% of international trade) in exchange for concessions on agriculture (8% of international trade); but this will not happen. The service sector of developed countries is another major loser as the possibility of an opening of markets of emerging countries — if not all, at least some sectors that would have offered new outlets — now looks more remote. While China and Japan are among the winners with regard to agriculture, they are losers with regard to factory goods of which they are major exporters. Moreover, everyone is aware that the political schedule is not going to help matters. The presidential election in November in the United States, the general election in May 2009 in India, the elections to the European Parliament in June 2009, not to forget the renewal of the European Commission and the end of Mr Lamy’s term of office next year, are major political hurdles in the way, at the very least, of a rapid end of the talks. However, this week, some parties have shown they had not thrown the towel in. For instance, Mr Lamy still believes an agreement could be hammered out as early as this autumn and, accordingly, is going to meet Indian officials, but also businessmen, to highlight to them the progress achieved in the July talks about non-agricultural markets. This is a shrewd move, but one fails to see how the Indian government could afford such a rapid U-turn, especially a few months away from elections that are going to be held in a tough economic and social context, as the votes of peasants are crucial in a country where more than one working member of the labour force out of two lives from agriculture, versus 3-4% in developed countries. For his part, Brazil’s President Lula, arguing that the solution has to be political, has suggested holding a meeting of heads of states and governments to kick-start the process. He has begun and will continue to talk with the leaders of major countries (notably the United States, China and India) also in order to relaunch the Doha process. Indeed, Brazil, as a major exporter of agricultural goods, would benefit from an agreement, as foreign markets would then be opened to its production. Moreover, this pays also holds significant market shares in certain industrial sectors. However, dissensions have appeared within the major blocs, i.e. developed countries and emerging countries, which are used to facing one another during multilateral trade negotiations, something that complicates the situation even slightly more. Thus, Brazil, precisely, by accepting very early on Pascal Lamy’s proposals, has found itself in disagreement with Argentina, its partner within Mercosur, and with India, the other leader of the G20 group that comprises the main developing countries. Moreover, European rifts have been brought to light. France, Italy and Ireland, in particular, have argued that Europe had made too many concessions on the agricultural component, but had failed to get enough from emerging countries with respect to industry. It has been suggested that agriculture should be withdrawn from the scope of responsibility of the WTO and entrusted to other institutions, such as the Food and Agriculture Organization of the United Nations (FAO). Such an idea is bound to complicate the task of Peter Mandelson, the European Trade Commissioner, who represents Europe at WTO talks, who has himself called for the negotiating process to be resumed as soon as the autumn. Lastly, for the United States, it is obvious that the offers made with respect to agriculture cannot be a starting point in future negotiations, from which further concessions would be called for, since they were conditional on concessions from emerging countries in the fields of industry and services. As it can be seen, getting the process back on track will be difficult, at least in the near term. This could lead to a wave of bilateral agreements although it is well known that they are hardly favourable for developing countries, increase the risks of a rise in protectionism and, last but not least, would deprive the global economy from the gains that could be expected from further trade liberalisation. (1)  For agriculture, significant cuts in subsidies of developed countries and a substantial reduction in European customs rights; in industry a reduction in customs rights, varying according to product and schedule according to country. (2)  In particular, via the decrease in so-called peak tariffs, or customs rights exceeding 15% or 20% and the limitation of categories of products, or tariff lines, which can be protected by high rights or, lastly, the delays granted to various countries to implement cuts in customs rights. (3) Which allow a country to apply higher customs either to weather an increase in imports deemed excessive or a price cut deemed excessive. Eric Vergnaud

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