In the USA, the Beige Book for mid-July to end-August, which will be used to discuss monetary policy at the FOMC's next meeting on 16 September, was published this week. It shows an economy already weakened in most sectors and declining further in others. This weakness comes mainly from anaemic private consumption despite the fact that the synthetic non-manufacturing index (NMI), which is extracted from the ISM survey, moved above 50 in August, showing a slight uptick in activity for the first time since May. The impact of the cheques sent out to consumers by the Treasury between end-April and July already seems to have come to an end. Moreover, activity in the manufacturing sector and in residential real estate remains weak. Only the mining and energy sector can truly be said to be bucking the trend, with high prices continuing to bolster output levels and investment. The sluggish state of the economy argues for holding monetary policy steady, despite inflationary pressures that will once again worry the central bank. Furthermore, the evolution of the unemployment rate, which is one of the three pillars of the Fed’s policy with price stability and long term interest rates, argues for the same decision. Indeed the jobless rate jumped from 5.7% in July to 6.1% in August (cf. Data Focus). In the euro zone, the publication of detailed national accounts for the second quarter confirmed the initial GDP estimate, down by 0.2% q/q, the first contraction since the EMU enforcement. Weaker global demand, the strength of the euro, the soaring prices of raw materials, tougher financial and monetary conditions, instability in the financial markets, all contributed to this drop in economic activity in Q2. Private consumption was also down 0.2% q/q, in line with the decline in retail sales over the period (down 0.8% q/q) and the slide in consumer confidence seen for a number of months. Consumers are concerned about weak purchasing power, which is being eroded by inflation, at a time when labour market prospects are worsening. Having been the main driver of growth in previous quarters, investment plummeted by 1.2% q/q in Q2. This followed a strong 1.5% q/q rise in Q1, boosted in part by a construction sector which benefited from last winter's favourable weather. Lastly, exports also fell, by 0.4% q/q. However, the overall contribution of international trade to GDP growth was nil, as imports also fell in line with weak internal demand in Europe. In addition, recent surveys and leading indicators (PMI, European Commission Economic Climate and EuroCoin ) all suggest that the economy will remain weak over the next few months. Under these circumstances, the ECB's decision to leave rates unchanged at its 4 September meeting was predictable, as was the scaling back of its growth forecasts. Thus following contraction in Q2 and the predicted stagnation in Q3, we are likely to see a gradual return to GDP growth from Q4. This would take overall economic growth to 1.4% for 2008 (from 1.8% forecast in June) and 1.2% in 2009 (from 1.5%). However, this does not mean that inflationary pressure will ease. The central bank is not expecting inflation to come back towards the 2% target until some time in 2010 (3.5% in 2008 and 2.6% in 2009, against June forecasts of 3.4% and 2.4% respectively), despite the recent easing of oil prices (which have returned to April's levels). In particular, the ECB fears that the rise in inflation expectations will trigger higher wage demands and that second-round effects, which have been limited so far, will gain ground, triggering a wage-driven inflationary spiral. Under these circumstances, the European Central Bank will have to resist calls for rate cuts and maintain the monetary status quo for some time to come. Money markets remain tense, as seen in the gap between the overnight rate and 3-month LIBOR, which is still close to 70bp (against 20bp before the crisis of the summer of 2007). Moreover, as part of the overhaul of risk control that takes place every two years, Mr Trichet announced that the ECB had decided to increase the haircut applied to certain types of collateral submitted against refinancing. The discount on asset-backed securities (ABS) will now be at least 12%, whatever maturity and structure. For example, the discount on ABS with maturity of less than 5 years (which is the average maturity on the money market) was just 4% before the changes. In Japan, the surprise resignation of the Prime Minister, Yasuo Fukuda, after less than a year in the post, further complicates the economic picture in the country, coming just days after the announcement of an 11,500 billion yen stimulus package (1,800 billion in new spending and around 10,000 billion in guarantees of public loans to small businesses). This plan, which is unlikely to have a significant impact on the economy, had been seen primarily as a way of improving the Prime Minister's popularity, which had recently dropped below 30%, in the face of the opposition DPJ which now has a majority in the upper house. Elections within the LDP to choose the new Prime Minister, planned for 22 September, will take place against a background of rising voter disenchantment. Consumer confidence is being hit by the sharp decline in Japan's economic position: the economy shrank by 0.6% q/q in the second quarter whilst underlying inflation (excluding fresh food) rose above 2% in July for the first time in ten years.

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