United States
Greenspan's Legacies; Bernanke's Challenges
Jan 30, 2006

Richard Berner (New York)

It’s a pivotal moment for the Federal Reserve.  After eighteen years under Alan Greenspan, leadership at the Fed changes this week, and while Mr. Greenspan’s legacy has defined many of the standards by which to judge policy outcomes and the means by which to prosecute them, the Bernanke Fed still faces critical policy challenges.  How they are resolved will have important implications for the economy and for financial markets.  Moreover, the immediate policy outlook has turned a little more uncertain since the last FOMC meeting, with incoming data raising questions about the prognosis for inflation and growth.  As a result, Mr. Bernanke may have a clean policy slate on February 1 but the policy agenda is already full.  Market participants, take note.

I don’t pretend to be able to review Alan Greenspan’s considerable legacy in this short space, nor is there great need since others — for example, at last year’s Jackson Hole conference — have done it already.   For me, however, three bequests that are relevant for thinking about future monetary policy stand out.  First, the Greenspan Fed helped achieve price stability, which I believe has contributed to better and more stable economic growth. 

Second, Greenspan’s pragmatism and intellectual leadership enabled the Fed to accommodate structural change in the economy and to foster more collegial debate about policy choices.  That openness famously nurtured a ‘risk management’ approach to policy, but probably also promoted more buy-in from Committee members about decisions made, and inspired commitment from the staff to provide the most thorough answers to the questions framing the policy debate.

Finally, while history has yet to judge Greenspan’s “mop-up” approach to asset bubbles, his consistency on this and other critical issues and steady increase in communication transparency has helped market participants better understand the Fed’s goals and how the Fed will react to either real or financial shocks — and probably has made the internal policy debate more coherent. 

Ben Bernanke’s challenges in some respects follow from his predecessor’s achievements.  First, he must lead the Fed in deciding whether quantitative targets are required to maintain price stability.  As I see it, the debate at the Fed will not be whether to adopt a strict inflation targeting regime such as that practiced by other central banks; neither Congress nor several members of the FOMC are likely to abandon the Fed’s ‘dual mandate’ that gives equal weight to price stability and maximum employment and growth.  The debate will instead involve the benefits and costs of a numerical definition for the Fed’s inflation objective.  De facto, the Fed’s two-year central-tendency inflation forecasts are really targets, but there isn’t agreement on going further.  Theory supports the case for better policy outcomes from being more specific, but the empirical evidence is thin.  And while the Fed will likely retain the core PCE price index as its inflation metric, the details of the policy horizon over which the Fed should specify the objective and the range around it will be part of the debate.  The debate and a decision could come sooner than many expect.

Second, the incoming Chairman must lead the Fed in deciding how to build on and extend transparency about goals without overly committing to policy actions.  By expediting the publication of FOMC minutes, evolving the language of the post-meeting statement, and extending forecasts out to two years, the Fed has already gone a long way to increasing the quantity and nuance of communication in the directions advocated by Governor Bernanke.  In addition, as Chair, his preferences are to publish forecasts more frequently, and to appraise the Committee’s success in meeting objectives.  I expect the new Chair to push for quarterly forecast updates soon.  In addition,  forward-looking policy language will probably get a thorough review.  Many FOMC members believe that such language is appropriate only for special circumstances and may be mistaken for an unconditional promise rather than a conditional description of policy reaction.  Thus, I expect that transparency about objectives will increase, but the Fed may become less forward looking in language describing policy actions, especially in today’s inflation and economic setting.

Finally, Mr. Bernanke will probably want to conduct a thorough debate on whether and how to embrace financial stability as a (intermediate) goal for monetary policy.  The issue is whether the Fed could improve policy outcomes by trying to reduce sharp fluctuations in asset prices.  Not surprisingly, he embraces the Greenspan strategy of not trying to prick asset bubbles, and to contain the potential for damage to the economy when they burst; after all, Bernanke was one of the authors of that approach.  To lessen the likelihood of asset bubbles or busts, he far prefers to use “the right tool for the job,” in this case, prudential microeconomic policies.  He made that clear in his inaugural speech as Fed governor on October 15, 2002:

By using the right tool for the job, I mean that, as a general rule, the Fed will do best by focusing its monetary policy instruments on achieving its macro goals — price stability and maximum sustainable employment — while using its regulatory, supervisory, and lender-of-last resort powers to help ensure financial stability.

This debate will go deeper, however, partly because other central banks and the Bank for International Settlements put more explicit emphasis on financial stability.  Also, many market participants believe that the Fed’s current stance creates moral hazard and excessive risk-taking — the famous Greenspan “put” — notwithstanding the Fed’s tolerance of sharp declines in stock prices as the bubble burst in 2000-02.  As I see it, financial stability will become more important for monetary policy, but not as an explicit goal.

Those challenges aren’t the only ones facing the incoming Fed Chair — far from it.   The economic and inflation environment that Ben Bernanke inherits is more uncertain than in the recent past, and policy moves are likewise less assured than they have been since mid 2004.  To begin, the stance of monetary policy (narrowly defined by the real federal funds rate) even before this week’s FOMC meeting is neither stimulative nor restrictive, so future policy moves are completely dependent on the outlook. 

Moreover, the immediate outlook for growth and inflation is less certain than it seemed to be just a few weeks ago.   The apparent sudden downshift in economic growth to just 1.1% in the fourth quarter certainly challenges the premise that the Fed has more work to do.  But it does not change our favorable outlook for growth and confidence that a strong rebound is likely in the current quarter, and we suspect that the Fed will view these data similarly. 

In our view, that first-quarter rebound likely will be even stronger than the 4.2% rate in our last published forecast for four reasons.  First, we believe that a timing quirk temporarily depressed Q4 defense outlays and that expected state and local outlays for hurricane recovery haven’t shown up in the data; we expect sharp, early-2006 recoveries in each.  Second, the follow-on effects of the supply shock from the Gulf Coast hurricanes and the dip in vehicle output — evident in surging energy imports and in lower-than-expected inventory accumulation — together may have slashed a percentage point more from annualized growth than we estimated; a reversal of those factors will add even more to current quarter growth.  Moreover, judging by monthly data for consumer and capital spending, for industrial production, and from business surveys, the economy’s momentum at year end was stronger than we thought three weeks ago.  Finally, unseasonably warm weather will boost growth in construction and related activity this quarter.

To be sure, there are other near-term challenges to growth, most importantly the recent rebound in energy prices triggered by fears of curbs on supply from Iran (see “Oil Prices: Tight Markets + Geopolitics = Upside Risks,” Global Economic Forum, January 17, 2006).   Obviously, it matters whether this shock is transitory or not.  But rising stock prices and a weaker dollar mean that financial conditions are becoming more supportive of growth, and we view the low level of long-term rates as an additional source of stimulus (see “The Term-Premium Case for Higher Yields,” Global Economic Forum, January 20, 2006). 

Moreover, while underlying inflation stabilized or moved lower over much of 2005, the latest data suggest that it is creeping higher again.   Measured by the personal consumption expenditures price index, core inflation appears to have moved to 2% in the year ended in December.  That move may reflect some lagged and transitory “pass through” from rising energy prices into core inflation.  More likely, as I see it, it also reflects the elevated level of inflation expectations and some cyclical pass through of other costs in the context of dwindling economic slack, and therefore may be more durable. 

Against this backdrop, the challenge for the Fed is to decide whether these swings in growth and inflation are transitory or lasting.  Notwithstanding the weakness in fourth-quarter growth, with slack in the economy and labor markets having dwindled and inflation creeping higher, policymakers are unlikely to back away from their bias for a further “measured policy firming.”  But their description of the policy outlook may become less clear: After raising the funds rate to 4½% this week, officials may make future moves even more dependent on the inflation and economic outlook, stating that further action “may” be needed.  I think that such policy uncertainty likely will translate into financial-market volatility and rising term premiums.

As I see it, therefore, risks are rising for market participants.  Investors acknowledge that monetary policy has become more outlook and data-dependent.  But they continue to interpret forward-looking language from the Fed as promising little additional tightening and the much-hoped-for policy “soft landing.”  Ironically, that has made financial conditions more supportive of growth since the December FOMC meeting.  If, as we expect, inflation risks are higher and growth is stronger than the Fed’s conditional statements imply, officials will have more work to do, and upside risks for longer-term yields will predominate.

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United States
US
Jan 30, 2006

Ted Wieseman (New York) and David Greenlaw (New York)

Treasuries fell to their worst losses since late October last week, as sentiment on the economy and the market seemed to take a noticeable turn for the better and worse, respectively, as we head towards a move in the coming week towards a hike in the funds target to 4.50%, a continuation of the recent flood of supply at the refunding announcement, and potentially more evidence that the economy has picked up steam coming into 1Q in the employment and ISM reports.   Following the strong momentum in capital goods orders at the end of 4Q and the surprisingly weak GDP results that, on the positive side, in their composition pointed to upside in 1Q — a much smaller add from inventories and a surprising plunge in defense spending that seems likely to be reversed at least partly — we now see 1Q GDP on a 5%+ growth trajectory, compared with our previous +4.2% forecast.  And, with another much better jobless claims report than expected and positive revisions to the December ISM surveys (with a big upward adjustment to manufacturing orders particularly notable), we expect the key data in the coming week to be in line with this robust outlook, having raised our employment forecast from +250,000 to +275,000 and our ISM estimate from 55.0 to 56.0. 

The market seemed to be under significant, consistent pressure almost all week.   With the exception of an unexplained futures-driven surge Monday afternoon in thin trading conditions, which reversed earlier softness and a late long-end bounce Friday, the consistent patterns on the week were that dip buyers were largely absent, with the lack of much buying of weakness by the key Asian investor base particularly noted, strong data (revisions to the ISM surveys, durable goods, jobless claims and new home sales) hurt the market, and weak data (existing home sales and GDP) only led to modest, quickly reversed up-ticks.  The only consistent source of buying seemed to be periodic short covering, as some investors felt more comfortable at current levels going into the big upcoming events and data flat.  The result for the week was that yields broke out of their previously very tight ranges seen since mid-December to new highs for the year, and in the futures markets both more near-term Fed tightening and less medium-term easing were priced in.

Benchmark Treasury yields rose 13-15 bp last week and the curve steepened slightly.   Other than the last week in October, when the market was crushed by a sudden wave of mortgage-related selling, this was the worst performance across the board since last March.  Coming into it, this certainly did not look like a week when market sentiment would take such an abrupt turn — the economic calendar was light, there were almost no Fed speakers ahead of the FOMC meeting, and the upcoming week is filled with key data and events suggesting a more wait-and-see approach.  But, for whatever reasons, the market found itself under persistent pressure almost all week, during US trading hours and in overnight activity, with the only significant exceptions being a sudden, puzzling futures-led rally for a couple hours on Monday afternoon that turned around some significant initial losses, then a bit of upside at the long end on Friday afternoon, as some dip buying finally emerged and shorts continued to be covered.  On the week, 2’s-30’s steepened 2 bp on a 13 bp increase in the 2-year yield to 4.49% and a 15 bp rise in the long bond yield to 4.68%.  The 3-year, 5-year and 10-year yields all rose 14 bp to 4.45%, 4.44%, and 4.50%, respectively.  Near-term Fed pricing in the futures market moved towards fully pricing in a hike in the funds target to 4.75% in March (after the universally expected move to 4.50% on Tuesday) and started to contemplate the risk of an additional subsequent move to 5%.  The rate on the April fed funds contract jumped 5 bp on the week to 4.695%, a new all-time high, while the rate on the July contract broke through 4.75%, rising 8 bp to 4.79%. 

In marked contrast to the recent typical pattern, where pricing in more near-term tightening was offset by pricing in more medium-term easing, this week the market also scaled back the mid-2006 to mid-2007 easing embedded in the eurodollar futures market.   The June 06 to June 07 eurodollar spread steepened 7.5 bp to -13 bp, with the former contract off 10 bp to 4.905% and the latter losing 17.5 bp to 4.775%.  Also notable was that the expected easing was pushed out a bit, as the June 06 to September 06 spread disinverted, moving from -2.5 bp to flat over the course of the week.

Economic data released last week showed much softer 4Q GDP growth than expected, but with a relatively more positive composition and some quirky details that suggested upside to 1Q, very strong upside in capital goods orders led by extremely robust gains in orders and backlogs for machinery, mixed information on the housing market (existing home sales down, new home sales up — pretty much a wash taken together), and another much better jobless claims report than expected, which we do not want to read too much into, given the very large seasonal swings around this time of year, but obviously found encouraging, enough so to lead us to raise our January payroll forecast slightly from +250,000 to +275,000.   The annual revisions to the ISM surveys also led us to raise our ISM forecast.  Being merely recalculations of the seasonal adjustment factors, the ISM revisions were a net wash, but the recent pattern that emerged showed a better end to the year than the previous data, with the manufacturing survey now showing a somewhat smaller post-Katrina surge from September to November offset by a correspondingly lesser pullback and higher absolute level in December (55.6 vs. 54.2).  Particularly notable was the revision to the orders gauge — the key leading indicator among the activity indices — in December.  Orders in December were revised up to a robust 59.1 from 55.5, showing no meaningful deceleration from the September to November post-Katrina upswing average of 59.7.  Building in these revisions, we have raised our January ISM forecast from 55.0 to 56.0.

This stronger end to the quarter for the factory sector added to other data suggesting that, while 4Q was a rough quarter overall, the intra-quarter upward momentum off the post-Katrina weakness portrayed an economy coming into 1Q with significant momentum.   Most important here is consumption, which rose only 1% in 4Q, but after sharp gains in November and December (we will find how just how strong when the monthly details are released on Monday) is poised for 4%+ growth in 1Q, with even meager 0.2% or so monthly gains from January to March.  It certainly did not show up in 4Q, but the durables report released last week suggested similarly positive momentum in capital spending coming into 2006.  Overall durable goods orders rose a larger-than-expected 1.3% in December and November (+5.4% vs. +4.4%) was revised up.  Both the upside in December and revision to November were more than accounted for by strength in the key core gauge — nondefense capital goods ex aircraft — which surged 3.5% in December and was revised up sharply in November (+0.2% vs. -2.1%).  Almost all of this upside was accounted for by the machinery category, which spiked 6.5% in December for a 58% annualized surge over the past three months.  Even with significant strength in shipments over this period (which did show up as a pocket of relative strength in an otherwise disappointing investment outcome in 4Q), unfilled orders for machinery surged at a 22% annual rate in the three months through December to a series of record highs, pointing to significant equipment investment upside on tap for 1Q.

Growth in 4Q came in far below expectations, but there were details of the report that also supported the case for upside in early 2006.   GDP grew at a 1.1% annual rate in 4Q, much less than expected, with both final sales (-0.3%) and inventories (+1.45 pp) coming in well below expectations.  Downside in final sales relative to our expectations was concentrated in government spending (-2.4%) and equipment investment (+3.5%).  Weakness in government mostly reflected a plunge in defense (-13%).  We suspect that at least some of this drop reflects timing quirks that will be unwound in 1Q.  Note also that state and local spending rose a meager 0.4% — clearly the post-hurricane rebuilding efforts have not appeared in those data at all yet, not to mention more general plans for local infrastructure investment that seem to be proliferating across the country as state and local governments find themselves flush with cash after some very lean years.  Meanwhile, the investment gain was much weaker than implied by the capital goods shipments figures, depressed by significant weakness in transportation categories not sourced to these figures.  But the growing capital goods backlogs in the durables figures suggest stronger growth ahead.  One particularly puzzling aspect of the investment disconnect was the huge divergence between surging aircraft shipments as reported in the durables report and the decline in the data that the BEA uses as the direct input to GDP for this category (from a separate Census report).  Unless the durables aircraft data are completely wrong — and they seem to be in line with strong conditions reported by key industry participants — a big catch-up in aircraft investment seems due.  The inventory miss, with the 1.45 percentage point add to growth only about half of what we expected, was entirely a result of a shocking plunge in the inventory valuation adjustment (IVA).  Based on the drop in gasoline and oil prices (typically the key drivers of the IVA) from late 3Q to late 4Q, we had estimated a rise in the IVA in 4Q to -$32 billion from -$49 billion.  Instead it plunged to -$73 billion.  This $41 billion miss, which, looking at the key source inputs for the IVA, we cannot begin to explain, accounted for about 1.5 percentage points of our GDP forecast miss.  On the positive side, we had previously built a significant inventory drag into our 1Q GDP forecast, but with the much lower-than-expected 4Q inventory outcome, this no longer seems likely.

All in all, taking on board the 4Q GDP results, the durables report and other indicators pointing to a strong end to 2005, we now see a very good possibility of 5%+ GDP growth in 1Q — versus our prior estimate of +4.2%.

The upcoming week is very busy in terms of key events and data, with the FOMC meeting, the Treasury refunding announcement, the employment report, ISM report, and motor vehicle and chain store sales results the highlights.   It has been a long and winding road over the past 20 years for Fed Chairman Greenspan.  He leaves on a high note on Tuesday, with the unemployment rate below 5% and core inflation running nearly 2 percentage points lower than when he assumed office.  The send-off will hardly be tarnished by the disappointing GDP report released on Friday, and the outcome of Tuesday’s FOMC meeting is quite unlikely to be altered by the GDP news.  The Fed virtually promised at least one more rate hike last time around, and the funds rate will most probably be nudged up to 4.50% — a level that may roughly approximate a long-run “neutral” policy setting with core inflation near 2%.  The Fed is clearly in the process of shifting to a more data-dependent policy path and thus we expect the statement released at the conclusion of the meeting to be tweaked.  In particular, the indication that “some further measured policy firming is likely to be needed” might be altered to “may be needed”.   This would provide the Fed with sufficient flexibility to hike rates further if the incoming data warrant such as move.  Given our near-term economic outlook, we believe the odds favor another 25 bp rate hike at the March 28 FOMC meeting, but it is not a certainty, and the data will need to provide the justification for the move.

On Wednesday, we expect the Treasury debt managers to announce a $49 billion refunding package consisting of $20 billion 3-year notes ($2 billion bigger than last time), $14 billion 10-year notes ($1 billion bigger), and $15 billion 30-year bonds.   The bond offering will be reopened in August; our base case in the reopening will be $10 billion. 

The $2 billion increase in the 2-year note last week came a month earlier than we had expected but was in line with our view that a gradual move higher in coupon sizes will be seen through the rest of the fiscal year, including at this refunding.   Ahead of the refunding, Treasury will announce its revised 1Q and preliminary 2Q borrowing estimates on Monday.  We project a $181 billion borrowing need in 1Q and a $28 billion paydown in 2Q.  In general, the Treasury’s financing gap for the year as a whole looks a bit less daunting to us now than it appeared back at the November refunding, as we have trimmed our budget deficit estimate a bit to $400 billion from $410 billion, and non-marketable debt issuance and other non-market means of financing are coming in a bit stronger than we previously expected.

Key data releases in the coming week include personal income and spending on Monday; Conference Board consumer confidence and the employment cost index on Tuesday; ISM, construction spending and motor vehicle sales on Wednesday; productivity and chain store sales on Thursday; and employment, Michigan consumer confidence and factory orders on Friday.

* We forecast a 0.5% gain in December personal income and a 1.0% rise in spending.   The labor market report pointed to a modest gain in income but the quarterly figures released on Friday imply either a much sharper rise or upward revisions to prior months.  Meanwhile, a sharp jump in motor vehicle sales and some expected elevation in service outlays points a solid rise in spending — especially after factoring in a flattish headline PCE deflator.  Note that this leaves a very favorable ramp heading into 1Q.  Finally, the quarterly GDP data point to a 0.3% rise in the core PCE price index for December (a bit above the +0.2% seen in the CPI data), with the year-on-year rate ticking up to +2.0%.

* We look for a 0.9% gain in the 4Q ECI.   We continue to believe that much of the recent uptick in average hourly earnings reflects the disproportionate loss of low wage jobs in the wake of Hurricane Katrina.  Still, we expect the ECI (which adjusts for such shifts in the mix of employment) to show some mild acceleration in 4Q with the benefits category leading the way.  Private wage rate gains are expected to tick up slightly to +0.7%.  Year on year, we expect the overall ECI to hold at a relatively tame +3.1%.

* Based on the performance of the Michigan and ABC sentiment gauges during early January, we look for some further modest upside in the Conference Board index to 106.0 in January relative to the 103.6 recorded in December.

* We expect the January ISM to rise to 56.0.   Although the headline results for both the Empire and Philly manufacturing surveys posted declines, the component data were much stronger.  Indeed, on an ISM-weighted basis, both surveys showed solid gains.  Thus, we look for a slight rise in the headline ISM index versus the revised 55.6 reading for December that was announced last week.  Finally, we expect the price index to be little changed at 62.0.

* We look for a 0.1% rise in December construction spending.   Housing starts data point to some slippage in new home construction during December.  However, an expected rebound in home improvement outlays along with modest gains in the private nonresidential and public components should provide an offset.

* Our preliminary forecast is for a pullback in January motor vehicle sales to a 16.4 million unit annual pace following the relatively strong 17.1 million unit sales seen in December.   Automakers continue to tweak incentive offerings in response to short-run swings in demand.  This has led to considerable volatility in the monthly sales results, and there is little sign of this pattern coming to an end anytime soon.  We may update our estimate early in the week if additional guidance is provided by the Big 3.

* We expect 4Q nonfarm business labor productivity to fall 0.2% and unit labor costs to jump 4.0%.   The disappointing GDP results for the fourth quarter point to a significant moderation in productivity growth.  In fact, we now look for the first outright quarterly decline in productivity since early 2001.  Meanwhile, the pause in productivity implies that unit labor costs will come in well above the recent trend — despite only a modest rise in compensation per hour.  However, with the sharp spike in ULC seen in the fourth quarter of 2004 dropping out of the calculation, the year-on-year growth rate should slip to a quite benign reading of +1.0%.

* We forecast a 275,000 gain in January nonfarm payrolls and an unchanged 4.9% unemployment rate.   We expect a number of factors to contribute to an above-trend gain in January employment.  First, weather conditions appear to have been extremely favorable across the entire nation.  Most of the country experienced temperatures that were 5 degrees or more above normal during the survey week, while there were no areas with below average temperatures.  Precipitation was also well below average for much of the US.  Of course, this comes on the heels of some apparent negative impact from weather-related factors in December. 

Second, retail trade employment is likely to get a boost from a swing in the seasonal adjustment factors.   Because there were fewer hires than usual during the holiday season, the number of seasonal workers leaving their jobs in January will be less than is built into the adjustment factors.  Third, jobs lost in the wake of Hurricane Katrina should continue to be recouped at a gradual pace — such a trend should be particularly evident in the employment tally for the hospitality industry.  Fourth, even though we continue to believe that the jobless claims figures have been at least somewhat distorted by seasonal quirks of late, there is also a hint of underlying improvement.  Otherwise, we expect the unemployment rate to hold below 5% and average hourly earnings should be close to trend.  Finally, the favorable weather conditions mentioned earlier should help trigger a rebound in the average workweek.

* We look for a 0.9% gain in December factory orders, as the durable goods report pointed to another solid gain in overall bookings.  Meanwhile, shipments should show an even sharper advance, with inventories flattening out on the heels of the advances seen in October and November.

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Europe
Euroland
Jan 30, 2006

Eric Chaney (Paris)

Brace yourself for another growth surprise from old Europe, said this month’s business surveys, led by the German Ifo index.  All numbers crunched, our survey-based instruments, which had anticipated an acceleration of growth in the first months of the year, are now even more bullish, with 1Q manufacturing production now estimated at 1.4% (quarterly rate) vs. 0.9% after the previous round of surveys.  The qualitative picture described by companies is encouraging: demand is steadily accelerating and inventories are insufficient.  Because intra-European trade tends to grow faster than overall internal demand, many believe that the recovery is driven by exports, forgetting that the largest part of these exports go to neighbour countries.  In reality, the second phase of the European recovery that started in the middle of last year is driven essentially by domestic demand, and this is what makes it more robust to external shocks than most thought.  The other important feature of this recovery is that it is not evenly distributed across Europe: Germany, which has recovered its lost competitiveness, is leading the pack, while France is lagging.  German producers are fighting hard to capture demand where it is growing, i.e. outside their borders; in other terms, they are gaining market share.

Compass: “Strong and Steady Growth”

At the aggregate level, the Compass, our proprietary business cycle indicator, shifted from “Moving out of Recession” to “Strong and Steady”.   In other terms, the growth acceleration predicted last month was confirmed by January surveys, but, going forward, no further acceleration is expected.  From a monetary policy angle, the most important thing is that the Compass is in the north-east region of our map for the seventh consecutive month, which is consistent with robust or above-trend growth, with a recurrent tendency to accelerate.

Our Early GDP Indicator: above trend growth in 1Q

In contrast with last month, current production did not accelerate further; the indicator lost one-tenth of standard deviation at 0.7 psd.   Only Dutch producers, which had been in the doldrums for several months, reported a sharp acceleration, while French and Belgian producers mentioned a deceleration, linked to the highly volatile car industry, we think.  The positive surprises came from demand, up 0.2 standard deviation to 0.8 psd, and inventories, down three-tenths and now significantly lower than the long-term average, at -0.6, implying that companies are busy rebuilding inventories to meet current and future demand.  Boiling down the information from the surveys and other indicators such as past short-term interest rates and construction confidence, our early GDP indicator for the first quarter gained one-tenth, now at 0.7%Q, or 2.8% in quarterly annualised rate, after 0.5%Q in the previous quarter.  By any measure, this rate of growth is above the euro area potential growth, which we believe is probably slightly below 2%. 

The output gap is likely to shrink this year

Although hard data — 1Q GDP results will come in the second week of February — may still disappoint in a first stage, i.e. before revisions, I have learnt to trust the judgment of corporate Europe provided by business surveys, provided that surveys are correctly analysed and quantified.  At this very early stage of the year, the message from corporate Europe is loud and clear: the dynamics of the internal recovery are engaged and the output gap, which has widened every single year since 2001, is likely to shrink this year.  Rising operating rates would encourage corporate investment and, in some sectors, higher wages, feeding domestic demand in return.  Provided that policy mistakes do not choke domestic demand, the possibility of a virtuous growth circle is there.

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Europe
Euroland
Jan 30, 2006

Elga Bartsch (London)

When the ECB Council meets again this coming week to discuss the appropriate monetary policy stance for the euro area, Council members will find another round of relatively upbeat economic indicators in their preparatory packs.   Taken together, these indicators should induce the Council to conclude that the downside risks to GDP growth, which they highlighted at the January press conference, have since diminished somewhat. 

The recent batch of upbeat business surveys out of the euro area nudges our model estimate of 1Q GDP growth up by one-tenth to a non-annualised 0.7%Q (see Euroland: Growth Is Accelerating, January 27, 2006).   This puts our model estimate of EMU GDP two-tenths above our official 1Q GDP forecast.  However, there is some indication that 4Q GDP might have disappointed on the European continent.  In Germany, both the Statistics Office and the Bundesbank have warned that GDP growth has slowed down noticeably from the 0.6%Q recorded between July and September.  Our forecast of 0.35%Q might be on the optimistic side, but we will hang on to it until we get December retail sales, industrial production and manufacturing orders.  In France, disappointing December retail sales hint at disappointing consumer-spending dynamics.  In Italy, yet another fall in industrial production in November makes an outright contraction in 4Q GDP feasible.  Some of the softness will be short-lived, we think, as it will reflect spending being pushed into early 2006.  Nonetheless, GDP growth falling back below trend would likely cause the ECB to tread cautiously. 

At the same time, the first indication for consumer price inflation in early 2006 suggests that the renewed increase from a year-on-year HICP inflation rate of 2.2%Y in December might at most be two-tenths.   In addition to the increase in headline inflation, a further gradual increase in core inflation, which strips out the volatile energy and food components, might be in store, on our projections.  That said, the ECB has always tried to de-emphasise the role of core inflation in its monetary policy decisions.  This is because, over the relevant timeframe for the ECB’s monetary policy decision — the medium-term — headline and core inflation should not be too different.  Furthermore, inflation, both coincident and future, is not going to be the tipping point in the ECB’s decision-making at the current juncture.  This tightening cycle is mostly about normalising interest rates (see EuroTower Insights: ECB to Return to Normal, December 19, 2005).  Hence, the euro-area growth outlook is likely to have a pivotal role. 

The notion that ECB monetary policy is very expansionary at the moment was also underscored by December monetary aggregates.   They showed that the upward trend in loan growth remains in place and that narrow M1 money supply growth accelerated further.  Together with the fact that, at 7.3%Y, broad M3 money supply growth remains considerably above the rate of expansion in nominal GDP, at around 2.25%, this is likely to deepen concerns among Council members about the upside risks to price stability over the longer term.  This is especially the case because the strong money supply growth occurs against a backdrop of already ample liquidity in the euro area and an accelerating economy.  The moderate appreciation of the euro since the December rate hike, in our view, does not change this assessment of a very expansionary monetary policy stance — neither does the recent rise in long-dated government bonds yields. 

To sum up, our main case remains that of another 25 bp rate hike in March.   Given the perceived lack of preparation of financial markets for an imminent rate hike in the January press conference, which contrary to the ECB’s intention was seen as dovish by many observers, we would assign only an outside chance to a rate hike at the upcoming meeting.  The subtle change in the language at the January meeting from “monitoring developments closely” to “monitoring them very closely” should be enough, though, to keep ECB watchers glued to their screens this coming Thursday.  We continue to expect the ECB to raise interest rates by more than the market expects and look for a total tightening of 100 bp in the course of this year. 

Source: Reuters, Morgan Stanley Research

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Europe
Turkey
Jan 30, 2006

Serhan Cevik (Vienna)

Even against the worst energy shock in decades, Turkey is moving towards price stability.  Inflation, measured by the consumer price index, declined from an average of 77.5% in the 1990s to 9.4% in 2004 and then to 7.7% at the end of last year.  The pace of disinflation is remarkable, especially considering the adverse effects of higher energy prices and real output growth exceeding 30% in the last four years.  In our view, Turkey’s macroeconomic normalisation is a result of prudent policies and structural reforms that have functioned like an ‘innovation’ moderating volatility and raising productivity and potential growth rate.  In other words, broader economic reforms (including privatisation and deregulation) and closer integration with the global economy have exposed the Turkish economy to intense competitive pressures and become a self-reinforcing mechanism driving the secular disinflation process.

The globalisation of supply chains is a source of disinflationary pressures.   A few years ago we argued that market participants should get ready for deflation in certain sectors of the economy, not because of a collapse in consumer demand but arising from productivity gains and the globalisation of supply chains (see Start Reading About Deflation, November 3, 2004).  And the latest inflation data confirm our view: nine out of 22 manufacturing sub-sectors of the producer price index posted deflationary readings (as much as 11.2% in the case of office equipment) and six sub-sectors experienced price increases less than 3% on an annual basis.  Accordingly, the overall PPI increased by a mere 2.7% last year, down from 15.3% at the end of 2004.  This is a significant but not surprising outcome that has also been experienced by many other countries around the world.  In our opinion, structural shifts in the global economy have altered the inflation processes, even though higher commodity and energy prices and the inertia in services may still cause friction.

Competitive pressures create disinflationary shocks in the Turkish economy.   The share of international trade in Turkey’s gross domestic product has risen from 8.1% in 1960 to 23.4% in 1990 and 56.5% last year.  In turn, a higher degree of integration with the world economy has unleashed competitive pressures changing price-setting behaviour and lowering mark-ups in the corporate sector (see Payback from Globalisation, August 9, 2005).  In our view, this phenomenon is strikingly similar to how Wal-Mart’s logistical innovations have contributed to higher total factor productivity and thus to lower consumer prices in the US (see Charles Fishman, The Wal-Mart Effect: How the World’s Most Powerful Company Really Works and How It’s Transforming the American Economy, New York: Penguin Press, 2006).  As the growth rate of labour productivity has doubled to 8.3% per year in the post-crisis period, the Turkish manufacturing sector has experienced an unprecedented 40% drop in unit labour costs that now partly account for the divergence between tradable and non-tradable inflation rates.

Greater openness and deregulation will help to achieve price stability.  The decomposition of consumer prices shows a notable divergence in inflationary behaviour between tradable and non-tradable sectors of the Turkish economy.  Because of distinct differences in the factors driving tradable and non-tradable inflation rates, goods prices has increased by 6.2% in 2005, less than half of the 12.7% increase in the prices of services.  According to the latest figures, the behaviour of mark-ups in sectors open to international trade is converging to the ‘price stability’ range.  For example, clothing prices in the CPI basket declined by 0.1% last year, whereas the housing component posted a 9.9% increase.  It seems that backward-looking price adjustments and higher energy prices have limited the pace of disinflation in non-tradable prices.  However, beyond these temporary setbacks, Turkey’s real challenge is, in our view, the modernisation of traditional segments of the economy that have lower productivity and higher unit labour costs.  This is why, in addition to prudent macroeconomic policies, price stability requires microeconomic reforms that would unchain labour and product markets.

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Europe
UK
Jan 30, 2006

David Miles (London)

The arguments for today’s exceptionally low long-term real interest rates persisting are not compelling.   We believe the risks are substantially biased one way — towards long-term real rates being significantly higher, and perhaps in the relatively near term.

Yields on long-term government bonds have fallen to unusually low levels

The real yield on UK inflation-proof, long-dated government bonds has recently fallen below 0.5%.  In the 300 years since the government first issued bonds, rarely have expected real yields fallen under 1%, almost never under 0.5%. 

If we expect low long-term real interest rates to be a permanent phenomenon, this has profound implications:

— There would be no compelling reason for a government rush to issue overwhelmingly long-term bonds. 

— Investors looking to increase bond holdings might as well do so now, since the cost will not fall in the future. 

— Low real interest rates should be reflected in a wide range of long-lived asset prices. 

Arguments unconvincing as to why real yields might stay low

The idea that a world savings surge has driven real interest rates lower is not easily reconciled with IMF data, which show that the global savings-to-GDP ratio has barely increased in recent years. 

A rise in global risk aversion might account for a fall in the return on safe assets.   But this is hard to reconcile with the pricing of other risky assets.  Consistently lower future growth in GDP, or permanently greater global economic risk, might account for a permanent fall in real rates, but the scale needed is too large to make it plausible. 

Portfolio rebalancing seems the most convincing explanation for low bond yields …

Probably the most convincing explanation for exceptionally low real yields on long-dated UK government bonds is that past, current and anticipated rebalancing of UK pension fund and life insurance portfolios towards fixed income assets may have driven yields down.  The rationale is that demand for gilts from these investors is large, as they aim to match their liabilities in response to regulation and in an effort to improve their risk management profiles. 

New pension developments could help keep yields low.   On new guidelines, individual defined-benefit (DB) pension schemes will be charged with assessing their own (FRS17) funding shortfall and having a recovery plan to eliminate it.  It is likely that DB pension funds will increase their holdings of long-dated government bonds.  Long bonds are a better match for debt-like liabilities than most other asset classes.  While not effective in hedging longevity risk, they can protect against duration risk and, in the case of index-linked gilts, against inflation risk. 

The Pensions Regulator will require pension schemes to have a plan in place to eliminate deficits over a suggested maximum of 10 years, subject to not putting undue strain on the strength of the underlying company.   It is clear, however, that where the Regulator believes the deficit can reasonably be plugged within a much shorter time, it will require companies to do so.

A related development has been the establishment of a Pension Protection Fund, set up to compensate members of DB schemes in the event of sponsor company insolvency.   With a consultation exercise planned in 2006, in the following year or two pension funds may find that levies become linked to portfolio allocations and that funds with low bond holdings face higher levies. 

… but the impact could be muted

Whether these factors are powerful enough to keep yields at exceptionally low levels is unclear.   A number of factors act against such an outcome.  The majority of private-sector DB schemes are already closed to new members; and over the next few years many may also stop existing members from accruing additional rights.  Assuming these pension funds aim to hold a much larger percentage of bond assets, strong demand for UK bonds can be expected for several years.  But our analysis suggests that the scale of that demand is likely to fall off rather sharply around eight years from now (based on a portfolio switch to holding two-thirds of assets in bonds over an eight-year period).  If there are investors and issuers willing and able to take account of this demand pattern, the impact on bond yields of likely very strong nearer-term demand will be muted. 

But there may be few investors with the scope to take advantage of likely big swings in demand over such a long horizon.  If that is so, government and corporate issuers should take advantage of strong demand for long-duration fixed income assets by issuing very long maturity debt at prices that could come to seem very favourable in the medium term.  One possible impact of the de-risking of pension fund portfolios might therefore be that issuance of long-term corporate debt rises sharply.  If a company issues more debt that sits directly on its balance sheet, but simultaneously buys more debt to hold as a matching asset against its pension liabilities, it has not increased its net debt and its overall gearing has not changed.  If that happens more broadly, the bond and share price impact of corporate pension scheme rebalancing could be small.  Essentially, corporates could buy back their own shares that are held in other companies’ pension funds and issue debt to finance the transaction.  This creates the right amount of new debt to match that required by the portfolio switch within the pension fund.  In this case, the whole notion of a bond supply shortage would look strange, as does the argument that an imbalance between bond demand and supply can keep bond yields at remarkably low levels. 

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Japan
Japan
Jan 30, 2006

Robert Alan Feldman (Tokyo)

 

 

Outflows from Japan to foreign bond markets may be set to slow in 2006.  Since mid-2003, resident outflows into foreign bonds have averaged between Y15-20 trillion (US$135-180 billion) at an annualized rate.  The large interest differential, coupled with stable foreign bond markets and a strong or strengthening dollar have been the key factors.  However, these factors may change during the course of 2006.  As a result, Japanese investors are likely to concentrate more on domestic assets — especially equities and real estate — than in recent years.

Going Abroad Looks Problematic

Forecasts by my colleagues around the globe make a dismal case for buying foreign bonds.   My colleagues in the US forecast a rise of 10-year Treasury yields to 5.25% by year-end, implying capital losses at the long end.  True, a rise of short rates — triggered by a Fed Funds rate rising to 5.00% by year-end — would keep attractive assets at the short end, especially compared to the zero interest rates that are likely to continue in Japan.  However, the exchange rate could be a problem.  My colleague Stephen Jen, in FX Pulse (January 12, 2006), sees the yen strengthening toward Y106/US$ toward end-2006, in partial sympathy with moves of Asia ex-Japan currencies.  If Stephen’s call is correct, it implies two things.  First, the bloom is off the model that says currencies move in lock step with interest rate differentials.  Second, it means that there could be significant capital losses in yen terms for open positions even in short-dated US paper. 

What about Japanese purchases of European bonds?    Basically, the story is the same.  My colleagues in Europe see a similar pattern of yield increases, on the back of a strengthening European economy and an out-of-consensus call for a hike of the ECB refi rate to 3.25%.  In the meantime, the yen is expected to strengthen to Y131/EUR.  If our forecasts are on the mark, it makes even less sense for Japanese investors to take open positions in euro bonds than in US bonds.

The final twist to the story is a question of consistency.   Our forecasts of US bond yields are based on the assumption of benign capital flows into the US.  However, even with this assumption of benign capital flows, US yields go to levels that make the assumption questionable. 

Is Staying at Home Attractive?

The problem with reducing weights (at least at the margin) in foreign bonds is finding alternative investments.   Already, the Japanese stock market is up significantly in the last few months.  The equity market has already discounted significant future earnings increases.  Valuations are high — although not extremely so.  The swift reaction of the authorities this week to revelations of accounting irregularities at a high-flying Internet company reassured investors that Japan’s revamped regulatory structure is capable of acting quickly.  Confidence returned to the market just as fast, and equities ended the week on a very high note.  Thus, finding bargains is proving hard.

Domestic real estate seems likely to become a more attractive asset.   Land prices in center-city areas have already begun to rise around the country, and increases are spreading outward from city centers in some cases.  As Japan eventually exits from deflation, the attractions of land will likely become clearer.  Another step toward that exit from deflation occurred this week, as the nationwide CPI for December showed a positive year-on-year increase for the second straight month.  Moreover, the Bank of Japan continues to move cautiously on monetary policy.  Along with my colleague Takehiro Sato, I believe that the BoJ will continue its zero rate policy well into 2007, even though quantitative easing (i.e. the provision of extremely high levels of excess reserves) could end as early as end-April this year.  With positive price movements and zero interest rates continuing, real rates will be negative.  This is a very positive environment for real estate investment.  Indeed, the attendance at Morgan Stanley’s Tokyo conference on Japanese real estate last week was extremely high, with about 70% of participants being domestic investors.

Where Are the Risks?

What most worries investors in Japanese assets, both at home and abroad, is the lack of apparent risks, in our view.   Perhaps the biggest risk is complacency, at both corporate and policy level.  Corporations are finally seeing strong levels of profits, and are planning further increases of business investment.  There has also been a further acceleration of M&A activity.  It is natural for investors to worry over whether the investments will be wise.  At the policy level, there is one major cloud.  No one is certain about the political environment after Prime Minister Koizumi leaves office in September.  Whoever succeeds him will have to prove that he is just as serious about reform and just as willing to knock heads.  Without assurance of policy continuity, investor confidence in the reform agenda may ebb. 

For now, however, the relative attractiveness to Japanese investors of investing at home is rising, and that of investing abroad is declining.

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Europe
Currencies
Jan 30, 2006

Stephen L. Jen (London)

The Dollar’s Hegemonic Status Will Be Validated

The dollar will remain the dominant currency, I believe; no other currency will come close to supplanting its reserve currency status.   While the USD can rise and fall for cyclical reasons, talk of wholesale diversification or threats of divestment from USD assets motivated by geopolitical reasons are not persuasive. 

Threats from Iran (or Venezuela last year) are relatively unimportant, but we cannot dismiss the most severe potential risk event − one that involves China.  While this is still a low-probability risk, a conflict over Taiwan could very quickly raise the issue of an embargo, the US freezing Chinese assets and China moving assets out of US jurisdictions or even out of dollar assets to pre-empt the whole process.  I am not suggesting that this will happen.  However, officials in Beijing, being entrusted with such a large pool of national wealth, would not be doing their jobs if they did not consider this risk scenario. 

Both Asia and oil exporting countries are likely to remain USD-centric for years to come.  These countries may switch to money managers that are not under the jurisdiction of the US.  But in the end, they will continue to hold USDs as the main part of their reserve assets. 

Iran’s Announcement

Last Friday, Iran announced that some of its official reserves would be moved away from European banks.  This threat was subsequently retracted.  This announcement was probably motivated by concern that these funds might be frozen by either the US or its allies as a reaction to the nuclear stand-off.  Iran’s official assets have been frozen since President Carter’s declaration of national emergency with respect to Iran in 1979.  Iran’s concern, presumably, is that this ‘asset freeze’ may also be pursued by Europe. 

The Data We Have on Iran’s Foreign Asset Holdings

What we do know is that, first, as of June 2005, total assets held by Iran were US$23.5 billion, and total liabilities were US$25.6 billion.  Second, Iran’s gross official reserves, as of end-2005, stood at US$39.8 billion.  Third, the Oil Stabilization Fund value should have reached US$9.5 billion by now.  We can assume that, at present, Iran has combined reserves of around US$60 billion. 

My Thoughts

If Iran decides to apply its threat, will it be negative for the US Treasuries or the USD? 

•            Thought 1.  Iran has virtually no US Treasuries to sell, but holds a lot of USD deposits.  It is unlikely that Iran has accumulated new US Treasury holdings since 1979.  The point here is that the bulk of the reserves are likely to be in USD deposits.  Iran has no US Treasuries to sell and has no reason to be afraid of keeping its deposits in USD cash with commercial banks outside US jurisdiction. 

•            Thought 2.  Moving the location of the money managers is different from pulling out of USD assets.  Even though the location of the money management operations may have shifted outside US jurisdiction, foreign capital flows into the US have been sustained, and point toward no USD divestment by the Middle East.  As long as the US can offer superior risk-adjusted returns on assets or cash deposits, the threat of lasting divestment away from USD assets is not credible. 

•            Thought 3.  Malaysia may be one beneficiary, if Iran or other Islamic countries do move their assets.  Indeed, it has been preparing itself for years to be the Islamic financial centre. 

•            Thought 4.  The key risk is China, however.  The big risk, though not at all an immediate or a probable risk, is whether the US would consider freezing China’s foreign assets under US jurisdiction if tensions across the Taiwan Strait escalate significantly.  We should keep in mind that China holds close to US$300 billion in US sovereign paper, and possibly another US$300 billion in other USD assets or deposits

•            Thought 5.  China/the rest of the world will have little choice but to remain dollar-centric, however.  Most central banks’ key criteria when investing are: (i) security, (ii) liquidity, and (iii) return.  On the latter two, USD assets still reign supreme.  Thus, if push comes to shove, foreign reserves could move outside US jurisdiction and sit in USD cash deposits, rather than in non-US sovereign debt holdings. 

The risk of asset freeze has several implications.   (1) The trend toward UK and off-shore financial centres should continue.  (2) It will be even more difficult to track capital flows.  (3) Demand for gold from non-US, non-European central banks may rise.  In any case, the scope for USD divestment is limited. 

Bottom Line

The dollar may rise or fall for cyclical reasons, but talk of wholesale diversification and threats of divestment from USD assets motivated by geopolitical reasons are not persuasive.

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Europe
Currencies
Jan 30, 2006

Stephen L. Jen (London) and Luca Bindelli (London)

EUR/GBP’s Volatility Has Evaporated Since July 2003

Business cycles and monetary policies in the UK and Euroland have not been in sync in recent years and, structurally, the two economies are quite different.  However, the fact is that EUR/GBP moves have remained in a remarkably narrow range since the release of the ‘Five Tests’ by the UK Treasury in May 2003.  It is almost as if investors had, since then, treated the UK as a de facto member of the EMU. 

The Prevailing View in the Market

In the past two years, strategists have had a relatively bearish view on GBP/EUR, regardless of the general view on the EUR, which has fluctuated sharply in the past two years, and an absolutely bearish view on GBP/USD.   This view centres on the notion that the UK has serious structural flaws.  Its housing bubble could pop, making consumption and growth vulnerable.  The UK also has twin deficits and a relatively low productivity growth rate.  In holding this view, investors have persistently looked for any hint of rate cuts by the BoE. 

Selling GBP against the USD and EUR has been one of the strongest consensus views in the market.   However, this trade has not worked.

Some Facts

First, EUR/GBP has witnessed a strong decrease in volatility since July 2003 and has maintained below-average volatility since early 2004.

Second, this has occurred despite the substantial change in the yield differentials between the UK and Euroland.  In early 2003, Libor and Euribor displayed a spread of 125 bp.  Now, the spread is 225 bp.  Despite this move, the EUR/GBP spot rate exhibited no trend or increase in volatility. 

Third, we may think of the GBP as being ‘pulled up’ by the USD and the EUR.   Before mid 2003, the USD had been more important as a driver of GBP, but the reverse has been the case since mid 2003.  Ironically, the timing of this shift occurred at around the time of the UK’s Five Tests. 

Fourth, EUR/SEK also experienced a decline in volatility since 2002.   From an economic fundamentals perspective, it makes sense that EUR/SEK is trading lower than it has been in the past few years.  The puzzle, as for EUR/GBP, is how stable this cross has been, and how ‘sticky’ it has been relative to the EUR. 

Our Thoughts

These are not hard proofs, but some tentative hypotheses that may help explain why EUR/GBP has refused to move. 

•            Hypothesis 1.  Despite the Five Tests, investors may already be treating the UK as a member of the EMU.  The UK is already a well integrated member of the EU, and economic integration is likely to be even more entrenched going forward.  For long-term investors, this fact may be more important than the nominal yield differentials between the two economies. 

The UK’s more liberal and transparent economic/financial structure may have encouraged foreign investors to buy UK companies.  As the latest UN report shows, the UK is the second-largest recipient of gross FDI inflows in the world.  This has helped support the GBP, offsetting headwinds from macroeconomic variables. 

In short, the structural convergence of the UK and Euroland may have significantly muted the volatility in EUR/GBP: this cross will still move, but it might only move in a narrow range. 

•            Hypothesis 2.  Asian central banks may see the GBP as a high-yield proxy for the EUR.  We suspect that many Asian central banks see the UK as a good proxy for the EUR.  This relates to our point above regarding economic integration and the UK’s exposure to the business cycle in Euroland.  The latest BIS reports showed that the GBP has gained significant ‘market share’, in both terms of central banks’ holdings of GBP assets and the GBP’s share in the currency markets.

•            Hypothesis 3.  The dollar has dominated the G10 currency space since 2002.  The low variability of EUR/GBP and EUR/SEK may also have reflected the fact that the trend in the USD has dominated the currency markets since 2002.  Most currencies rose and fell in sync with the dollar, even though the relative magnitudes were different.  It may be that the market’s changing views on the USD have been much more dominant than their views on the GBP versus the EUR versus the SEK. 

Bottom Line

Despite the popular and persistent view that the GBP should weaken against the EUR, the fact is that the variability in EUR/GBP has been decreasing and has remained low since mid 2003.  Investors with longer-term horizons may already be treating the UK as a member of the EMU.  We are bearish on the GBP but now recognise that this may be a trade within a range.

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