Tripwires
Mar 13, 2006
Stephen Roach (New York)
On the surface, the global economy seems to be off to a great start in early 2006. The Great American Growth Machine has revved up again after a Katrina- and energy-related sputter in the final period of 2005. Japan is back, and even Europe is stirring. For China, India, and the rest of the developing world, vigor generally remains the name of the game. The global growth dynamic looks synchronous and increasingly powerful. With inflation remaining low, isn’t this the best of all possible worlds?
Beneath the surface, the answer is a resounding “no.” Contrary to widespread expectations, synchronous growth in an unbalanced world compounds the imbalances -- it doesn’t resolve them. When imbalances reach the magnitude they are today, rebalancing actually requires an asynchronous global growth outcome. Excessive growth in the deficit country (the United States) needs to slow, while lagging growth in the surplus countries (especially Japan and Europe) needs to pick up. The latter seems to be happening, but the former is not. America’s record $68.5 billion trade deficit in January 2006 says it all: US imports and exports are now so far out of balance, that sustained solid growth in the US economy can only beget larger and larger external deficits. This could well be a major -- yet largely unappreciated -- point of vulnerability for the global economy and world financial markets. Consider first the arithmetic of the problem. In the United States, total imports of goods and services are now 59% larger than exports. With the US still running a small surplus on services of around $5 billion per month -- probably not for much longer, I may add -- that cushion masks an even larger mismatch in the goods piece of the trade balance. In fact, America’s imports of tradable goods are currently 89% larger than US exports of manufactured products. This astonishing mismatch between purchases of goods made abroad and overseas sales of American-made products is an important outgrowth of a huge surge in import penetration into the United States over the past 20 years. Goods imports rose to 37% of America’s domestic purchases of goods in 4Q05 -- up dramatically from readings of 27% in 1995 and 20% in 1985. High levels of import penetration pretty much pre-ordain the vicious circle of ever-expanding trade deficits for economies with vigorous growth in internal spending. Again, it’s hard to argue with the math. Given the high import content of domestic demand, a given increment of consumption growth, for example, produces a much larger surge in imports than would have been the case in days past when import content was considerably lower. Moreover, the extreme imbalance that now exists between goods imports and exports makes it next to impossible for the US to export its way out of this problem. Exports would now have to expand at twice the growth rate of imports just to hold America’s outsize trade deficit on goods constant! Consider next the analytics of the problem. There are two distinctly different strains of thought that are used to explain America’s gaping trade deficit -- the micro of competitiveness and the macro of saving. The former speaks to the rough and tumble battle in the arena of global trade and often involves politically contentious trade disputes between nations. Taken to its extreme, disputes over competitiveness can lead to trade frictions and even protectionism -- hardly a trivial concern these days in light of the outbreak of China-bashing now evident in Washington. The other rationale follows from the classic saving-investment identity of orthodox macroeconomics -- that nations with shortages of domestic saving will attempt to import surplus saving from abroad in order to maintain investment and overall growth objectives. That means they must then run massive current account deficits in order to attain the foreign capital. Moreover, with the trade deficit accounting for fully 93% of the US current account deficit, this explanation also implies that the extraordinary imbalance between imports and exports is very much an outgrowth of an equally extraordinary shortfall in domestic saving. With America’s net national saving rate having plunged into negative territory for the first time ever to the tune of -1.2% of national income in 3Q05, it is next to impossible to avoid large trade deficits. For the US, there is an important twist to the macro underpinnings of the trade deficit: Inasmuch as the surging wealth of American consumers biases the income-based personal saving rate sharply to the downside, the trade deficit is also an outgrowth of the asset-dependent character of the US economy. The truth as to what lies behind the US external deficit is undoubtedly a combination of the micro and the macro. But the bottom line is that these external imbalances are getting worse rather than better -- even in the face of an apparent resynchronization of the global growth dynamic. In my view, that reflects the dominance of the macro aspects of the problem. The income-based saving of America’s asset economy is so low and the import penetration of its real economy is so high, that more growth in US aggregate demand simply begets ever-mounting trade and current-account deficits. This imposes enormous strains on the international financing mechanism to keep the game going. In 2005, the US needed about $3 billion of foreign capital inflows each business day of the year -- up dramatically from the $2 billion daily funding requirement just two years ago in 2003. Such external dependency of any nation is simply without precedent in the annals of globalization and international finance. Moreover, it is the diametric opposite of the flows that drove the globalization of the late 19th and early 20th centuries, when surplus saving of rich European countries was used to fund the development of newly settled developing countries in the Americas and Asia/Pacific. Today, China -- still one of the poorest countries of the world in terms of per capita income -- has played an increasingly critical role in funding the US hegemon. The rules of engagement in foreign aid have been turned inside out -- rather than flowing from the rich to the poor as once was the case, capital is now moving from the poor to the rich. Nor does the saving-short US seem to have much appreciation for the precarious nature of this arrangement. Not only is China bashing on the rise, but Washington politicians are becoming increasingly heavy-handed in attempting to manage the external lifeline of capital inflows. The Dubai port incident, unfortunately, is only the tip of a much bigger iceberg. There was also last year’s high-profile rejection of a bid to buy Unocal by a Chinese oil company. Moreover, in recent weeks, Washington’s increasingly xenophobic politicians have gone even further. A leading US senator floated the possibility of legislation preventing cross-border acquisitions of US companies by foreign state-owned entities. And during last week’s negotiations over the debt ceiling bill -- with a lifting of the government’s debt limit required only because a saving-short US has decided to up the ante on deficit spending -- there was actually an attempt made to restrict foreign ownership of US Treasuries. The good news, if you want to call it that, is that this latter attempt has since been watered down “only” to require a detailed accounting of the overseas holding of US government debt. But the irony of these politically motivated efforts to throw “sand in the gears” of America’s external funding mechanism is especially striking: At precisely the moment when the US has pushed its external funding requirements into unprecedented territory, it is becoming more and more aggressive in dictating the terms of the requisite inflows. Meanwhile, there’s another very important shoe about to fall in the arena of global capital flows -- the likely shrinkage of current-account surpluses by the world’s largest biggest savers. Japan, China, and even Germany are all making determined efforts to stimulate internal consumption in order to promote balanced and sustainable economic expansions. This will have the effect of drawing down their excess saving, reducing their trade and current account surpluses, and leaving them with less external capital available to fund America’s saving shortfall. Japan is leading the way in that regard; on the back of a marked pickup in domestic demand, its trade balance has gone from surplus to deficit for the first time in five years. China is also increasingly focused on transforming its export-led economy into a consumer-driven growth dynamic; that emphasis is very much in evidence at this year’s National People’s Congress currently in session in Beijing. These developments in both Japan and China are further examples of the pitfalls of a renewal of synchronous growth in an unbalanced world: Unless the deficit nation (the United States) starts saving again, a drawdown of saving elsewhere in the global economy will only complicate the world’s current-account financing tensions. To me, all this speaks of an increasingly treacherous endgame for the current state of tranquility in world financial markets -- especially the all-important expectational underpinnings of the dollar and longer-term US real interest rates. Investors are nearly unanimous these days in dismissing the mounting economic and political tensions of an unbalanced world -- arguing that it is in everyone’s best interest to keep the game going. The retort of increasingly smug US fund managers is typically something along the lines of, “What else are the Chinese going to buy -- euros?” At the same time, I worry about an even more treacherous aspect of the endgame. An earlier era of globalization was brought to a tragic end by two world wars in the first half of the 20th century. While history rarely repeats itself, the rhymes never cease to amaze me. The current wave of globalization is occurring against the backdrop of a very different mosaic of geopolitical risks than those which prevailed a century ago. Nation-specific rivalries have given way to threats coming from the amorphous terrorist ranks. Yet there is a worrisome common thread: In both cases, the integration of economies and capital markets clashed with the fragmentation of geopolitical order. Add in the current tensions associated with widening income disparities, real wage stagnation in developed countries, and the growing outbreak of trade frictions and protectionism, and today’s world looks far from secure. The tripwires of globalization are now being set.
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Tweaking the Fed Call
Mar 13, 2006
Richard Berner (New York) and David Greenlaw (New York)
Forecast at a Glance | | 2005E | 2006E | 2007E | | Real GDP | 3.5% | 3.5% | 3.2% | | Inflation (CPI) | 3.4 | 3.0 | 2.2 | | Unit Labor Costs | 2.6 | 2.4 | 3.0 | | After-Tax “Economic” Profits | 8.0 | 11.6 | 2.3 | | After-Tax “Book” Profits | 33.4 | 9.7 | 2.6 | Source: Morgan Stanley Research E = Morgan Stanley Research Estimates Growing risks of higher inflation have prompted us slightly to adjust our Fed call: We now expect the Fed to increase the Federal funds rate to 5¼% by September or so; previously we thought the Fed would stop at 5%. The key reason: Although core inflation has so far remained benign, dwindling economic slack and escalating costs in the context of strong US and global growth have marginally raised the risks that prices will accelerate. Thus, we haven’t changed the major features of our baseline prognosis for inflation and growth compared with a month ago, but the tails of the distribution are fatter and are skewed to the upside. We emphasize that this adjustment is simply a tweak in the spirit of the Fed’s own “risk management” policy procedures. The Fed has already completed 350 basis points of what we see as a 425 bp tightening cycle, so they are much closer to the end of the job than either of the other two major central banks. Their goal is to restrain inflation, not to kill the economy. And we acknowledge that there are some downside risks to both inflation and growth. Thus, the Fed and market participants find themselves increasingly in uncertain territory, probing for the right balance that will cap inflation but still support growth. We think the Fed will succeed, and still believe that, as inflation subsides, officials eventually will be able to trim rates from that 5¼% level. But contrary to the persistent belief among many market participants that a reversal in monetary policy is likely in 2006, we think that’s a story for 2007. Here’s why. First, let’s assess inflation risks. For some time, we’ve stressed that the risks for inflation were tilted higher, calling for a rise in core CPI inflation to 2.6% over 2006. If anything, at today’s interest rates, we think there are upside risks to that forecast. Yet “core” inflation — excluding food and energy — has flattened out at just over 2% as measured by the CPI and at only 1.5% measured by the market-based personal consumption price index over the past year. Despite our concerns and the Fed’s that companies with rising pricing power would pass higher energy and materials costs through to underlying inflation, that has yet to happen in a significant way. And we agree that both globalization and a higher trend for US productivity growth — the latter in our view centered on 2½-2¾% — are secular forces limiting any rise in US inflation. So if it hasn’t happened yet, why will inflation rise now? As we see it, both fundamental and statistical factors have kept core inflation subdued thus far, but they are unwinding. On the fundamental side, a tug of war between two sets of opposing forces over the past year left core inflation low and stable. First, a stronger dollar trimmed the gains in consumer import prices that had likely hiked both inflation and inflation expectations over 2004 and early 2005. Excluding autos and trucks, the deceleration in consumer import prices during the past seven months from 1.4% to 0.1% likely has played a role in capping US inflation and to some extent inflation expectations. Second, and in contrast, rising industrial operating rates, a sinking jobless rate, and a narrowing gap between actual and potential GDP have slowly helped many US firms recapture pricing power and pass along increased costs. As evidence, in the face of fading operating leverage, many US companies in industries ranging from railroads to hotels are raising prices — and in those two specified industries at a significantly faster clip than last year. Apart from energy, however, the cost side of the picture turned more benign last year: Materials cost growth faded significantly, courtesy partly of the dollar’s strength, and unit labor costs were benign — gaining only 1.3% in nonfarm business as productivity ran at trend and most of the 3.8% gain in compensation was lodged in benefits growth. Moreover, statistical quirks have in our view held core inflation down over the past year. Hotel room rates have recently accelerated, but at 4.1% in the year ended in January, are still short of both wholesale increases (6%-plus) and industry data on revenue per average room. We believe that this distortion shaved about 0.2 percentage point from core CPI inflation last year. In addition, we think that a quirk involving utility prices suppressed owners equivalent rent (which accounts for 30% of the core CPI). In calculating OER, statisticians subtract utilities from actual rents paid in order to derive a measure of "pure" rent, so rising fuel prices tend to depress OER inflation. That was then. Today, we see some further upside risks because some of the factors restraining inflation have faded and those pushing it higher have gained the upper hand. Inflation expectations have drifted down and are relatively well-anchored but remain slightly higher than a year ago. The dollar has become a neutral factor for pricing. But slack in both product and labor markets continues to dwindle, with industrial operating rates now rising above historical norms, and the unemployment rate solidly under 5%. Neither output nor employment is booming, but corporate capital discipline has restrained growth in capacity, and entry into the labor force by both women and teens has flattened or declined for the last five years. Thus, it would take a capital spending boom and a sharp increase in labor force participation to offer relief on either front. The results are lately apparent in tightening labor markets: Average hourly earnings accelerated to a 3.5% clip in the year ended in February, the fastest pace in nearly five years. And while AHE is a flawed measure of wage growth, it likely does accurately indicate the direction of change (see “Will the Real Wage Measure Please Stand Up?” Global Economic Forum, January 6, 2006). Dwindling slack in product markets will enable companies to pass some of those costs through to finished prices. And as employment growth catches up with the economy, productivity seems likely to slip marginally below trend, adding to the rise in unit labor costs. Statistical quirks, moreover, are now likely to move in favor of higher inflation: Hotel rates seem likely to catch up to “revpar” results, and slight declines in utility quotes will now likely put upward pressure on OER. What about growth? That catchup in jobs and wages is also critical for the American consumer, as it underpins our call that consumers will have sufficient income to sustain moderate growth in spending as well as to rebuild saving (see “All About Income,” Global Economic Forum, February 21, 2006). Indeed, the combination of February’s labor inputs, hourly earnings, and a likely decline in headline inflation means that a proxy for real wage income rose by 3% compared with February 2005. So while we expect some weather-related “payback” in February consumer spending from the unsustainable strength over the past three months, the fundamentals for healthy consumer spending are looking better by the month. What’s more, healthy pent-up demand for capital spending, improving global growth, favorable financial conditions, and unmet state and local government needs also represent strong support. Indeed, following a moderate 6.1% annualized gain in equipment outlays in the fourth quarter of 2005, incoming data suggest a gain nearly three times that pace in the current quarter. Strong global growth is boosting gains in exports: Real merchandise exports jumped at a 35.7% annual rate in the last four months. So while booming imports will prevent a narrowing in the trade gap, the drag on growth from net exports may be fading. And in our view tight credit spreads and ample credit availability mean that financial conditions are still supportive of growth. These forces in our view will swamp the drags from fading housing activity, cooling home prices, and rising interest rates. Yet many are still convinced that those last three forces will soon undermine growth, especially when looking at the precedent from Australia and the UK. In our view, the deterioration in US housing affordability is largely the product of rising home prices, in contrast with Australia and to some extent the UK, where rising interest rates have played more of a role (for a comparison of the three markets, see “Housing, Mortgages and Consumption: Comparing Australia, the UK and the US,” Global Economic Forum, March 3, 2006). Thus, the case for a faster decline in home prices than we expect (we look for a return to 2-4% nominal gains in the next 18-24 months) would hinge on a significantly larger and faster rise in interest rates than we expect. And our analysis of the three markets also convinces us that the housing wealth/spending connection is looser and the threat from an “ARM squeeze” is smaller in the US than in the other two venues (see also “Housing Wealth and Consumer Spending,” and “Home Sweet Home” Global Economic Forum, October 7 and December 17, 2005). Some of the upside risks to inflation and persistently strong growth is now priced into bond markets, with 10-year yields backing up to nearly 2-year highs and the yield curve “disinverting” over the past month. In our view, the Treasury yield curve probably will see-saw around a flat level for the next few months as market participants try to discern at what level and when Fed tightening will end. Although the US curve will probably remain relatively flat for some time, it likely will resteepen slightly later this year and into 2007 as rising term premiums and the effect on the global saving-investment balance from stronger growth abroad will offset an incipient demand for duration (see “The Term-Premium Case for Higher Yields,” and “Demand for Duration: Coming Soon?” Global Economic Forum, January 20 and March 10, 2006). Market participants are now scaling back positions in risky assets like emerging market equities and currencies as they fear that synchronized tightening by all major central banks will terminate the flow of liquidity that has supported these markets. Those fears may be overdone; for example, our Bank of Japan expert Takehiro Sato believes that it will be late 2006 before the BOJ actually increases rates, and that any increase will be modest. We think the risks point to higher rates because global growth is strong, but that mix should not be bad news for risky assets (see “A Rise in US Rates: Made in Japan?” Global Economic Forum, February 27, 2006). As we see it, however, the real risks for risky assets continue to derive from either a supply-shock induced spike in energy prices that would hobble growth or higher inflation that would trigger even more aggressive Fed tightening. Neither of those is currently in the price.
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Review and Preview
Mar 13, 2006
Ted Wieseman (New York) and David Greenlaw (New York)
The Treasury curve’s big bear steepening move continued in the latest week, with both technical/flow and fundamental drivers contributing to the further sell-off. The bear steepening had first begun after the end of February, when support for the back end from month-end index duration extension faded quickly. The past week’s key fundamental driver, the delayed February employment report, was much stronger than we expected, showing little if any negative weather impacts while pointing to both a strengthening in the underlying pace of job growth and also a further acceleration in wage gains. In the wake of this upside surprise, we now expect the Fed to hike rates 25 bp at both the March and May FOMC meetings, taking the funds target to 5%, then pause before a final hike in Q3 to a peak 5.25% fed funds target. Previously, we had anticipated a pause after the March move and a subsequent 5% peak. The strong employment report dominated fundamental market attention over the past week -- though a big flow driven bear steepening sell-off on no news Monday actually accounted for most of the week’s net losses -- but the balance of the other incoming economic news was negative, leading us to cut our Q1 GDP estimate to +4.6% from +5.0% coming into the week and +5.6% two weeks ago. Much of this Q1 shortfall, however, should be made up in a further upward revision to Q4 and stronger Q2 growth than we previously anticipated. Focus in the coming week will be on the CPI and retail sales reports for February, which we expect to be market friendly, with an energy driven flattening out in headline prices and steady core inflation along with a broadly based partial reversal of the January surge in consumer spending. Over the past week, the benchmark 2’s-10’s and 2’s-30’s curves steepened another 8 and 9 bp, respectively, on top of the 8 and 11 bp moves of the prior week, as the 2-year yield dipped 1 bp to 4.74% and the 10-year and 30-year yields rose about 8 bp each to 4.755% and 4.74%. These large benchmark moves, however, significantly overstated the underlying curve dynamics, as the current 2-year caught fire in repo mid-week and richened significantly as a result. So in sharp contrast to the 1 bp decline in the on-the-run 2-year yield for the week, the first off-the-run saw its yield rise about 2.5 bp and the second off-the-run about 3.5 bp, while the June 2-year contract fell 2.5 ticks. The 3-year yield rose 5 bp on the week to 4.79% and the 5-year yield 6 bp to 4.77%. Since month-end support drove its yield down to 4.50% at the close on February 28, the new 30-year’s yield has now backed up a whopping 24 bp in just eight trading sessions. An interesting reversal in the TIPS market suggested a changing dynamic of the latest leg of the bond bear market. Through the close on Friday March 3, the 5-year benchmark breakeven inflation rate had surged 50 bp since the end of 2005 to 2.77% entirely as a result of rising inflation expectations -- the nominal 5-year yield had risen 35 bp, while the 5-year TIPS yield had actually fallen 14 bp. A similar, if less dramatic pattern was seen in the 10-year sector -- the 10-year breakeven inflation rate was up 28 bp year to date through March 3 to 2.62%, with the nominal yield up 29 bp and the real yield up fractionally. But suddenly in the latest week, TIPS fell sharply, a strangely delayed but certainly fundamentally appropriate reaction to the steady ratcheting up of Fed expectations that has been ongoing almost all year. Over the past week, the 5-year TIPS yield (with its now almost ludicrous looking 7/8% coupon) surged 21 bp to 2.14%, leading to a 15 bp decline in the benchmark breakeven inflation rate, while the 10-year TIPS yield jumped 16 bp to 2.22%, reducing the breakeven inflation rate 9 bp. Futures markets continued to price in an ever more aggressive Fed path over the past week. Some of this came in response to the employment report, but a good part of it came earlier in the week when the data were weaker than expected, suggesting that spillover impacts from more hawkish ECB and BoJ expectations continued to play a role. On the week, the April fed funds contract rather oddly sold off 1 bp to 4.76%, suggesting the market may actually consider a 50 bp hike this month or an inter-meeting move in April a slight risk. The May contract lost 2.5 bp to 4.91% and is now pricing in a greater than 90% chance of a hike in the funds target to 5% at the May 10 FOMC meeting. The July contract lost 5.5 bp to 5.05% as the market began to price in a possibility of 25 bp rate hikes at the March, May, and June meetings. Looking further out, the eurodollar futures market moved marginally further towards reversing its curve inversion, with the Sep 06 to Sep 07 spread rising 1 bp to -13.5 bp on a 4.5 bp loss in the former contract to 5.225% and a 5.5 bp loss in the latter to 5.09%. The February employment report was surprisingly strong from our perspective. Considering that a severe blizzard hit the eastern part of the country early in the survey week and that there was a major negative temperature swing relative to seasonal norms -- this January was the warmest in the 112 years the government has collected data, while February was only slightly warmer than average -- we had expected to see a significant, temporary weather-related hit to employment growth. But with payrolls rising a well above-trend 243,000 (compared with average monthly job gains of 173,000 in the year through January), there appeared to be both no weather impact of any significance and potentially also a notable pickup in underlying trend job growth. With a strong gain in weather-sensitive construction payrolls and no unusual upside in the household survey’s measure of “not at work because of bad weather,” there was certainly little direct sign of weather effects on actual job gains. But a dip in the average workweek to 33.7 hours, which resulted in aggregate hours worked declining 0.1% despite the robust gain in jobs, did suggest at least some weather impact on the details of the report that will probably be reversed next month. And in February job gains were broadly based, with, in addition to the jump in construction payrolls, strong increases in finance, business services, education, health, and government. Other details of the report were somewhat mixed. Average hourly earnings continued their solid recent acceleration, rising 0.3% in February for a 3.5% year/year gain, the largest annual increase since September 2001. While some of the recent acceleration reflects a shift in the mix of employment -- specifically, the loss of low wage jobs in hurricane-impacted areas of the Southeast -- there is no question that labor markets have been getting tighter, leading to some underlying build-up of wage pressures. The next employment cost index report (due out on April 28) should show some acceleration in wages. On the softer side, in addition to the dips in the average workweek and aggregate hours worked -- though we believe these were probably just temporary weather distortions -- the unemployment rate ticked up a tenth to 4.8%. This was not a result of soft job growth, however, as the household survey showed a 183,000 gain in employment. Instead the labor force participation rate showed some rare upside, ticking up a tenth to 66.1% on a 335,000 jump in the labor force. The Fed had better hope this trend continues, because if the recent upswing in wages does not prompt a sustained pickup in labor force participation, with job gains now apparently trending at over 200,000 a month, the unemployment rate could well resume sinking in a hurry and the FOMC’s fears of rising “resource utilization” could be increasingly realized. In response to the significantly stronger results in the employment report than we were expecting, we made a slight adjustment to our Fed forecast. We now see a year-end fed funds rate target of 5.25%, up from our prior 5.00% estimate. Another 25 bp hike to 4.75% at the upcoming March 28 meeting appears to be assured, and it is getting harder to see how another tightening at the May 10 meeting can be avoided given the expected outcomes of the GDP, ECI, and employment reports that will be released ahead of it. While we expect to see some moderation in economic activity beyond the first quarter, we also look for the core CPI to accelerate by about 0.5 percentage points over the course of the year. We doubt the FOMC would remain on the sidelines in the face of such an upswing, so we expect a final further rate hike to 5.25% sometime around September. Aside from the employment report, other data released the past week were softer than expected and resulted in a further downward adjustment to our Q1 GDP estimate. Most noteworthy was the trade report. The trade deficit widened to a record $68.5 billion in January from $65.1 billion in December, with both exports (+2.5%) and imports (+3.5%) posting sharp gains. On the export side, the largest contributor was a surge in aircraft exports that was in line with industry data, and there were also big gains in food and industrial materials. On the import side, a price driven jump in petroleum products offset a surprisingly small pullback in natural gas to leave overall energy imports up significantly. Strong gains were also seen in other industrial materials, autos, and consumer goods. Reflecting robust domestic and overseas demand, both real exports and imports look set to post their sharpest gains in Q1 in more than two years. But the net results of the two surges looks to be a larger subtraction from net exports from first quarter growth than we previously estimated, as more of the Q1 domestic demand surge appears to have been met out of imports instead of domestic production than we previously estimated. Combining the negative trade results with a number of other inputs into our GDP estimates released over the course of the week -- including manufacturing inventories, revised capital goods shipments, wholesale inventories, unit auto inventories, and state and local government employment -- we further reduced our Q1 GDP estimate to +4.6% from +5.0% at the start of the week and +5.6% two weeks ago. On the positive side, we now look for a further upward revision to Q4 to +1.8% from +1.6%, and some of the latest downward adjustment to our Q1 estimate reflected lower inventories, which should be made up in the second quarter, pointing to upside to our prior +3.2% Q2 GDP forecast. So over the course of 2005Q4 to 2006Q2, we continue to see annualized GDP growth running near +3.3%, but with a somewhat smoother quarterly pattern than previously expected. The upcoming week has a busy economic calendar. In Fed events, the Beige Book prepared for the March 28 FOMC meeting will be released Wednesday. Given the recent decline in the unemployment rate and concurrent acceleration in wages, anecdotal comments from regional business contacts on labor market conditions will probably be most closely watched for in this report. Ahead of the start of the traditional quiet period before the upcoming FOMC meeting, a number of Fed speakers will also be making public appearances, including San Francisco Fed President Yellen, Atlanta Fed President Guynn, and Governors Kohn and Olson. On the data calendar, main focus will be on retail sales Tuesday and CPI Thursday. The key early regional manufacturing surveys -- Empire State Wednesday and Philly Fed Thursday -- will set initial expectations for the March ISM report. Other key releases due out include the current account and business inventories Tuesday, housing starts Thursday, and industrial production, and University of Michigan consumer confidence Friday: * We look for a broadly based retracement in February retail sales of January’s blow-out performance and forecast a 0.8% drop in overall sales and a 0.6% decline ex autos. Specifically, the reports from the auto companies point to a pullback in the motor vehicle category. Meanwhile, chain store results imply a flat reading for general merchandise and a sizeable decline in the apparel sector. Also, we expect to see a modest price-related dip at gas stations. Finally, drug store sales and activity at restaurants also appear to have been unusually soft. Some of the expected weakness in February sales no doubt reflects a weather-related payback from the unusually mild conditions that prevailed in January. In any case, we still see real consumer spending on track for about a 5% rise for the quarter as a whole. * We expect the fourth quarter current account deficit to rise to $219.5 billion. The monthly trade statistics imply that the current account gap set another new all-time record in Q4. In fact, even gauged relative to the overall size of the economy, the current account deficit is expected to have been 6.9% last quarter -- surpassing the prior record of 6.5% seen in 2005Q1. * We forecast a 0.1% rise in January business inventories. A drawdown in stockpiles of automobiles is expected to help lead to the smallest rise in overall inventories in six months. Meanwhile, the I/S ratio is expected to hit another new record low. * We look for a flat reading for the overall consumer price index in February and a 0.2% rise excluding food and energy. A partial pullback in the energy category should help hold down the headline CPI this month. Otherwise, we look for offsetting swings in a number of key categories, which should leave the core rate close to its recent trend. In particular, motor vehicle prices should post a more modest rise than seen in January. And quotes for apparel items are likely to slip back into negative territory. On the upside, hotel rates should continue to catch up with private surveys. And the medical care component should rebound following an unusually low reading in January that appeared to be tied to a one-time swing in doctor’s fees. If our estimate for the core CPI in February is on the mark, the year/year rate should hold at +2.1%. * We forecast a 14.3% decline in housing starts in February to a 1.95 million unit annual rate. Unusually mild weather conditions appeared to contribute to the 14.5% surge in starts during January -- even though gains in the West and South regions suggest that this was not solely a weather story. We expect to see an unwind in February given the less favorable weather conditions and the recent build-up of unsold inventory. * We look for a 0.7% jump in industrial production in February. A sharp, weather-related rebound in utility output should more than offset some slippage in motor vehicle assemblies, leading to a solid gain in overall IP. The key manufacturing component is likely to be little changed overall and +0.3% excluding motor vehicles. Based on the labor market data, solid gains are anticipated in the furniture, machinery, and printing categories. Finally, the utilization rate should tick up to another new cycle high of 81.4%.
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Diverging NAIRUs
Mar 13, 2006
Eric Chaney (London)
Despite tepid GDP growth performance, the euro area is enjoying a steady decline of its unemployment rate, beyond cyclical fluctuations. To see that, we first focus on survey based unemployment rates, consistent with ILO international standards rather than on data derived from unemployment benefits, which are too sensitive to policy decisions. Second, we look at peaks and lows. In the aftermath of the 1992-1993 recession, the aggregate unemployment rate of countries now forming the euro area peaked out at 10.9%, in early 1994. Following the 2002-2003 growth recession, the unemployment rate rose ‘only’ to 8.9% in early 2004, two full points below the previous peak. Back in 1990, when European economies were so stimulated by the massive fiscal stimulus that resulted from the German unification that most of them were overheating, the aggregate unemployment rate dropped to 8.0%. In early 2001, still good times for growth and jobs, it did not fall significantly lower (7.8% in June 2001). Is 8% a floor for Euroland unemployment? I don’t think so Does this imply that there is some sort of natural floor around 8% in the euro area? I do not think so. Back in 1990, 8% unemployment was associated with inflation higher than 5%, whereas, in 2001, inflation was only 2.5%. In order to clarify the structural changes that may have taken place in the euro area, the short-term trade-off between unemployment and inflation, known as the Phillips curve, needs to be taken on board. Focusing on core inflation rather than headline, highly sensitive to import prices and thus less relevant for the purpose of labour market analysis, it strikes me that the euro area unemployment rate has steadily declined since the end of 2004 (down to 8.3% in January), while core inflation has also declined, from 1.9% at the end of 2004 to only 1.2% in the latest reading. That both unemployment and core inflation may recede in sync sounds counterintuitive: if the economy was moving along a given Phillips curve, then lower unemployment should lift up core inflation, shouldn’t it? The answer is yes, if the Phillips curve were constant. The simplest explanation that fits with the facts is that the Phillips curve is currently shifting inward in the euro area as a whole. If this hypothesis is correct, no wonder that the ominous “second round effects” feared by the ECB after the quadrupling of oil prices have not yet shown up. Watch country NAIRUs However, the trade-off between inflation and unemployment holds only in the short term. A more adequate concept, which has the favour of most economists, is the NAIRU (non-accelerating-inflation rate of unemployment). For a given structure of the labour market, it is thought that the unemployment rate cannot fall permanently below some threshold without causing ever higher inflation. In other terms, the long-term Phillips curve is vertical, if one plots unemployment on the horizontal axis and inflation on the vertical one. It has also been argued that the Phillips curve might become horizontal at very low levels of wage inflation, because of nominal rigidities (See “Resurrecting Phillips Curves”, Eric Chaney, November 2002). In addition, the very concepts of Philips curve and NAIRU may have some solid theoretical foundations for a given labour market, but they are less relevant for a region such as the euro area, where labour is not mobile and labour market institutions (wage bargaining, labour laws, employment protection and so on) are quite different across borders. This is why, in the end, the economic reality is embedded in country economics, not in euro area aggregates. Looking at short-term Phillips curves in the four largest EMU economies, one conclusion stands out: the NAIRU is declining rapidly in southern economies, i.e. Spain and Italy, where inflation is broadly constant and unemployment is falling fast. Although things are less clear-cut in Germany, I would consider the current state of wage deflation (compensation per employee was down 0.1% in 2005) as a sign that the unemployment rate is significantly higher than the NAIRU and that the NAIRU is probably declining. Last, the stability of inflation in France despite unemployment rising since 2001, is a sign that the NAIRU might be actually increasing in this country, probably as a consequence of the hefty rises in the minimum wage that followed the 35-hour work week. I draw two conclusions from this quick investigation. First, the ECB needs to watch carefully country developments in order to anticipate inflation trends. If the NAIRU kept on falling in Italy and Spain, then inflation would be unlikely to take off, even if GDP growth accelerated significantly. Conversely, if the NAIRU stabilised in these countries, then, inflation might accelerate even if unemployment did not fall further. Second, the relative competitive positions of EMU members are changing. Seen through the lenses of the labour markets, the advantage is to the South.
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The Risk of Political Instability
Mar 13, 2006
Vincenzo Guzzo (London)
New electoral rules will give pollsters hard time. On April 9-10, Italy will go to vote. Exactly one month away from that deadline, the election outcome is far from certain. Over the past two months, most opinion polls have been showing opposition candidate Romano Prodi and his center-left coalition leading by about 4-5 percentage points over Prime Minister Silvio Berlusconi and his ruling center-right bloc, but lately that margin appears to have eroded somewhat. Two opinion polls, commissioned by the Prime Minister’s party, would even exhibit a fractional advantage for the incumbent coalition. Beyond the unusual divergence in opinion polls, an even more important factor will affect the predictive power of these surveys, in our view. At the end of last year, the parliament pushed through a law that has introduced major changes in Italy’s electoral system. On the back of these changes, the translation of voting intentions into actual seats may result in a particularly arduous exercise. Back to proportional representation. Since 1994 Italy had relied on a mixed system that used to assign 75% of the parliamentary seats in the Chamber of Deputies and in Senate through first-past-the-post constituency contests and the residual 25% on a proportional basis. With the latest changes, Italy will go back to a system of full proportional representation. A number of thresholds will be in place. For the Lower House, each coalition of parties will have to reach at least 10% of the total valid votes and each party linked to that coalition will have to gather at least 2% of the votes in order to get a seat. Alternatively, parties will also be able to run outside a coalition, but in this case, the threshold would move up to 4%. The winning coalition will obtain at least 340 seats, roughly 55% of the total, no matter how narrow the margin of success is. For the Senate, whose seats are assigned on a regional basis, the three thresholds are 20%, 3% and 8% respectively. A majority premium applies in this case as well, with the prevailing coalition allocated at least 55% of the regional seats, regardless of the vote margin. The threat of a split Parliament. The premia system should guarantee some sort of clear majority in each of the two houses. However, in my view, two factors could throw sand in the gears of political stability. First, these new rules have encouraged the main parties on both fronts to seek alliances with a large number of miniscule formations, thus exacerbating the risk of political fragmentation within each of the two coalitions and possibly diluting the content of the two platforms. Second and foremost, because of the different rules affecting elections for the Chamber of Deputies and the Senate and the tight margin in the race, we should not underestimate the chances of a split Parliament that would ultimately result in political paralysis. First exams scheduled for July. One point is clear. With the President also approaching the end of his seven-year tenure, and local elections in the calendar for May 28 as well as prospects of a second round vote two weeks afterwards, Italy will go through a strenuous electoral season. Whichever (if any) coalition manages to get a clear mandate from electors, it will soon face a tight economic policy agenda, with the DPEF, the traditional multi-year economic plan, scheduled already for July. The international community, rating agencies and financial markets will anxiously scrutinize the first broad guidelines. Recent data have pointed to a cyclical turnaround in several indicators, particularly in the manufacturing sector, but we all know that Italy’s troubles are structural. The country has underperformed the euro area in 13 of the past 15 years, demographic projections show a 30% drop in the working-age population over the next forty years, and the debt to GDP ratio is now back to a rising trajectory. The new government will have to provide convincing arguments that the country is still well equipped to live and prosper in the European Monetary Union. In particular, it will have to succeed in combining growth-enhancing measures with a debt consolidation process. The poor guidance of electoral platforms. The challenging environment in which the economy has been operating over the past five years has certainly raised the degree of awareness among policymakers. During the previous electoral campaign, in 2001, right after the peak of a robust business cycle, trend GDP growth was around 2% and even a 3% growth rate was regarded as attainable. Nowadays, trend growth has probably fallen closer to 1% and policymakers in both coalitions have come to cope with expectations that are more realistic. Yet, electoral platforms ‑ which we will assess in detail in a separate report ‑ are still full of populist pledges and offer little guidance on how to achieve specific goals. International investors know that any serious assessment will only come after April 10. In the meantime, the risk of political instability could overshadow any plan on both fronts.
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The Spread of Prosperity
Mar 13, 2006
Serhan Cevik (London)
The income gap between the richest and poorest has narrowed in the post-stabilisation era. The normalisation of political and macroeconomic landscapes, leading to above-trend output growth and disinflation towards single-digit territory, has also started delivering sustained improvements in Turkey’s socio-economic conditions. In particular, contrary to what has become an urban legend, the rich are not getting richer at the expense of the poor in today’s Turkey. Thanks to reasonably broad income growth and declining ‘welfare’ transfers to the rich in the form of interest payments from the Treasury’s coffers, the ratio of the average income of the lowest-earning 20% of the population to that of the highest-earning quintile increased from the nadir of 4.3% in 1983 to 12.4% in 2003 and 13.0% in 2004. In other words, it is not just that per capita income rose from US$2,146 in 2001 to about US$5,000 last year, but also measures of income inequality have moved towards a more egalitarian stance in the post-crisis period. The Gini coefficient improved from 0.49 in 1994 to 0.42 in 2003 and 0.40 in 2004. Income inequality, though receiving little attention from market participants, is crucial for socio-economic development and thus for the political sustainability of prudent policies and structural reforms (see Getting the ‘Gini’ Out of the Bottle, November 30, 2004). Despite statistical shortcomings due to underreporting of labour income at the lower quintiles and, more importantly, of non-labour income among affluent households, the latest figures show a gradual but continuous improvement in the distribution of income. The top 20% of income earners, for example, received 46.2% of all income in 2004 (down from 48.3% in 2003 and 50.1% in 2002), while the poorest 20% earned about 6.0% (unchanged from the 2003 reading but up from 5.3% 2002 and 4.9% in 1994). Furthermore, the combined share of middle-income households — the second, third and fourth quintiles — increased from 40.2% in 1994 to 45.7% in 2003 and then 47.8% in 2004. Even a more detailed data set (estimating income distribution for 10% segments, rather than quintiles) confirms the encouraging trend. The share of the most affluent 10% declined from 33.2% of total household income in 2003 to 30.9% in 2004, while the share of the poorest 10% remained unchanged at 2.3%. As a result, the Gini coefficient — a widely used index of income concentration — improved from the peak of 0.56 in 1968 (and 0.49 in 1994) to 0.42 in 2003 and 0.40 in 2004. On the whole, the rising tide may not have necessarily lifted all boats, but unquestionably left fewer of them high and dry in the post-stabilisation era. Wealth disparities and the tax regime affect the distribution of income. Albeit narrowing, the gap between the richest and poorest income groups is still disappointingly wide in international comparisons. In our view, Turkey’s problem arises from income concentration among most affluent households, since the share of lower quintiles in total income is roughly in line with what comparable income groups receive in Europe. However, this is not a surprising result, given the power of path dependence that makes wealth distribution the key factor in determining the functional income distribution. Indeed, 1% of the depositors hold more than two-thirds of the total deposits in the Turkish banking sector, and the top 100 retail investors have about 40% of total equity holdings. Even if we exclude the largest 10,000 investors, who own about 85% of the total, the rest of the investor community accounts for barely 15% of market capitalisation. Consequently, the top quintile of households own 70% of property income and about 80% of financial earnings, compared with a mere 1% of non-labour income received by the lowest quintile. This is why the distribution of financial income explains 50% of income inequality, and thus growth alone is enough to improve income distribution. In our view, the challenge for policymakers is, while maintaining economic stability, to increase the economy’s labour absorption capacity and reform the archaic tax system, which has created a haven for evading or avoiding income and capital gain taxes (see Of Taxes and Fat Cats, December 14, 2004). The growing education-earnings gap is an important contributor to income inequality. An unequal distribution of income partly manifests a history of unequal opportunity and a divergence in educational attainments across the income groups. For instance, children of poor and less educated families generally experience a slower progress in skill development and, as a result, face a restricted opportunity landscape as adult workers. In other words, today’s opportunity inequalities may result in income inequalities lasting for generations. The Turkish data highlight such an inequality trap. The lowest quintile of households accounts for a mere 1.2% of total spending on education versus 69.1% by the richest 20% of the population. This appalling divergence widens the opportunity gap between lower-income and wealthier households and consequently worsens the distribution of income and wealth. Reversing such trends is not easy in the near term and requires a comprehensive reform approach. However, compared with other countries in Europe, Turkey has demographic advantages. By improving the quality of educational attainments, the country can narrow the education-earnings gap and thereby achieve a more egalitarian distribution of income.
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Cyclical vs. Structural
Mar 13, 2006
Andy Xie (Hong Kong)
Summary & Conclusions India’s private asset value (stocks, properties, and gold) may have appreciated by about 100% of 2005 GDP since mid-2003, I estimate. The wealth effect of the extra paper wealth is the engine of demand growth. As long as asset prices remain high, India’s domestic demand will likely remain strong, I believe. The government of India is determined to be supportive of the financial markets. Inflation and global liquidity are the two areas that could interrupt the current cycle. On the former, the government is in a position to change taxes to keep inflation within an acceptable range. Such an approach is likely to cause the current account deficit to widen further, which requires more capital inflow to sustain the growth dynamic. India’s long-term fundamentals remain strong. Its flexible financial system is a major strength. The modernization of its consumer sector from retailing/distribution to production will be a major source of demand and productivity growth. The capital for funding this transformation requires India to boost its exports considerably. Its regulatory framework should also improve to accommodate the infrastructure development necessary for this transformation. China and India Four years ago, India’s Chamber of Commerce invited me to speak to the chamber about China in New Dehli. The fear that China would squeeze out India in trade was pervasive then. I visited India last week and found a different attitude there. While the apprehension of China is still there, the zero-sum-game view on India vs. China has dissipated. Both India and China have achieved high growth rates (9.9% for China and 8% for India in the past three years). This is the main reason that India has become more comfortable with China. The development models of China and India’s are very different. China’s model follows that of other East Asian economies and pursues income expansion through maximizing trade and investment. Government policies aimed at incentivising export production and capital accumulation are at the heart of this model. Furthermore, when China began opening up two decades ago, the government owned everything and there was no domestic business class to lobby against opening up or government exercising its power. This is why China has gone further than other East Asian economies in export/investment model. India’s private sector leads its economic development. Under its democratic system, balance of interests and income distribution dominate the government’s policies. It has been leaning towards growth through liberalization of trade and domestic market in the past two decades also, though at a slower pace than China’s. In particular, its domestic business community has a powerful voice on how fast to open up domestic markets to foreign capital. Furthermore, its trade is much smaller than China’s and, hence, India is less vulnerable to international pressure in opening up its domestic markets. India has an Anglo-Saxon style financial system, radically different from China’s government-controlled financial system. This has made India’s asset markets more sensitive to global liquidity cycle than China. This is the main reason that global liquidity, though supporting India’s asset markets, has become the engine of India’s growth now. China’s supply response is much quicker than India’s. Because China’s business community is new and very focused on market shares, local governments are eager to create infrastructure, and the banking system is willing to support capital accumulation, China’s supply responds very fast to demand growth. This is why China’s exports have risen so fast in the current global boom. India’s system does not allow the local or central government to respond to demand pressure easily; i.e., infrastructure buildup is gradual. Its business community is much more conscious of business cycles and does not build up capacity quickly in response to either low interest rate or demand growth. These differences have led to a very different mix of demand growth in this cycle between the two economies. Production for export and construction drives China’s economy in the current cycle, while India’s consumption, funded by credit, is driving its demand. I spoke on ‘India and China’ or ‘India or China’ in Delhi last week at the invitation of India Today. The former seems to have been the case for the past few years. Both have seen their economies and trade growing rapidly. India’s trade with China and Hong Kong grew by 43% in 2004 and 38% in the first 11 months of 2005, according to India’s Customs data. The rapid growth in India’s exports to China and imports from China suggests that the scope for cooperation between the two economies is greater than that for competition. Convergence between the two is inevitable in the long run. China is reforming its financial system and exchange rate regime. The state banks are being listed. The stock market is opening up gradually to foreign capital. The exchange rate regime is very gradually increasing flexibility. India’s political, business and media establishment has a strong consensus that India must build up its infrastructure to sustain high growth in the long run. Many politicians still hope that the current infrastructure can cope with growth for another two years. But, if growth stalls due to infrastructure insufficiency, the political system is likely to respond effectively. In the long run, India will become competitive in manufacturing and construction also. Ten years from now, India and China may well compete in global trade of goods and services. But, this does not mean that it is bad for either. One Indian politician commented to me that competition between the countries was ok. It would keep both to strive harder, which is good for everyone in the end. Wealth effect leads India’s demand growth for now On the demand side, wealth effect appears to assume a large role in India. It is increasingly overwhelming the income effect in demand creation, I believe. On the supply side, imports have risen disproportionately. Of course, productivity and investment also play important roles in meeting the demand growth. India’s current account balance deteriorated from $3.2 bn in surplus in 3Q03 to $7.7 bn in deficit in 3Q05. The swing is equal to 5.4% of 2005 GDP annualized. As India’s asset markets remain buoyant, there is no reason to believe that the trend would reverse. It is possible that India could calculate the current account balance differently to reach a lower level of deficit. The customs data for trade deficit is much smaller than that in the BoP data. However, the calculation methodology would not change the magnitude of the swing in the past two years. India needs capital inflow to make an opposite swing in similar magnitude to reach balance and sustain demand growth. The transmission from capital inflow into demand is very similar to that in Anglo-Saxon economies. India’s aggregate debt to GDP ratio has increased by 28 percentage points in the past five years, largely to fund household and government demand growth. India’s economic momentum, therefore, depends on capital inflow that sustains credit growth that sustains demand growth. The financial story is the swing factor on the margin for India’s high growth rate. It does not negate the attraction of the underlying structural story. India is beginning to modernize its consumer sector, from retailing/distribution to production. India has about 60 shopping malls now with 300 planned. As the economies of scale in retailing increase, it would lead to the rise of a new distribution system with large businesses replacing traditional and multilayered small-scale distributors. As distribution scales up, it requires production to scale up also. This modernization requires both investment funds to be available and sufficiently robust demand to make investment attractive. When this process began in China, it embarked on a massive export push to generate the necessary capital and income for demand. India is using its asset markets to make capital available and support demand at the same time. This strategy is workable as long as global liquidity is sufficiently strong. I suspect that India has to boost competitiveness by creating sufficient infrastructure, which would boost export income and add a source of income to support modernization. Global liquidity and inflation could be headwinds India’s stock market has become critical to its economic performance. The foreign inflow into its stock market is a major source of liquidity for funding its current account deficit, keeping interest rates low, and sustaining credit growth necessary for its demand growth. As the stock market is so important to the economy, the government is likely to take actions and provide rhetorical support to sustain the momentum in the market. The overall background of global liquidity will likely decide the momentum of the Indian stock market and its economic momentum. The excess liquidity in India’s banking system has vanished in the past three months. The overnight interbank rate has jumped to 6.7% now from an average of 6% in December 2005, and the three-month interbank rate jumped to 7.5% from an average of 6% in December 2005. The liquidity pressure is still intensifying. Some state banks have not raised either deposit or lending rates. They are resorting to borrowing in the interbank market to close their liquidity gap. They will have to raise deposit and lending rates soon. In other economies that depend on asset markets, demand is quite sensitive to interest rates. But, India’s wealth on paper has increased so much and so fast that demand may not be sensitive to a small rise in interest rate. The tightening liquidity environment so far may not slow down India’s economy. If global liquidity dries up, the Indian economy would slow down substantially. Global liquidity depends on the monetary policies in the G-3 and the risk appetite in the global financial system. The policy of the Bank of Japan is critical in that regard, especially since Japan’s retail flow into the Indian stock market is so important in the overall foreign inflow. The Bank of Japan has just ended quantitative easing. The market is pricing in a small increase in interest rates by the Bank of Japan before the year end. We don’t know that that would be sufficient to cool the global liquidity boom or Japan’s inflow into the Indian stock market. Commodity prices and India’s SENSEX are correlated in that regard. If liquidity does dry up, they are likely to cool together. Accelerating inflation and the accompanying rate hikes by the RBI would be another way to end the liquidity boom in India, because it would trigger a stock market correction and outflow of foreign capital from the Indian stock market. The government is keenly aware of this risk and is cutting taxes to decrease the notional inflation rate. It is possible that the CPI basket could be re-weighted to decrease inflation also. I think that we are not likely to see a shocking number on inflation in the coming months. The short-term outlook for India, hence, depends very much on global liquidity. Betting on India’s stock market is equivalent to betting on sustained global liquidity boom, I believe.
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