The Nat-EUR-al Rate of Interest (Part II)
May 04, 2006
Joachim Fels (London) and Manoj Pradhan (London)
In Part 1 of this piece, we presented our proprietary estimate of the time-varying Wicksellian rate of interest in the euro area. Since the start of EMU in 1999, that estimate has fallen by about one percentage point to presently 1.3% real and 3.5% nominal, 100bp above the actual refi rate.
Nat-EUR-al rate much lower than US counterpart
Exhibit 6 in the full briefing note compares our natural interest rate estimates for the US and the euro area. While the US natural rate has been higher than its European counterpart since the early 1990s, the gap between the two has widened significantly in recent years, to about 100bp. We believe that such a widening is consistent with the observed divergence of important drivers of the natural rate between the two economies. As discussed earlier, slowing productivity and population growth, a rising propensity to save, and a rapid gain in ECB credibility after the bank’s inception help explain the decline in the natural interest rate in the euro area. On the other side of the Atlantic, by contrast, productivity has been strong and accelerating, the population is growing at a more solid pace, and private household’s propensity to save has dropped markedly in recent years. All these factors argue for both a higher level of the US versus the euro area natural rate of interest, and for a widening gap between the two. In other words, given the different characteristics of the US and the euro area economies, the Fed needs to keep real interest rates higher to achieve stable inflation than the ECB.
Monetary policy stances in US, euro area diverge
Judged by our estimates of the natural rate in the two regions, US monetary policy is currently restrictive, while euro area monetary policy is expansionary. This is illustrated in Exhibit 7 of the full briefing note by a positive real interest rate gap in the US and a negative gap in the euro area. As a consequence, our Wicksellian model would suggest that the US economy and, eventually, inflation should slow, while the euro area economy and, eventually, inflation should pick up over the medium term.
Implications for the transatlantic bond yield spread
Putting our estimates for natural interest rates in the euro area and the US together suggests to us that US bonds can be expected to outperform euro area bonds over the medium term. The argument proceeds in five steps.
First, we suggest that our respective estimates of the real natural rate of interest are good predictors of the actual average level of short-term interest rates over the long run. This is because both the ECB and the Fed are unlikely to have a systematic bias to produce accelerating or decelerating inflation. As a consequence, and ignoring term premia for a moment, our estimates of the real natural interest rate should be the best estimate of the real long-term interest rate.
Second, we assume that the term premium in the euro area does not differ systematically from the term premium in the US. Both central banks enjoy a high level of credibility and share a similar low-inflation philosophy. Given that keeping inflation low is the ECB’s primary objective, while the Fed has a dual mandate of keeping inflation low and employment high, one might argue that the term premium in the euro area should be lower. On the other hand, the fact that the euro area is a monetary but not a political union, and might thus not be as stable in the long run as the US monetary union, could be seen as an argument for a higher term premium in the euro area. We assume that these two factors roughly cancel each other out and that term premia in the euro area and in the US are thus roughly identical.
Third, we suggest that the ECB and the Fed have a similar long-run inflation objective of about 2% in HICP terms. The ECB’s objective is HICP inflation of below but close to 2%, but actual inflation has averaged a little above 2% since the start of EMU. The Fed doesn’t have an official numerical objective, but several FOMC members including Chairman Bernanke prefer a 1-2% band for core PCE inflation, which would be roughly consistent with a 1.5-2.5% band for HICP inflation.
Fourth, putting the above three considerations together, the current gap between our estimates of the natural rate in the US and the euro area of about 100bp (2.3% in the US versus 1.3% in the euro area) should be a good approximation of the ‘fair’ long-term bond yield spread between the US and the euro area. This compares with a current actual yields spread of 120bp between 10-year US Treasuries and German Bunds. Thus, based on the natural rate estimates, US bonds are slightly cheap compared to German Bunds.
Fifth and last, our measures of the real interest rate gaps in the US and the euro area suggest that US monetary policy is restrictive while ECB policy is expansionary. Hence, US growth and inflation should slow while euro area growth and inflation should accelerate. Consequently, we think that the Fed is likely to stop tightening and might potentially ease policy at some stage this year, while the ECB is likely to continue to tighten policy. These considerations add a cyclical argument in favour of US over euro area bonds to the structural ‘fair value’ argument explained above.
Summary and Conclusions
Using the Wicksellian approach we previously applied to the US case, we estimate that the natural rate of interest for the euro area currently stands at around 1.3% real, or 3.5% nominal, one percentage point above the present level of the ECB refi rate. Our measure of the natural interest rate has fallen by one percentage point since the launch of the single currency seven years ago. A decline is consistent with slowing productivity and population growth, and with the notion that households’ propensity to save has risen. Moreover, the decline might partly be due a higher credibility of euro monetary policy compared to the pre-EMU regime, implying that the level of short rates that is required to keep inflation stable has come down. Elsewhere, a comparison with our US estimate suggests that the natural rate of interest is currently about one percentage point lower in the euro area than in the US.
Thus, if our (naturally imprecise) estimate is anything to go by, and if the ECB wants to walk the full walk towards neutrality, roughly another 100bp of rate hikes would be needed. Conversely, if an economic slowdown stops the ECB in the tracks before that, excess liquidity would keep growing and inflation would rise over the medium-to-long term. Finally, assuming similar term premia and inflation targets in the euro area and the US, our natural rate estimates suggest that the ‘fair’ level of the US-euro area bond yield spread should be around 100bp, some 20bp below the current level. Together with cyclical considerations, this suggests a case for favouring US over euro area bonds.
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May 04, 2006
Jeffrey Matsu (New York)
In a national pandemic response plan just issued by the White House, the federal government announced comprehensive measures to address the threat of pandemic influenza. As the H5N1 virus ravages bird populations worldwide, the tipping point for a pandemic draws near. Is the world prepared for a rude awakening?
Understanding global economic linkages as a conduit for disease transmission — and its allocated costs — is critical in assessing the macro implications of an avian flu pandemic: (1) Vastly improved technologies to transport goods, services and people favor the spread of communicable diseases. (2) Once a pandemic is declared, the infectiousness of H5N1 asymptomatic cases coupled with the airborne nature of influenza would render even an immediate shutdown of national borders ineffective. (3) Perception of risks plays a key role in driving demand- and supply-side dynamics. (4) SARS was a wake-up call in recognizing the importance of an integrated global health emergency plan and the political leadership needed to manage public perceptions.
Risks and market implications
Globalization heightens the risk of contagion spreading disproportionately from the health arena to economic and financial markets. SARS exemplified the velocity with which infectious diseases can spread across national borders, and exposed the vulnerabilities associated with a global economy highly integrated through export markets and just-in-time delivery systems.
The global spread of the H5N1 virus in wild birds and poultry has triggered fears that humans may be next. In a national pandemic response plan just issued by the White House, the federal government announced its intentions to stockpile 75 million doses of antiviral medications and 20 million doses of vaccine. Underscoring a US$7.1 billion budget proposal to support pandemic preparedness over the course of several years, the report elaborates that a modern pandemic could lead to two million deaths and economic losses of US$600 billion in the US alone. While there remain clear challenges on both these fronts, globalization heightens the risk of contagion spreading disproportionately from the health arena to economic and financial markets, as was evidenced by the SARS outbreak a few years ago. Understanding global economic linkages as a conduit for disease transmission — and its allocated costs — is critical in assessing the macro implications of an avian flu pandemic.
Sustained human-to-human transmission of the H5N1 virus — the tipping point of a pandemic — has not yet occurred, and the World Health Organization (WHO) currently reports 205 confirmed human cases and 113 deaths in nine countries across Asia, Africa and the Middle East. In contrast, SARS spread to 30 countries on six continents and affected 8,097 people within a matter of six months (February-July 2003). Although its mortality rate was just under 10%, and the disease was quickly contained, SARS exemplified the velocity with which infectious diseases can spread across national borders. More importantly, it exposed the vulnerabilities associated with a global economy highly integrated through export markets and just-in-time delivery systems. With transportation at major hubs such as airports and ports grinding to a halt, businesses held their breath as they watched the global trade of goods and services — over US$9 trillion in 2003 — held hostage. This was particularly devastating for trade-dependent economies such as those in East Asia. Given that considerable uncertainty surrounds our understanding of the H5N1 virus (see Pandemic Fallout, February 28, 2006 and Foul Winds, March 30, 2006), SARS offers timely insights into what might happen and how we can better respond.
Based on available epidemiological evidence, we now know that the H5N1 and SARS-CoV viruses emerged from wildlife or other animal reservoirs in southern China. ‘Wet markets’ for exotic wildlife, backyard farms and other unsanitary venues for animal husbandry are fertile breeding grounds for communicable diseases, and likely sources for cross-species infection. It is important to note, however, that the virus subtypes occur naturally in a low pathogenic form in animals such as wild waterfowl (H5N1) and the palm civet (SARS-CoV) with no apparent harm. While the transmission mechanism to humans is not yet fully understood, primary infection routes include direct contact with or the consumption of (raw) infected animals. Once transmitted, HPAI and SARS attack the respiratory system of otherwise healthy people (often children and young adults), starting with classic flu symptoms that in most cases progress into severe pneumonia. HPAI victims experience rapid deterioration in health and multiple organ failure.
Genome sequencing conducted by the US Centers of Disease Control and Prevention (CDC) suggest that the origins of the 1918 influenza pandemic virus are bird-related, so while it may not be identical to H5N1, the two diseases are similar enough to make broad inferences. Based on its analysis of this sample, a study by the Harvard School of Public Health indicates that H5N1 may be no more, if not less, transmissible between humans than SARS. One factor behind the limited spread of SARS-CoV was that its basic reproductive rate of 2.2-3.7 compared favorably to 5-25 for normal influenza. This means that, on average, each case of SARS resulted in three secondary infections versus 15 for the flu. With an incubation period of up to ten days and a serial interval (defined as the average time between primary and secondary cases) of 8-10 days, isolating SARS-infected patients, quarantining their close contacts and encouraging social distancing proved to be effective in disease containment. In the event of a pandemic, however, H5N1 is likely to have a serial interval of just four days, and unlike SARS, would be communicable to others before the onset of physical symptoms — often within a day or two of infection. Once a pandemic has been declared, the infectiousness of asymptomatic cases coupled with the airborne nature of influenza would render even an immediate shutdown of national borders ineffective.
From a global health perspective, the 774 deaths resulting from SARS are relatively insignificant given that diseases such as malaria and HIV/AIDS annually claim the lives of more than one million and three million people, respectively. In the US alone, normal influenza hospitalizes some 226,000 people, leading to 36,000 deaths each year. The economic impact of SARS, however, was disproportionately large, costing the Asia-Pacific region about US$40 billion in economic damages. At the height of the epidemic in the second quarter of 2003, real GDP fell by 3.0% in Singapore and 0.3% in Hong Kong over the year prior, while in China, growth declined two percentage points to 7.9% before rebounding in the third quarter. In Canada, the country hardest hit outside Asia, year-over-year growth fell from 3.1% to 2.0% in 2Q03 (-1.2% QoQ); according to the Bank of Canada, SARS cut second quarter GDP by an estimated 0.6%. The virulence and protracted nature of a pandemic would magnify these losses exponentially.
The rapid geographic spread of any unclassified disease can be a frightening event, and in the case of SARS, the initial lack of sufficient medical information and delayed public health response led to an exaggerated sense of vulnerability. China’s reluctance to acknowledge the outbreak early on only amplified concerns that governments were withholding critical information. This fuelled a divergence between the perception of risk and actual risk, which resulted in economic losses that extended far beyond the direct economic costs of the disease itself. Paranoia and the impulse to avoid social interaction led to a plunge in consumer confidence and private consumption spending, crippling industries such as travel and transportation, entertainment and retail — in Hong Kong, retail sales fell by 10.7% in 2Q03. Further, in the event of a pandemic, the US government estimates a 40% absenteeism rate among workers, which, while conservative, would have profound implications on both the quality of available healthcare and the subsequent decline in labor productivity.
Perhaps the biggest policy lesson from the SARS experience was recognizing the importance of an integrated global health emergency plan and the political leadership needed to manage public perceptions. During the outbreak, the WHO led efforts to facilitate the collection and dissemination of epidemiological data throughout the scientific community, and played a prominent role in containing widespread panic through regular updates and advisories to the general public. For the first time in a decade, the WHO issued a global health alert and travel advisories. Electronic forms of communications such as the internet, email and around-the-clock cable news coverage kept even the poorest of countries abreast of the latest developments, providing real-time access to global networks of technical expertise and information. Not only did this expedite the identification and containment of the disease, but it also forced China to accept transparency and accountability on a scale not seen before — the debacle led to the prompt dismissal of China’s Minister of Health. At a time when very little was known about SARS’s mode of transmission, virulence or the relative efficacy of various personal protection measures, the WHO served as a unified and authoritative voice in the global health arena.
Whether the next pandemic is caused by H5N1 is highly uncertain, but the mere threat of such an event must be taken seriously. The relevance of SARS in framing the discussion of an avian flu pandemic lies not so much in its health impact as it does on the implications it posed to the global economy. Economic contagion moved even faster than the disease — primarily due to a delayed global health response. Pandemic preparedness requires open communication and cooperation at all levels of government, and contingency plans that strengthen our capacity to respond more effectively. While globalization may render national borders obsolete, it has enhanced our ability to identify and monitor infectious diseases. Never before has an ounce of prevention been worth more than a pound of cure.
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Tightening or Spinning?
May 04, 2006
Oliver Weeks (London)
After an impressive election victory, Prime Minister-elect Gyurcsany has promised “the most intensive reform of the post-communist era” but firm details remain thin on the ground. The disarray of the opposition and the PM’s new authority within his party suggest an opportunity for radical and painful moves. However, leaks from policy negotiations so far look inadequate to us. We expect further leaks to test market and public reaction before real measures are unveiled in early June, but on current indications we remain sceptical that the government intends to do enough to put fiscal policy back on a sustainable path, or that it will be able to avoid rate hikes.
Little urgency so far. The Socialists and Free Democrats have said they expect coalition talks to take several weeks and do not anticipate a deal before the end of May. The first session of parliament will be on May 16, from when Gyurcsany will have up to 40 days to get parliament to approve his programme and government. Beyond that, the European Commission (EC) has given the government until September to present an updated convergence programme containing concrete measures to reduce the budget deficit. The government has so far said that the outline of the new plan will remain the same, with the deficit falling 1.4% of GDP each year in 2007 and 2008 from a 4.7% of GDP target for 2006. We remain doubtful that the EC, which is highly unlikely to withhold structural funds, will prove a binding constraint. However, local elections, due in mid-October, are increasingly unlikely to be a major obstacle, in our view, given the weakness of the opposition. Politically, it makes sense to concentrate the adjustment at the beginning of the cycle, and the government seems strong enough to drop its no tax hike promise (see also Electoral Promises and Fiscal Reality, March 6, 2006). After some more spin and leaks, we expect a firm tightening announcement in early June, but for now no serious new commitment to euro entry.
Required adjustment growing. With the 2006 deficit on course for a massive overshoot, the base for fiscal adjustment looks increasingly challenging. While part of the overshoot is an accounting consideration, the majority relates to actual demand. On the accounting side, the import of Gripen fighter aircraft will add 0.4% of GDP to the 2006 ESA deficit (though the actual spending is over a much longer period). For Maastricht comparability, transfers to private pension funds, 1.4% of GDP, should also be added, as required by Eurostat from April 2007. Potentially even larger will be the likely assumption of off-budget debt built up by state guaranteed agencies, notably the railways and municipal transport, which added nearly 3.0% of GDP to the 2002 deficit. We believe that the magnitude is similar for the last four years, though this time the debt is more likely to be distributed over the 2003-6 deficits. Of the items that add to current demand, the single largest remains the off-budget road building programme, worth around 1.2% of GDP and in our view still likely to be included in the ESA budget by Eurostat. More importantly, budget execution in 1Q, at 51% of the annual target, clearly points to a large overshoot on the full year cash deficit. Most notably, VAT revenue targets look implausibly ambitious to us. At the same time, central government administrative spending is well ahead of target. In 2005, a HUF 260 billion undershoot on VAT collection was saved only by HUF 409 billion of excess revenue on state property from the Budapest airport deal. Without adjustment or another improbable windfall this year, we think that the cash deficit target would be on track to overshoot by around 2.5% of GDP. With a small election-year overshoot in local government deficits also likely, the all-in 2006 deficit would be heading towards 11.0% of GDP, in our view, against a 2005 deficit currently at 7.5% of GDP (but also likely to be revised up).
Leaked adjustment not enough. In this context, the plan for HUF 300-350 billion of tightening in 2006 as leaked to the leftist newspaper Nepszabadsag looks inadequate to us. The estimated revenue boost from tax hikes appears to be reached by annualising the impact of measures implemented in 2H. On our estimates, a hike in the 15% VAT rate to 20% would raise VAT revenue by around HUF 150 billion only over a full year. Similarly a 5 percentage point rise in the simplified business tax rate to 20% would raise around HUF 25 billion over a year. Promises of administrative savings are harder to assess, but such measures have already been widely promised over the last three years, with much of the saving usually disappearing in arrears or outsourcing costs. At most, the measures specified suggest savings of around HUF 200 billion in 2006, even if the tax hikes can be introduced by July. This would leave the 2006 deficit still around 10% of GDP. For 2007, already existing spending commitments, which add around 0.5% of GDP to the deficit, need to be dropped and much more fundamental reform, involving a significant reduction in staffing levels and new funding sources for health, education and local government, needs to be considered, in our view. EU funds may help cut government investment spending, but still require co-financing and are likely to continue to be disbursed late. Since the magnitude of the reduction needed to bring euro entry back on track in the current parliament would be around 7% of GDP, we think that the government is likely to concentrate on promising enough to satisfy the market rather than the EC. Given the positive market reaction to its initial attempts, we think that the first fiscal announcements may err on the side of too little, and will not be enough to avoid rating downgrades.
FX and rate risks remain. Tension within the Monetary Council over how much pressure to put on the government is clearly intensifying, and a split vote looks imminent to us. It is important to note that the NBH does not evaluate fiscal policy on an ESA basis and has long taken account of off-budget spending. On this basis, simply including road spending in the ESA deficit is not news for the Council — and could even be positive due to the longer-term costs associated with PPP programmes. The latest NBH inflation report assumes a 1.0% of GDP fiscal stimulus in 2006 and a 0.5-0.0% of GDP fiscal contraction in 2007. However, this would still require further corrective announcements. Meanwhile, recent inflation releases have already been above NBH assumptions, and medium-term risks remain firmly on the upside, in our view. Despite the recent rally, we think HUF risks remain on the weak side. FX borrowing by households and corporates remains strongly supportive, up an all-time record of HUF 270 billion in March, as new local currency borrowing all but disappears. However, the officially recorded trade deficit is disappointingly stable in the context of strong Euroland demand, while planned dividend outflows are accelerating and MOL and OTP are threatening a massive outflow of direct investment this year. Real private sector wage growth, at 7.5%Y in the first two months of the year, also remains uncomfortably high. A VAT hike will add a further, albeit temporary, boost to inflation of around 1.0 percentage points. Even without this, we think that the end-2007 inflation target of 2-4% is already at risk. The composition of the Monetary Council is likely to gradually become more government-friendly as the terms of the governor and the two most hawkish staff members expire next March and July. However, we believe that it will be hard to avoid at least 100bp of rate hikes before that unless the government comes out with a stronger plan than it currently seems to have in mind.
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