United States
From Inflation Alarm to Growth Scare?
Jun 05, 2006

Richard Berner (New York) and David Greenlaw (New York)

 Forecast at a Glance

	2005E	2006E	2007E
Real GDP	3.5%	3.4%	3.0%
Inflation (CPI)	3.4	3.4	2.4
Unit Labor Costs	2.3	1.7	3.5
After-Tax "Economic" Profits	9.4	12.3	0.3
After-Tax "Book" Profits	34.5	10.9	0.6

Source: Morgan Stanley Research. E = Morgan Stanley Research Estimates

The inflation scare that spooked financial markets just three weeks ago has morphed into a growth scare — and it’s one that may last several weeks. Spring growth has quickly decelerated to less than half the first-quarter pace and headwinds to growth seem to be multiplying. That combination may appear to validate forecasts for a second-half deceleration to below-trend growth and consequent relief on inflation. Steve Roach and we agree on one thing: Stagflation is the least likely outcome (see his dispatch, "Stagflation Scare?").

In contrast to Steve’s view that inflation will be contained by the forces of globalization, in our view, a slight further cyclical quickening in inflation is still likely. But we believe that the growth scare for now will prove to be just that — a scare. We think that a more decisive slowing in growth — one that will bring a more lasting inflation respite — awaits 2007. As a result, while there is a strong case for the Fed to pause in its tightening campaign now, in our view officials still have more work to do later this year. Here’s why.

The long-awaited spring economic deceleration is well in train; we now see second quarter growth at just 2.4% annualized, down sharply from the 5.3% winter spurt. Two key factors have trimmed the pace: First was a sharp payback in activity, principally in retailing and construction, from a weather-assisted boost in the first quarter. In addition, surging gasoline prices robbed consumers of an estimated $65 billion or 0.7% of disposable income in the second quarter, reversing the first quarter boost to discretionary spending power from falling energy quotes as the Gulf Coast recovered from the fall hurricanes. While we’ve long tracked the depressing influence on growth of both of these developments, it appears that their impact has been deeper than we expected.

Indeed, there’s no mistaking the weaker tone to incoming data. Housing sales and activity have been on a slightly steeper slide than we expected, and builders still face the need to shed unwanted inventories of unsold new homes. While retailing hasn’t collapsed, excluding vehicles, gasoline and building materials, it probably softened from a 9.5% annual pace in the first quarter to a 4.3% rate in the spring trimester, and spring outlays among lower-income consumers appear once again to be especially limp. Similarly, vehicle sales, especially of less fuel-efficient larger trucks and SUVs, slipped sharply in May.

Producers appear to be responding quickly: As orders reported by manufacturing purchasing managers declined for the third straight month in May, manufacturers cut growth in production and payrolls. Payroll growth overall declined in May to just 75,000, or less than half the first-quarter rate, and the pace of hourly earnings leveled off at 3.7%. If it persisted, this deceleration would undermine our case for moderate gains in spending. Likewise, while April’s 1.7% dip in capital goods bookings may represent a typical first-month-of-the-quarter payback for an unsustainably strong March, it raises questions about the strength of capital spending.

And there are also considerable headwinds to growth that have only begun to affect economic activity. Among them: higher interest rates. more restrictive financial conditions generally, a further decline in housing activity, and decelerating home prices that will brake the growth in household wealth. As we see it, however, even the combination of these factors will not kill growth in the second half of 2006.

Financial conditions have only begun to be somewhat restrictive, and mostly because of a rise in term premiums that has boosted long-term yields. According to Fed calculations, one measure of the ten-year term premium rose by about 40 basis points between January and mid May, while other dimensions of financial conditions are still supportive of growth (see "Have Financial Conditions Turned Restrictive?" Investment Perspectives, June 1, 2006). Since that time, yields have declined by about 20 basis points — mostly in real terms — while stock prices have declined by 2-5%. There’s little hint of restraint in consumer or business lending; bank footings lately have accelerated. To be sure, housing activity is a different story: We expect real residential investment to plunge at a 15% annual rate in the second half of 2006, paring about ¾ percentage point from overall annualized growth. Home prices, however, are slowing merely on schedule, from a double-digit pace last year to 8.4% annualized in the first quarter — hardly a collapse.

Moreover, in our view, there are also significant tailwinds for growth. Stronger global growth, while no longer accelerating, seems likely to underpin both US exports and earnings of the foreign affiliates of US companies. Despite the recent moderation in payrolls, a firming labor market, indicated by high job opening rates and a sinking unemployment rate, speak to hearty pent-up demand for hiring, a consequent rebound in job growth, and likely further increases in pay gains. Strong pent-up demand for capital goods, the rise in operating rates that has reached the point where investing to add capacity makes sense, the fact that investors are rewarding managers for growth; and the need for new, more energy-efficient equipment and facilities all are likely to support moderately strong growth in capital spending.

The upshot: We still think that economic growth will improve in the second half of 2006 at close to a 3½% annual rate as the tailwinds get the upper hand, so our expectation for real growth over the four quarters of 2006 at 3.6% is down by only 0.1% from our May forecast

Even if growth proves relatively resilient, as we expect, recent developments appear to have reduced inflation risks. If growth remains below trend, it might flatten the hitherto relentless rise in operating rates and the decline in the jobless rate. Revised data indicate that unit labor costs rose by only 0.3% over the year ended in the first quarter rather than the 1.4% initially reported. Distant-forward (5-year, 5-year forward) inflation compensation measured in the TIPS market has declined about 13 bp from its peak to about 260 bp, hinting that inflation fears have receded. But 5-10 year median inflation expectations in the University of Michigan canvass drifted up to 3.2% in May. In this expansion, operating rates have risen faster than in any postwar business cycle and are now above historical norms. And the past moderation in labor costs may prove short lived, as slowing productivity gains and firmer compensation growth seem likely to begin appearing soon. The bottom line: Many factors still point to slightly higher inflation, and we still see the peak for core inflation later this year at 2.7% measured by the CPI, and 2.5% measured by the personal consumption price index.

Uncertainty about the outlook for growth and inflation is rising, and with it, risk premiums in financial markets. Moreover, the Fed may have promoted increased market volatility, because the path for monetary policy is now data dependent, so markets gyrate to every important data shard. Thus, it’s too soon to declare that the risk-reduction trade is over; more growth and inflation scares probably lie ahead. Ironically, what’s rattling markets helps the Fed by increasing risk premiums and making financial conditions more restrictive. Ultimately, however, we believe officials must back up their commitment to bring inflation down with a bit more tightening. For investors, that may be good news: Capping inflation will reduce risk premiums and interest rates, and perhaps unleash some expansion of earnings multiples next year.

Investors face four related sets of risks: Even with above-consensus growth, earnings are likely to slow significantly because operating leverage is fading and costs are likely to rise at a faster pace. A more immediate deceleration in top-line growth would intensify those threats, as operating leverage would work in reverse. As noted above, we think upside inflation and interest-rate dangers are likely to persist into the second half of 2006. And even modest credit risks — either for consumers or for businesses — are simply not yet in the price.

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Global
Surveying Pandemic Preparedness
Jun 05, 2006

Jeffrey Matsu (New York)

* What’s new

Recent surveys of global corporations and business leaders reveal that, on average, only 30% have contingency plans in place to address the potential disruptions caused by a pandemic. This comes in the face of a national preparedness plan released by the US government that effectively relegates its responsibility to a secondary role. Can the private sector weather the storm?

* Conclusions

There is an increasing disparity between how companies perceive the risk of an influenza pandemic and their underlying ability to respond. (1) Nearly three-fourths of US companies express a lack of sufficient knowledge on how best to prepare as the primary reason for inaction. (2) Globally, 68% of companies expect a negative impact on profits, yet only 17% have earmarked a budget specifically for pandemic preparedness. (3) Unlike most natural disasters that wreak havoc on physical infrastructure, the primary impact of a pandemic will be on human resources. (4) Risk preparedness is a dynamic process that must take into account supply and distribution networks and the ability of key partners to respond. (5) Employers should encourage remote connectivity and alternative work arrangements such as telecommuting, so that familiarity is built into the system prior to a crisis.

* Risks and market implications

Without interoperability and sufficient redundancy built into the system, failure at any node of the business model can leave a company highly exposed. The resilience of the global economy over the past few years has lulled many into a false sense of security. As was the case with SARS, it is this complacency that may prove to be more costly than the disease itself.

After nearly three years since the current outbreak of H5N1 avian influenza, pandemic preparedness in the private sector remains highly inadequate. Recent surveys of global corporations and business leaders reveal that, on average, only 30% have contingency plans in place to address the potential disruptions caused by an extended health crisis. While an overwhelming majority of businesses recognize the negative impact such an event would have on current operations and profitability, most are poorly positioned to respond. The National Strategy for Pandemic Influenza report released last month by the Bush Administration, however, makes it clear that the magnitude and duration of a possible pandemic would likely place a considerable burden on public resources and limit the extent of government assistance. Given the associated risks to human resources and global supply chains, businesses have an obligation to protect their employees and shareholders through the implementation of responsible risk mitigation measures.

Corporate success relies on the ability to remain agile and responsive to a changing environment. Yet when it comes to low probability, high severity events, many businesses are unduly exposed. Complacency is fuelled by "othering" (i.e., the belief that "it won’t happen to me") and a reliance on government as the insurer of last resort. But unlike natural disasters such as earthquakes and hurricanes, the impact of a pandemic will be global and sustained -- pandemics typically occur in waves spanning two years. With governments focusing on containment and eradication strategies, this places a disproportionate share of the response effort on private sector participants. In a global economy that generates nearly $13 trillion in annualized global trade flows, the survival and recovery of commercial enterprises hinges critically on the ability of companies to maintain business-critical operations. Understanding supply chain vulnerabilities under a variety of pandemic scenarios, and having the wherewithal to respond, is therefore essential.

Central to effective public heath policy is the preparedness of the private sector, which accounts for over 80% of gross domestic output in most industrialized countries. Yet nearly three-fourths of US companies responding to a survey conducted by Deloitte Consulting expressed a lack of sufficient knowledge on how best to prepare as the primary reason for inaction. This was further reflected in the fact that while 57% of the respondents felt threatened by a pandemic, 43% were undecided as to its overall impact on their businesses. These results were supported by a Mercer Consulting survey of 450 companies in 38 countries across 26 industries, which found that while 68% of the organizations polled expected a negative impact on profits, only 17% had earmarked a budget specifically for pandemic preparedness. To address these shortcomings, the federal government can take a lead role in providing the resources necessary for state and local authorities to promote flexible and responsive business practices.

With a lack of credible information and guidance, uncertainty and hype generated by dramatizations such as the recent movie "Fatal Contact: Bird Flu in America" can cloud public perceptions of risks. It is perhaps for this reason that countries directly affected by the SARS epidemic are better prepared to address an outbreak of avian flu. The Mercer survey found that 58% of SARS-affected businesses are currently involved with business continuity planning at the regional and local levels; by contrast only 44% were involved in non-SARS affected areas. While variations across industries and companies were significant, multinationals and those located in the Asia-Pacific region were the ones most likely to be in the advanced stages of planning.

Unlike most natural disasters that wreak havoc on physical infrastructure, the primary impact of a pandemic will be on human resources. Through a combination of illness, quarantine, care giving, and social distancing, employers should anticipate worker absenteeism rates reaching upward of 40%. This will present significant challenges to businesses that rely heavily on person-to-person interface. The labour-intensive services sector, which accounts for about 70% of GDP in the US, Japan and Europe, will be hardest hit. The good news is that this sector has done the most in the way of preparation. In its latest global survey of business executives, McKinsey found that the health care, banking/finance, and business services industries were the most prepared to address pandemic risks. Unfortunately, the same cannot be said for capital-intensive manufacturers. Least prepared, according to McKinsey, were industries in the heavy industry group (e.g., manufacturing, autos, electronics, chemicals), with less than a quarter of these respondents stating that they had taken active steps to prepare. The relative lack of preparedness in manufacturing should not be taken lightly. Given the approximately 64,000 truck, rail, and sea containers, 2,600 aircrafts, and 365,000 vehicles that cross US borders each day, manufacturers need to evaluate their ability to procure raw materials and manage inevitable supply chain disruptions in the event of an outbreak of H5N1. In a pandemic scenario, the fragility of just-in-time delivery systems could be a serious weak link in global manufacturing platforms.

Open platforms incorporating interoperability and sufficient redundancy will enable businesses to mitigate risk while not impeding current operations. Companies that position themselves to respond proactively in the event of a pandemic will help minimize disruptions to economic activity, while protecting the reputation and integrity of their franchises. Decisive leadership requires the delegation of authority and a clear chain of command, coupled with an employee communication strategy that stresses the timely and accurate dissemination of information. According to the Mercer survey, however, only one-third of respondents have such pandemic-ready mechanisms in place. Moreover, senior management and other key personnel will be no less susceptible to the disease, so it is imperative that staff be cross-trained to handle a variety of responsibilities. As a pandemic moves in waves across the globe, the devolution of control to incorporate regional and field offices will enable firms to sustain core business functions throughout the crises.

Risk preparedness is a dynamic process that requires periodic revisiting to remain relevant. It must therefore reflect changes to the organizational structure and business model when they occur, and take into account supply and distribution networks and the ability of key partners to respond. Without back-ups, the failure of any loop in this daisy chain could result in a costly unravelling that can leave a company highly exposed. In a global corporate risk survey conducted by Swiss Re at the end of last year, senior executives ranked the threat of a pandemic as the third "top emergent risk" just behind natural disasters and computer-based risks. When queried on how they were managing and limiting their exposure to this risk, however, many had only rudimentary precautions in place with an overt reliance on a government response. It is interesting to note that few, if any, have implemented more sophisticated mitigation strategies such as financial hedging.

Globalization and recent technological advancements enhance the ability of companies to structure a more flexible workforce. Connectivity via the internet, email, video-conferencing, and secure VPN networks are now practical and affordable channels of long-distance communication. Employers should encourage remote access and alternative work arrangements such as part- or full-time telecommuting, so that familiarity is built into the system prior to a crisis. There are already an estimated 60 million Americans who telecommute and roughly 200 million worldwide; multinationals such as Dow Chemical and IBM have reported productivity increases of 30 to 50%, respectively, from such remote connectivity. Utilizing multiple work sites and supply vendors enhances social distancing as well, thereby reducing the exposure of employees to potential infection. In this regard, the diversification of business operating models to incorporate offshore sourcing bolsters available capacity.

The key take-away from recent survey data is that there is an increasing disparity between how companies perceive the risk of an influenza pandemic and their underlying ability to respond. Business leaders widely acknowledge the inevitability of disruptions to human resources and supply chains, but surprisingly few have formulated comprehensive contingency plans to weather the storm. The resilience of the global economy over the past few years has lulled many into a false sense of security. As was the case with SARS, it is this complacency that may prove to be more costly than the disease itself.

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Global
Shadowing the ECB
Jun 05, 2006

Joachim Fels (London)

A week ahead of the ECB Council meeting in Madrid, the ECB Shadow Council yesterday voted to raise the refi rate by 25bp. One member favoured an increase by 50bp (not me this time!), 13 voted for +25bp, and the remaining four wanted to leave rates unchanged at 2.5%. Last month, the group narrowly voted to keep policy on hold, with ten for unchanged rates and eight for a hike. The Shadow Council also endorsed a rate hike ahead of the December 2005 meeting, when the ECB started its tightening campaign, but (with a thin margin) failed to endorsed a hike before the March 2006 meeting, when the ECB raised rates for the second time.

Since its inception in 2002, the Shadow Council majority vote has deviated from the subsequent ECB decision on only two occasions. This is remarkable because this is a heterogeneous group of 18 economists from academia, think tanks and financial institutions who vote on what they think the ECB should do rather than trying to forecast the ECB’s decision the following week. Arguably, the Shadow Council is a more diverse group than the real ECB Council, and would seem to have slightly more dovish leanings. But the fact that this group’s interest rate recommendations have virtually always matched the real ECB Council’s decisions suggests that, contrary to what many critics say, the ECB’s monetary policy course has been fairly close to what mainstream economic thinking — as reflected in the majority vote of the Shadow Council — would have suggested. Whether this is good or bad is open for debate of course, but that’s a topic for another time.

The proponents of a rate hike argued that with the data pointing to a continuation of economic growth at around its trend rate, a further normalisation of monetary policy is warranted. Most members thought that the lack of underlying inflation pressures warranted a steady pace, rather than accelerated rate hikes or a more aggressive 50bp move. Also, most felt that the recent appreciation of the euro and the sell-off in financial markets argued against a 50bp move. This was also the reason why I shifted from advocating a 50bp increase in May to voting for 25bp this month. My reasoning went as follows:

"In the last few months I have been favouring a 50bp rate hike in order to bring rates closer to a neutral level of around 3.5% more quickly. My point was that with relatively solid growth, buoyant financial markets and a stable euro, the ECB had a window of opportunity to normalise monetary policy. However, that window has now started to close: the euro has appreciated and risky assets are selling off. Also, there are some early signs that the cyclical growth momentum is decelerating, especially in the US but also here. Hiking interest rates by 50bp would probably lead to a further shake-out in risky assets and a rally in the euro, with potentially negative repercussions on the real economy. Also, the financial market correction has helped to push inflation expectations slightly lower. Therefore, I now think a 25bp move in June, rather than 50bp, is appropriate."

Those members voting for unchanged rates argued that despite the ongoing recovery, inflation expectations were well anchored. Also, they felt that the appreciation of the euro and the decline in equity prices posed downside risks to the business cycle and argued for a more gradual and cautious approach to normalisation.

Finally, note that both the outcome of this Shadow Council vote and current market pricing suggest only a very small chance of a 50bp rate hike in Madrid. Our ECB watcher Elga Bartsch also thinks that a 25bp move is the most likely outcome. However, Elga reckons that the risk of a 50bp increase is as high as one-third (see A Bull Fight in Madrid?).

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Euroland
Liquidity and Surprise Gap
Jun 05, 2006

Eric Chaney (London)

Since last month’s equity sell-off, there is a lot of talk in the markets about the liquidity cycle. A widespread view is that central banks have pumped enormous amounts of ‘liquidity’ into the global financial system in order to fight actual deflation (in Japan) or risks of deflation (US, Europe). As the theory goes, they (the central banks) are now ‘withdrawing the punch bowl’, thus running the risk of soaking liquidity excessively to the point that financial markets and the real economy might be badly hurt. Are we running this risk, as a couple of disappointing data releases on each side of the Atlantic may suggest? In order to address the question seriously, we probably need to clarify what we mean by liquidity, a word so widely used in the financial markets that I suspect it might have very different meanings, depending on who you are talking to (traders, investors, CFOs, not to mention economists of various schools). In this note, I will not try to add my own definition. However, I believe that the link between the financial sphere (liquidity, asset prices) and the real one (real demand) is critical in a globalised economy relying heavily on ever-bigger financial markets. That is why I will look at the financial versus real economies link from a pragmatic European angle.

Troubling coincidences

In this regard, I find it remarkable that our euro area Surprise Gap index, which is derived from monthly surveys of manufacturing companies, dropped markedly in May, in perfect sync with equity markets. This coincidence happened several times in the past (for instance July 2000, September 2001, June-July 2002, March 2005). As a reminder, the Surprise Gap is a qualitative measure of the difference between real-time production and previous production plans. Since it is hard to believe that manufacturing production could be instantaneously influenced by changes in the financial markets, we are left with three non-exclusive possibilities.

(i) The ‘real economy’ hypothesis

The markets may anticipate or just react in real time to news from the real sphere that will not be recorded in official statistical books for months. After all, the markets can be viewed as a very large-scale information processor taking its clues from the real world. In that case, the causal link would be from the real economy to the markets.

(ii) The ‘exogenous shock’ hypothesis

A common exogenous factor may influence both production and the markets. This is likely the case of unexpected events with clear global implications. The Asian crisis, the Russian debt default or 9/11 were among them, to take some recent examples.

(iii) The ‘money’ hypothesis

A more hidden common but endogenous factor could be changes in liquidity, or money, as my colleagues Joachim Fels and Manoj Pradhan are trying to measure.

With a little help from Occam’s razor

In current developments, it seems to me that the ‘exogenous shock’ hypothesis should be rejected: I just do not see what could be this exogenous common factor behind the correction in the markets and the drop of the Surprise Gap. Hence, we are left with the ‘real economy’ or the ‘money’ hypothesis. Because the former does not require the strong economic assumptions that are behind the latter, I would favour the ‘real economy’ hypothesis, without rejecting the ‘money’ hypothesis either.

If, as I indeed think, market gyrations were caused by changes in the real economy, the focus should be on the real economy, not on liquidity. On this ‘real’ ground, there are no reasons to be excessively worried, in my view, as fundamentals continue to be robust in the global economy in general and Europe in particular. Besides, our Euroland Surprise Gap index is now in neutral territory, indicating a stabilisation of growth, not a deceleration. If and once we enter the deceleration zone, we’ll have to re-assess risks carefully. But we are not there yet.

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Turkey
Courage Under Fire
Jun 05, 2006

Serhan Cevik (London)

Under a cloud of uncertainty, Turkey cannot afford to leave an anchor of stability behind. For one reason or another, the global economy is going through a risk-reduction phase during which emerging markets bear the brunt of the sell-off. Turkey, albeit on a fundamentally stronger footing, is not immune to asset fluctuations and has in fact experienced significant capital outflows. With an economic structure that is highly dependent on imported energy and intermediate goods, it is not surprising to witness a depreciation of the Turkish lira. We were anticipating a weaker currency this year, but the extent of pressure on the lira has reached beyond what economic fundamentals would justify. Unfortunately, the lira’s depressed valuation is likely to have inflationary consequences. Direct pass-through effects are relatively easier to estimate, but the key is how expectations will respond to the idiosyncratic shocks — a commodity bubble and global risk reduction — Turkey is now experiencing simultaneously. Although uncertainty is a ubiquitous feature of financial markets, the policymakers’ challenge is to establish a sense of calm without intensifying financial distress.

The increase in inflation is disturbing, but we should not rush to make long-term conclusions. The consumer price index posted a monthly increase of 1.9% in May, more than twice as much as our estimate of 0.9%. As a result, the year-on-year inflation rate jumped from 8.8% in April to 9.9% last month. This is certainly out of sync with the central bank’s target range and is likely to weigh on the rest of the year, especially considering the recent bout of currency volatility. However, we should not extrapolate the latest figures and rush to make long-term conclusions. The deviation from our forecast profile is because of certain items in the CPI basket. Even though the lira’s weakness played just a marginal role at this stage, a 0.7% increase in food prices (compared to our projection of no change) and a 10.9% surge in clothing prices (even higher than last month’s 9.2% and our estimate of 6.5%) and higher oil and gold prices made the most significant contribution to last month’s inflation. What are we missing here? Is there a fundamental shift, or is this just an unlucky chain of deviant readings? It is true that inflation, after declining from 80% to below 8%, has been stuck in a narrow range in the last 18 months, but that is mainly a result of higher energy and other commodity prices. Though some observers argue that the Turkish economy is overheating, even the latest figures do not support such a conclusion. The labour market is still weak, disposable income growth presents no underlying threat, and the economy as a whole is still operating with an output gap.

Higher commodity prices and ‘seasonal’ adjustments pushed inflation higher. Core measures of inflation showed higher readings as well last month, but these indices can be misleading when exogenous and seasonal adjustments take place. For example, if we leave out gold prices (which pushed the miscellaneous category of the CPI basket by 5.1% last month and 11.7% in the first five months), the ‘core’ CPI excluding energy, unprocessed food and administrative prices increased by 0.5% month on month and 5.5% year on year in May. In other words, the underlying inflation trend is still consistent with the central bank’s year-end target. We are not sure how international commodity prices will behave in the remainder of the year, but domestic price movements in food and clothing categories are likely to be favourable in the coming months. For example, clothing prices, after increasing, once more, by around 1.5% this month, should decline in the rest of the summer. Sector representatives suggest that firms will have deeper discount campaigns and lower prices almost as much as the increase in the past two months. Although recent adjustments were higher than we expected (particularly considering the VAT cut), this is still one of the most competitive sectors of the economy. In fact, the year-on-year increase in clothing and footwear prices was just 0.01% in May, down from 9.4% a year ago. In other words, after direct effects of the lira’s recent depreciation start fading away, we still expect the overall state of the economy to keep disinflation on track. But can the central bank sell such a reasonable scenario to investors who are already worried about ‘risky’ assets and question the institution’s credibility?

The rise in uncertainty could paralyse the economy and financial markets. The exchange rate is an important ‘price’ even in a closed economy, and has significant effects on economic behaviour, especially in an open economy. Therefore, policymakers cannot ignore what market participants think about the current and future state of the economy. This is, as Keynes put it, a beauty contest, and picking the winner depends on ‘estimating’ what others think. Israel offers an interesting example for such a policy dilemma. Following an unexpectedly large cut in interest rates at the end of 2001, the shekel depreciated by almost 20% and inflation surged from 1.4% to 6.9% over the course of seven months. The Bank of Israel responded by raising short-term interest rates from 3.8% to 9.1%, which helped to stabilise the exchange rate and brought a correction in inflation. That was a costly response to an unfortunate policy failure, putting the economy into recession. However, unlike what Turkey is now experiencing, the development in Israel was not initiated by global factors, but a loss of residents’ confidence. Despite the spell of volatility, Turkish investors continue de-dollarising portfolio holdings. Nevertheless, we are still in the early stage of a ‘liquidity shock’ that could worsen expectations and create bandwagon effects. Thus, even with a limited pass-through from the lira’s weakness, an inflation-targeting central bank cannot ignore a significant threat to price stability, in our view.

Interest rates are not the key determinant of portfolio allocations in today’s setting. Inflation has already moved above the uncertainty band’s upper bound of 8.5% for the second quarter, and the CPI must post a 1.1% drop in June to stay within the range. But that is unlikely, given the pass-through effect that we are yet to see. So the central bank owes us an explanation, but what can it do to bring inflation lower in the short term? Nothing is the honest answer. Indeed, all inflation-targeting central banks accommodate the first-round effects of certain supply-side shocks, like higher oil prices. Are exchange-rate movements that bring an increase in inflation different? Well, it depends on contributing factors. As argued above, the Turkish case is not a result of domestic imbalances, but mainly a consequence of global risk aversion. Hence, interest rates are not the key determinant of portfolio allocations, as investors adopt a higher degree of home bias. That is why we still argue for waiting until markets cool down and there is more data on demand-side developments in Turkey. Of course, one can rightly reason that expectations are adaptive and higher uncertainty may alter fundamentals as well. Indeed, Turkey’s own experience confirms such a self-fulfilling relationship between expectations and economic outcomes. However, we also need to point out that there is a high degree of uncertainty about how the exchange rate would respond to a tightening cycle with an expensive price tag for the economy. All in all, we understand the case of ‘doing something’ but are not convinced that raising interest rates is warranted at this stage. Don’t forget that monetary policy works with a long and variable lag, and chasing contemporaneous inflation would do more damage than good.

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Thailand
Domestic Demand Contracted in 1Q06
Jun 05, 2006

Deyi Tan (Singapore) and Denise Yam (Hong Kong)

The economy grew 6.0% YoY in 1Q. GDP expanded 6.0% YoY in 1Q05 (versus +4.7% YoY in 4Q05). This is higher than our and market expectations of 5.5% and 5.7%, respectively. On a sequential seasonally adjusted basis, the economy expanded 0.7% QoQ (versus +0.8% QoQ in 4Q05). Despite the strong headline, details show that conditions are not that favourable.

Domestic demand contracted 2.3% YoY in 1Q05 from 7.0% YoY in 4Q. The slowdown was due to three factors — government consumption, fixed capital formation and inventories. In particular, inventories saw the biggest pullback (-5.8 percentage points versus +1.3% percentage points in 4Q05). 1Q typically sees the most inventory additions due to the agricultural harvest season, but this time, inventory destocking stood at -Bt2.3 billion (versus Bt53.1 billion in 1Q05). While agricultural inventories did rise, destocking came from a depletion in both industrial product stocks and raw materials amid the 3.3% YoY contraction in goods imported. We believe that the de-stocking is likely a reaction to the political uncertainty.

Gross fixed capital formation rose 6.6% YoY (versus +8.1% in 4Q05). The deceleration in fixed capital formation was mainly found in equipment take-up (+7.9% YoY versus +10.2% YoY in 4Q05). In terms of the private-public divide, private fixed investment decelerated to 7.2% YoY (versus +9.3% YoY). Public fixed investment has been sustained at 4.7%YoY (versus +4.3% YoY in 4Q5). However, with the government deciding to shelve the mega infrastructure projects (Bt150 billion, 2.1% of GDP) planned for 2006, the impact will show up in public GFCF numbers going forward.

Meanwhile, government consumption contracted 0.7% YoY (versus +7.8% in 4Q05), as the government reduced purchases from enterprises and abroad by 5.5% YoY while compensation of employees rose 2.2% YoY.

Consumer spending only sustained momentum at 4.1% YoY despite an easier base. Fundamental factors supporting private consumption seem reasonable. Seasonality aside, the unemployment rate in the labour market appears to be on a declining trend. Average wages rose by a respectable 6.2% in 1Q (versus +6.0% YoY in 4Q). However, temporal factors, such as declining consumer sentiment, the lagged impact from monetary tightening and high unsubsidized oil prices, mean we could see a deceleration ahead.

Headline growth helped by extensive pullback in imports. Goods exported are still supported by the global demand (+14.1% YoY) while services exports rose 10.9% YoY on the back of the post-tsunami weak base and tourism recovery. Meanwhile, goods imports contracted 3.3% as corporates cut back on raw and intermediate goods. The growth contribution from the external balance was 8.0 percentage points (versus -1.1 percentage points in 4Q05).

Political uncertainty undermines domestic demand; look to external balance for support ahead in 2Q. Elections have been delayed until October 15, with the new government to be formed within 30 days. This means that domestic sentiment could remain weak under the caretaker government. In the meantime, we look to the external balance to support growth in 2Q.

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