Debating the Liquidity Cycle (Part II)
Jun 29, 2006
Joachim Fels (London)
In yesterday’s GEF, the team debated the importance of a downturn in the global liquidity cycle for risky assets and the potential parallels between the current situation and the 1994 episode, when liquidity contracted as the Fed raised rates and the bond market crashed. The debate takes a different turn today.
David Miles (UK Economics) Joachim, I must say that I find the term ‘liquidity’ immensely confusing. Sometimes it appears to mean the level of interest rates; sometimes it appears to be about the scale of transactions in financial markets; sometimes it seems to be about the ability to sell in quantity at close to prices quoted on traders’ screens; sometimes it seems to be about credit restrictions (i.e., somebody’s inability to borrow at the level of interest rates banks set on loans). Can I make a plea that if we use the term we define exactly we mean?
Joachim Fels Good point. Many people are fuzzy about the term ‘liquidity’. But I thought I had defined it clearly when I described my chart. Global excess liquidity in my definition is the ratio of a narrow monetary aggregate like M1 to nominal GDP, for a broad group of countries. I chose a narrow aggregate rather than a broader one like M3 or credit, because this is most sensitive to the level of, and changes in, short-term interest rates. I view my measure of excess liquidity as a summary indicator for past and present monetary policy actions.
David Miles Understood. But as you well know the Fed and the Bank of England have massively downgraded their assessment of the usefulness of measures of the aggregate money supply, and to a somewhat lesser extent credit, as indicators of what is happening in the economy. This is not just a matter of whim or of intellectual fashion. It is a process that began at least 20 years ago. Empirical evidence of the statistical link between what is happening in the wider economy (to inflation, employment and output) and measures of money have consistently shown two things: first, that correlations (and no-one seriously thinks we are talking about causation here) are variable and unpredictable; second, that if you throw measures of money and credit into the mix with other information (e.g., surveys, movements in retail sales, interest rates and exchange rates and so on), they do not tend to have any consistent and reliable forecasting power. So on purely statistical grounds there is, I believe, a pretty clear message — don’t rely on shifts in measures of money to tell you too much reliable about what is going on in the economy.
But the reason that measures of money now play so much less of a role for policy makers in the US and the UK is not so much the empirical record. Far more important is the economics (that is the causal links) behind what is going on. In a nutshell it is this: if you focus on narrow money (M0 or M1), it is highly likely that movements in those aggregates reflect shifts in the technology of transactions — e.g., better and more ATMs, the existence of new types of credit cards and so on. There is also some correlation with spending — though there is unlikely to be much link between where spending might be over the next year or so (which is what matters for monetary policy) and shifts in yesterday’s stock of narrow money.
What about the economics of broad money? The problem here is that shifts in the private sector’s desire to hold a part of its total wealth in a subset of assets labelled ‘money’ (bank deposits of various sorts) are many and varied. To a large extent they reflect portfolio movements that are driven by shifts in the perceived attractiveness of a very wide range of assets. Quite what the interpretation of a shift in broad money for spending and inflationary pressures should be is absolutely unclear, until you drill down to what is driving it. Of course, once you drill down, you start asking questions about investment intentions, confidence indicators, consumer sentiment and so on. But if you need to measure and assess those factors to makes sense of a monetary aggregate, why bother looking at the monetary aggregate any more — focus instead on the indicators themselves, which are more directly linked to the pressures of spending and supply.
Joachim Fels None of this is controversial David, but my point is not about the ability of money or credit to explain what’s happening to spending, output or inflation. I merely claim that there is a link between the global stance of monetary policy, which I think is captured in my simple (and maybe simplistic) global excess liquidity measure, and asset prices. That link may not be precise, and it may be difficult to prove with rigorous statistical tools, but it seems to be there. And if we accept that (1) monetary policy affects asset prices and (2) asset prices affect the real economy, it follows that monetary policy affects the real economy via asset prices.
Stephen Roach Joachim, the turn — or lack thereof — in the global liquidity cycle is key for the financial market debate. We are all in agreement on that. The metrics that enable us to judge how and when are in serious dispute, however. As for the quantity story, my advice is to give up the ghost. Rather than looking at quantity measures of liquidity, I would prefer, instead, to focus on the price of liquidity — i.e., by focusing on real interest rates. On that basis, the Fed has turned the knob on the liquidity spigot — but the flow is still steady (i.e., neutral). It is still wide open in Japan and flowing with reasonable speed in Europe.
Richard Berner I agree 100% that the price of credit is the relevant metric. Now if we only knew what the right price is!
Joachim Fels I’d be the first to admit that quantity measures of liquidity are not the holy grail — they are just one (though, I think informative) indicator to gauge the policy stance and thus the impact on financial markets and the economy. That’s exactly why Manoj Pradhan and I have taken a very different approach — estimating the natural, or neutral, rate of interest using a neo-Keynesian framework that is very different from the monetarist-inspired quantity measure of liquidity. Comparing actual interest rates to the estimated natural rate probably comes closest to a ‘price’ measure for whether liquidity is abundant or scarce. And guess what? Our results for the US suggest that the Fed is already in restrictive territory, with the neutral rate in the 4.25-4.5% area, which would seem to fit in with the notion that global liquidity has become less plentiful.
Stephen Roach Joachim, you have made a noble effort at the short end of the US yield curve — what about the short end of other curves? What about the long end?
Joachim Fels Regarding long rates, when estimated properly, the measure of the natural rate also reflects the impact of long rates (and the exchange rate, and fiscal policy, etc) on the economy. The natural rate is the interest rate that keeps the economy growing at trend and inflation stable, taking into account all the other headwinds or tailwinds for the economy, such as high or low long-term interest rates.
Regarding the same analysis for other countries, our estimate of what we call the Nat-EUR-al rate of interest for the euro area suggests that the ECB refi rate is still some 50bp below the natural rate — so the ECB is still expansionary, though not much so. For Japan, we don’t have good estimates yet (this is work in progress), but it’s a fair guess that policy is expansionary at a policy rate of zero! I would warn against putting too much weight on any particular estimate of the natural rate, however. Like output gaps, this is a somewhat vague concept
Robert Feldman (Japan Economics) I would emphasise your latter point, Joachim. There are three sets of uncertainties here: (1) The quality of the underlying data, (2) the accuracy of the underlying model, and (3) the accuracy of the statistical techniques. Given these problems, it is only honest to give standard errors of estimate when making forecasts based on such models.
For example, the Bank of Japan is pounding the table about the output gap being back at zero. However, as I showed in my piece several weeks ago, ‘zero’ actually means ‘zero plus or minus 8 percentage points’ for a 95% confidence band.
Joachim Fels I agree with Robert. We show standard errors for our natural rate estimates and they are several percentage points wide. Like output gaps, they can be a treacherous concept. That’s exactly why I advocate looking at a variety of indicators for monetary policy stances or liquidity conditions, including (and I’m repeating myself now) quantity indicators. Talking about Japan, what should we make of the Bank of Japan’s draining of excess reserves in the money market? Some investors I have spoken to claim that this is one reason for the sell-off in risky assets since May.
Tune in tomorrow for Takehiro Sato’s reply and a continuation of the debate.
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Budget Blues and Beyond
Jun 29, 2006
Elga Bartsch (London)
Struggling to comply with budget rules
After a six-month delay, the German parliament approved the budget for the current fiscal year last week. The planned budget deficit, at €38.2 billion for the federal level alone, will be the largest ever planned by a German government. The overall budget position including social security bodies, regional states and local municipalities will thus likely be in violation of the 3% ceiling of the Stability and Growth Pact for the fifth consecutive year. In addition, the government again had to resort to invoking a special rule, saying that a macroeconomic disequilibrium needed to be averted, to ensure that the budget is in line with the German constitution. The German constitution stipulates that in any given fiscal year the government cannot borrow more than it invests except for special circumstances such as a macroeconomic disequilibrium. Here, the German Golden Rule is stricter than Gordon Brown’s UK version, where the government needs to balance borrowing and investment only over the course of a business cycle. And it is in fact the Golden Rule rather than the Stability and Growth Pact that is giving the government some headache in putting together the fiscal plan for next year. In order to meet the Golden Rule, the federal net borrowing requirement needs to come down to around €21 billion. To achieve this ambitious goal, the government has already pushed through legislation, which among other things will hike the VAT rate by three percentage points in January. The full 2007 budget is scheduled to be discussed and approved in Cabinet on July 5.
Corporate tax and healthcare reform could create an extra burden…
The tight budget situation severely limits the government options on two other major reform projects it currently has in the making while most of the nation is celebrating the World Cup. This past weekend, the key players of both coalition parties met to discuss the planned corporate tax reform. The reform intends to lower the corporate income tax rate in Germany substantially from the current 25%. In order to bring the total tax rate on corporate profits, which also includes the trade income tax imposed by local municipalities and the solidarity surcharge, down to around 30%, the corporate tax rate itself would need to be cut to 12.5%. One aim of a lower corporate tax rate is to prevent further relocation of companies to low-tax countries in central and eastern Europe. In addition, the government feels that the present system gives multinational companies incentives to shift corporate profits abroad, while trying to shift financing costs to Germany. With a total corporate tax rate of slightly below 30%, Germany would move from being a high-tax country within the enlarged European Union to a ‘midfield’ position. However, the main issue for many companies’ location decisions are labour costs and labour laws, not corporate taxes (see Old Europe, Old Ideas, May 14, 2004).
…due to a potential net tax relief for corporates…
In addition, true to form, the Grand Coalition doesn’t seem to agree on many details of the corporate tax reform. While the Social Democrats, SPD, insist that there should not be further tax relief for companies (especially not in the face of a major VAT hike hitting households), their Christian Democratic Partners, the CDU and the CSU, think that exactly such a tax relief is what’s needed. Trying to find a compromise, Finance Minister Peer Steinbrueck, SPD, has proposed to include half of all interest paid, rents and leasing fees in the tax base used to calculate the trade income tax. This would change corporates taxes (comprising both the corporate tax and the trade income tax) from being pure profit taxes. By taxing company capital, the tax revenue stream should become steadier — which is a key concern for local municipalities. In isolation, it would likely make post-tax earnings more volatile. It also implies that highly profitable companies will benefit more from the proposed reforms than less profitable ones. Post-tax earnings dispersion will likely rise, in my view. The IW Institute calculates that companies with a return on equity below 9% will lose out under the proposed changes to corporate income tax system. The reform would also make debt financing in Germany less attractive than it is now. Thus far German companies have benefited from being more highly geared. But whether the corporate tax reform is accompanied by a meaningful tax relief — the talk is for around €7.5 billion — will likely become a sideshow once the government officially reveals its plans for a healthcare reform.
…and potential tax subsidies to the healthcare system
The healthcare reform is the key item on the agenda for the autumn, and it now looks as if it will imply a major increase in tax subsidies to the healthcare system. Initially, press reports suggested additional tax subsidies of up to €45 billion. After high-level meetings between both coalition partners, it seems that the additional tax subsidies to the system will be limited to €16-24 billion. This amount would cover all family-related subsidies within the statutory healthcare system, where children and unemployed spouses currently go free. In exchange for the higher tax subsidies, contributions to the statutory healthcare system will be lowered. To put the initial estimate of a financing need of €45 billion into perspective: such a sum is equivalent to hiking the VAT another six points or so to a whopping 25%. Alternatively, one could consider returning to the income tax rates of 1998 — thus undoing several tax reforms implemented under the Red-Green government — and raising the lowest income tax rate from 15% to 26% and the top income tax rate from 42% to 53%. Raising up to €24 billion takes about half these measures, still a major increase in taxes. The Finance Minister has indicated that he would agree to such a major reshuffle only under two conditions: first, efficiency gains in the healthcare system need to be mobilised; second, the higher taxes need to be fully offset by lower healthcare contributions in order to ensure that no additional burden is created.
If you think you have been here before, don’t worry: you have. Faced with an ever-rising budget hole in the statutory pension system, the Red-Green government decided in 1998 to raise energy taxes sharply and call them ecological taxes. Eight years later, the pension system is still not on a sustainable footing. Shying away from a fundamental reform of the healthcare system, characterised by considerable overcapacity and massive managerial bloat, the reform efforts seem again to be mainly focused on the revenue side. By now, it should be clear that the real need for reform is on the expenditure side.
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Lunch at Mandarin
Jun 29, 2006
Serhan Cevik (London)
We hosted an investor meeting with the new governor of the Central Bank of Turkey. Global risk reduction is not over, and emerging markets remain under pressure. Unfortunately, despite significant gains on the macroeconomic landscape in the last four years, Turkey is still vulnerable to mood swings in the international capital markets because of its exposure to liquidity-driven capital flows and excess lira liquidity in the domestic money markets. This is why the turn of the global liquidity cycle has had a disproportionate effect on Turkey’s financial markets and led to a sharp depreciation of the exchange rate. Of course, the lira’s weakness, especially coming on top of supply-driven inflation pressures, has worsened expectations and will likely bring marked price increases in the coming months. As a result, the Central Bank of Turkey has responded forcefully by raising short-term interest rates and introducing a new framework for liquidity management. So we thought there could not be a better time to host an investor meeting with Governor Durmus Yilmaz, which took place June 26 at the Mandarin Hotel in New York.
Fundamentals remain strong, albeit monetary tightening will slow economic growth. Overlooking Central Park, the venue was impressive, but the crowd had difficult questions in mind rather than enjoying the view or even a tasty three-course meal. The governor — facing one of the most challenging tests for a policymaker right after his appointment — started with an overview of economic developments and highlighted fundamental improvements that should limit the fallout from the global volatility shock. Indeed, thanks to fiscal consolidation and productivity gains, Turkey enjoyed above-trend output growth and disinflation from the post-crisis peak of 73.2% to the single-digit territory. As a result, fiscal dominance is no longer a major threat and the banking sector is now on a stronger footing, according to Mr. Yilmaz’s assessment. However, even before investors pointed it out, the governor acknowledged at the outset that financial volatility and the pass-through effect of a weaker currency will have changed inflation and growth dynamics for the worse. And in order to curb secondary effects on long-term inflation expectations and price-setting behaviour, the central bank moved aggressively by raising the policy rate from 13.2% to 17.25% within 20 days and also introduced measures to better manage liquidity conditions.
The central bank has adopted a more proactive approach to liquidity management. As we have argued in earlier dispatches, interest rate increases are not the most appropriate tool for dealing with what is effectively a liquidity crunch and speculative behaviour in the foreign exchange market. Looking towards a growing risk of financial distress, the monetary authority has adopted a more proactive approach to liquidity management and launched a new strategy based on real-time assessment of financial markets. The scheme works through two main channels: auctions to sell dollars and withdrawing excess lira liquidity in the money markets. Although market participants focus mainly on what happens in the foreign exchange market, we believe that draining lira liquidity is the more powerful aspect of the new framework. Indeed, the withdrawal of about 5.5 billion lira from the money market so far has helped to ease the pressure on the exchange rate. To make this arrangement even clearer, the central bank also widened the spread between the borrowing and lending rates from 300bp to 500bp, increasing the cost of shorting lira. Unfortunately, all these measures bring downside risks to the growth outlook and fiscal performance. However, as the central bank’s policy response gains credibility, the yield curve should reflect disinflation in the future and thereby limit the worsening in financial conditions. Turkey disinflated towards the single-digit territory with almost no output loss, but it must now pay a price for consolidating past gains and moving forward. After all, Turkey’s own experience shows that there can never be sustainable growth without achieving price stability first.
The central bank expects inflation to be below 10% this year and converge towards the target in 2007. Albeit cautious about the effects of global volatility in the near term, the central bank expects tighter monetary conditions and the overall state of the economy to keep consumer price inflation below the 10% mark at the end of this year and then lead to a deceleration towards the 4% target next year. It may sound optimistic, but not unrealistic. The volatility shock that hit the lira will also weaken domestic demand, which was not a source of inflation pressures anyway, and even limit the pass-through effect from the lira’s depreciation to consumer prices. Just as every cloud has a silver lining, the recent bout of volatility has given Turkey an opportunity to curb excessive behaviour and to accelerate structural reforms beyond macroeconomic adjustments and revenue-driven fiscal correction. Even though what has happened in financial markets may be a monetary phenomenon, the response should also incorporate fiscal instruments to limit a cyclical deterioration as well as faster institutional convergence. All in all, the governor’s lunch presentation at the Mandarin may not be recorded in the annals of best public speeches, but we believe that his actions have already spoken louder and made the central bank’s policy independence and commitment to price stability very clear.
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Choosing Stability Over Growth
Jun 29, 2006
Chetan Ahya (Mumbai) and Deyi Tan (Singapore) and Sharon S.Y. Yeshaya (Hong Kong)
Stephen Jen (Head of Global Currency Research), Sharon Yeshaya (Asia Ex-Japan Currency Strategist), Deyi Tan and I spent two days in Indonesia meeting with policymakers. Below is a short summary of our findings and thoughts:
A positive interest rate environment was one of the key factors supporting growth revival in Indonesia in 2004 and the first half of 2005. However, sharp rate hikes of 4.25% to 12.75% in a span of five months in 2H06 by Bank Indonesia (BI) in response to inflation concerns and volatility in rupiah affected the credit cycle and growth environment. Although inflation concerns may be beginning to dissipate, we believe that the rising US Fed rate and increasing financial market uncertainties will continue to restrain BI from resorting to major rate cuts in the second half of the calendar year. We now expect the benchmark 30-day policy rate to decline only marginally to 11.5% (from the current 12.5%) compared with our earlier estimate of 10.5%.
Inflation concerns may be dissipating…
Although headline CPI still remains high, we believe that BI is now less concerned on inflation. CPI inflation is expected to start decelerating from August 2006 onwards, possibly heading as low as 6-7% by the year-end. The deceleration is likely to be supported by the base effects of higher oil prices since last October. Obviously, the risk is that the oil price rises above US$80 and/or the rupiah depreciates sharply, bringing on the second round of inflation pressures. On balance, we believe that domestic inflationary pressures will start dissipating in the second half of the calendar year.
...and growth appears to be slowing...
On the growth front, several economic indicators are showing a softening in momentum in the second quarter. In particular, credit growth has been declining, primarily as manufacturers and the services industry slowed down on borrowing momentum. Loan growth in the trade sector also decelerated in sync with the weakening we saw in the export growth cycle. Discretionary spending, in the form of automobile purchases, which are typically the first to suffer when consumer sentiments weakens, have also taken a hit as fuel subsidy removals reduced purchasing power. Cement consumption, a proxy for fixed investment, also does not provide cause for optimism in the investment outlook. Indeed, data in the first two months of 2Q06 show a 2.4% contraction.
…..but exchange rate stability will remain the key focus for now
We believe that BI is currently focused on financial and exchange rate stability more than growth. In our view, the past experience of instability has made BI overly cautious on this aspect. It is concerned about exchange rate expectations turning quickly into a self-fulfilling vicious cycle of instability. We believe that, in this context, the balance of payments outlook and capital inflow trend will play a key role in determining the interest rate outlook.
Balance of payments uncertainties likely to continue
While the current account being in surplus has helped, volatility in the capital flow trend is causing uncertainties. Non-FDI, including SBI, foreign portfolio equity flows and government bonds, has been relatively unstable. The government’s ‘go slow’ approach on structural reforms is not helping to reduce reliance on these less stable inflows. We believe that the central bank will stay cautious in deciding on its interest outlook at a time when global interest rates continue to firm up. We are therefore revising our year-end forecast on the BI policy rate to 11.5% compared with our earlier estimate of 10.5%.
Muddle-through approach on reforms implementation
On the political front, despite much excitement following President Yudhoyono’s victory and the peaceful election, we have seen little follow-through. There have not been very many achievements in the first year of the new government, in our view. 2005 proved to be a disappointment. We believe that there is a need for faster implementation of structural reforms, such as increases in infrastructure investments, labour law reforms, improving legal certainty and improving tax administration. Although the government plans to take up some of these issues over the next three months, we believe that the pace might continue to be slow. The only area the government may pursue some positive measures is, we believe, in the banking sector.
Higher rates, financial market uncertainties and slow reforms hurting investments
Investment growth remained weak during the past three quarters. With machinery and equipment spending declining, the overall investment growth trend has only remained positive due to building spend continuing to grow at a strong rate. In such an environment, growth is likely to be dependent on government and private consumption. Private consumption growth has also decelerated post the sharp hike in interest rates and the rise in domestic oil prices during the second half of last year. However, we believe that moderate interest rate cuts and no further major additional oil price hike should allow a moderate improvement in private consumption during the second half of the year.
We believe that BI is likely to play safe, initiating gradual and smaller rate cuts in the second half of the year than we had estimated earlier, due to the continued reversal in global risk appetite and attendant pressure on Indonesia’s balance of payments. With the business investment cycle continuing to remain weak and support from the export market also weakening, the growth outlook is largely dependent on private consumption. We believe that while there is likely to be a minor acceleration in private consumption growth in 2H06, the overall growth trend is likely to be relatively subdued at 5.1%
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Jun 29, 2006
Chetan Ahya (Mumbai) and Mihir Sheth (Mumbai)
Inflation scare – how real is it?
After 54 weeks of soft inflation, Wholesale Price Index (WPI) inflation is again approaching the upper limit of the RBI’s comfort zone of 5.0-5.5%. Last week’s WPI data, which point to inflation of 5.24% yoy (up from 4.72% yoy during the previous week), have raised concerns among financial market participants that inflation could significantly exceed the central bank’s comfort zone. However, we believe that a sustained rise above the 5.0-5.5% range is still a low probability event unless the rupee witnesses sharp depreciation of 8-10% over a short period of time.
WPI — not an accurate measure of inflation anyway
The commonly used Wholesale Price Index (WPI) inflation indicator in India is similar to the Producer Price Index in other countries. Hence, India’s WPI inflation rate has been extremely sensitive to wholesale commodity prices and not necessarily representative of underlying final consumer goods prices. Moreover, WPI is also biased towards goods prices and offers very little representation of services. Although the government does release a CPI inflation rate, the base year (1982) is way too outdated for it to give true indication of the underlying inflation rate. With the Indian consumption basket having undergone major structural changes since 1982, neither policy-makers nor market participants follow this indicator closely. While the government has just released a new index, its data series is not long enough to allow a trend assessment. In the absence of any realistic alternative, WPI inflation is currently being used as some kind of representative indicator of underlying inflation.
Recent correction of global commodity prices to help check WPI inflation
Global commodity-linked products represent 37% of the WPI, and hence the WPI has largely been tracking the trend in the Commodities Research Bureau (CRB) Index. With global commodity prices weakening, we believe that the WPI is unlikely to witness any substantial rise in the near term. Indeed, if we exclude global commodity-linked products, implied WPI inflation is running at 4% — in line with its average over the last five years.
High integration with global market place limiting goods inflation
We believe that improving capital and labour productivity is limiting goods inflation for products other than global commodities. In an environment of low import tariffs and a high level of global integration, inflationary pressure in the domestic goods market is unlikely to keep accelerating unless this is a global issue and/or the Indian rupee depreciates sharply. Aggregate demand for tradable goods exceeding aggregate supply in the domestic economy has tended to show up in form of a widening trade deficit rather than higher prices. Not surprisingly, in its recent policy statements, the RBI has indicated that its monetary policy outlook is influenced not only by inflation but also by trends in the current account deficit, asset prices and bank credit quality.
Exchange rate effect is a key risk to stable inflation trend
Despite strong economic growth over the last three years, India’s inflation environment has remained benign. Low import tariffs have meant that domestic goods prices are closely linked to global trends. We believe that a relatively stable trend in the rupee/US dollar exchange rate has been a key factor supporting this trend. Hence, we believe that sharp exchange rate depreciation of 8-10% in a short period of time is the most important risk to the current benign domestic inflation trend.
Global rate environment is more important than domestic inflation for local interest rates
While local market constituents have focused consistently on domestic inflation, we think that a contracting risk premium, capital inflows and falling real interest rates have played a more important part in the decline in nominal interest rates over the last few years. The steep US yield curve (supported by low US short rates) and increase in global risk appetite (resulting in rising non-FDI capital inflows) had driven a fall in real interest rates and therefore nominal interest rates in the recent past. There is little evidence that market-oriented government bond rates have been influenced by WPI inflation.
Low real rate policy days are over
India is now running a current account deficit that is funded to a large extent through less stable capital inflows, influenced by global risk appetite and the US interest rate cycle. Hence, we believe that, incrementally, the RBI will hike its short-term policy rate in line with the Fed rate. With our US Economics team expecting a 50bp additional hike in the Fed rate, we think the RBI is likely to increase its short rate by the same magnitude. The risk, of course, is that the Fed takes rates higher than 5.5%. Given that the direction of US interest rates is so critical to the local rate interest environment, we believe that market constituents should be focused more on US inflation risks than local inflation risks in the near term.
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