Kim's Boost to Globalization
Jul 07, 2006
Stephen Roach (New York)
The North Korean missile crisis is only the latest reminder of the fragilities that continue to beset a post-9/11 world. In less than five years since the terrorist attack on the United States, the world has been shaken by wars in Afghanistan and Iraq, saber rattling over Iran, and the ever-escalating Israeli-Palestinian conflict. At the same time, global imbalances have worsened, world trade frictions have intensified, oil and other commodity prices have soared, and the global liquidity cycle has gone to excess. The fate of globalization could well hang on the interplay between these geopolitical and economic risks. Could the events in North Korea be a tipping point for globalization?
There are several channels by which this potential collision of forces could play out in both the real and financial sides of the global economy -- namely, through oil prices, trade flows, inflation, and the liquidity cycle. The oil price has long been a proxy for geopolitical insecurity. Military hostilities that are perceived to threaten the secure supply of oil obviously tilt the price of crude higher. By way of reference, today’s oil prices are nearly three times the $27.77 quote (WTI basis) prevailing on 11 September 2001. With global oil consumption up just 8% from 2001 to 2005, there can be little doubt of the impacts stemming from the insecurities of a post-9/11 world. Military hostilities can also threaten the security of shipping lanes -- underscoring the possibility of a disruption to the flow of global trade. Fears of such an outcome were a legitimate concern in the aftermath of 9/11 -- especially given the added pressures stemming from higher insurance rates and heightened security measures. So far, those fears have been unfounded -- growth in global trade averaged 6.6% per year over the 2002-05 period -- actually faster than the 5.7% pace of the previous four years. Globalization and the surging cross-border trade it has generated have led to increasingly powerful global arbitrages of labor costs and prices. This has provided a new and important impetus to disinflation in the world economy over the past 15 years. To the extent that a destabilizing geopolitical event leads to a serious setback for globalization, disinflation could be dealt a tough blow. That would undoubtedly force a policy response from inflation-targeting central banks that could pose a formidable challenge to the liquidity-driven underpinnings of world financial markets. Globalization knits the world together as never before. Yet one of the most painful lessons of modern history is the demise of an earlier wave of globalization that coincided with the outbreak of the First World War. A tipping point for geopolitical stability could well be a tipping point for globalization -- and all the powerful economic, social, and political impacts it has spawned. This is the context in which the potential economic and financial market impacts of the North Korean missile crisis need to be assessed. From my perch, the most critical aspect of the problem is containment -- not just from a military point of view but also from an economic perspective. The risk of a potential shortfall in the North Korean economy is not the problem. While the data on this economy are of dubious quality, at best, there is little to fear from the direct effects of any externally-imposed curtailment of North Korean economic activity. The only reliable estimates (taken from the CIA World Factbook) place North Korean GDP at $40 billion on a purchasing power parity basis -- less than 5% the total output of South Korea. If the world unites in protest over North Korea’s nuclear threat and imposes harsh economic sanctions, there would be little immediate consequences to the pan-Asian economy or the broader global economy. That point is underscored by North Korea’s limited external linkages. Yes, three countries -- China, South Korea, and Japan -- account for over 80% of North Korea’s foreign trade. As such, they are the only nations capable of applying any real economic pressure on this rogue state. However, given the small size of North Korea’s external sector -- exports and imports, combined, are only about 10% of its GDP -- its major trading partners can exert only limited leverage on this relatively closed economy. In short, economic pressure is likely to be of limited use if the international community wants to tame North Korea’s military belligerence. By default, that puts primary onus on the military option. The real question, in my view, is whether the world unites or splinters in dealing with the North Korea problem. In this regard, China, South Korea, and Japan probably hold the key. Not only does their proximity to North Korea put these nations on the first line of defense in case of an attack, but they have also invested significant capital in the so-called six-party talks over North Korean nuclear weapon production and delivery capabilities. Yet in the aftermath of the 4 July missile launching, a wedge opened up in the international community. The US and Japan were pushing hard for a UN resolution that would impose punitive sanctions on North Korea, whereas China, Russia, and even South Korea were expressing varying degrees of resistance. This is where the story gets particularly intriguing. It could well boil down to a trade-off between pan-Asian security, on the one hand, and the key alliances of globalization on the other hand. China’s role is critical in that regard. Through years of quiet diplomacy -- and especially over the past ten years -- China has forged important alliances within Asia, South America, and most recently, Africa. But perhaps the most important and oft-contentious relationship in this new era of globalization is that between the United States and China. It wasn’t always this way. In fact, the motivation behind China’s foreign relationships has changed dramatically over the past 27 years. Prior to the late 1970s, China formed alliances largely on the basis of its ideologically-driven political ambitions. Since then, as China committed to “opening up” through aggressive reforms, its foreign relationships have been forged largely on an economic basis. There are two major exceptions to that rule -- Iran and North Korea. In both of these cases, geopolitical security considerations have the upper hand. For North Korea, geographic proximity is an added complication. This is a very delicate balancing act for China. In effect, it could well force the Chinese leadership to make a critical choice between regional security (i.e., the North Korean matter) and economic prosperity (i.e., the US relationship). In a stable world, the choice would be an easy one -- economics would trump military considerations in almost every instance, in my opinion. Taiwan is an obvious and important exception, but the destabilizing impact of Kim Jong Il’s nuclear ambitions could possibly be another. Here, China needs to reach a judgment on the credibility of the North Korean threat. Needless to say, the aborted 4 July flight of the three-stage Taepodong-2 missile -- the main delivery system for North Korea’s long-range nuclear capability -- raises serious questions in that regard. If China judges this threat to be overblown or if it believes that US-led pressure could lead to North Korean disarmament, then it has no reason to compromise its critically important economically-driven alliances of globalization. If, on the other hand, China places greater emphasis on the military threat, then it may weigh the tradeoff very differently. In the end, I suspect that China will side with the US approach, thereby preserving one of the key alliances of globalization. In the words of Zheng Bijian, Chairman of the China Reform Forum and one of official China’s most highly regarded thought leaders, “China will play a part in everything that is conducive to stability and peace in the Asia-Pacific region, and strongly oppose everything detrimental to regional stability” (from Zheng’s April 2004 speech at the Boao Forum for Asia). He goes on to add, “Beijing wants Washington to play a positive role in the region’s security as well as economic affairs” (from “China’s ‘Peaceful Rise’ to Great-Power Status” in the September/ October 2005 issue of Foreign Affairs). In my view, this puts China’s cards on the table. Despite its lukewarm initial reaction to Japan’s draft UN resolution condemning North Korea, China is not about to side with Asia’s major source of instability. A successful globalization is forged on economic, political, and even military terms. Kim Jong Il is yet another challenge to an already precarious post-9/11 world. The irony of North Korea’s seemingly destabilizing threat is that it forces China to weigh the merits of its own commitment to globalization. This is an awkward but ultimately constructive opportunity for the Chinese leadership to take another important step as a leading global power. I am hopeful that China will seize the moment. Unwittingly, that casts Kim in the role as a major booster for globalization.
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Will the Real Core Inflation Measure Please Stand Up?
Jul 07, 2006
Richard Berner (New York)
What’s the right measure of underlying inflation? In a world that for the past five years has witnessed ever-rising energy prices, are so-called “core” measures that exclude energy quotes the right ones? Is the Fed’s preferred measure of underlying inflation — the core personal consumption expenditures price index (PCEPI) — the best index for an explicit numerical inflation guideline? Those questions underscore the fact that examining inflation gauges is far more than an arcane statistical exercise; after all, market participants, policymakers, workers and retirees all have huge stakes in the outcome. Nor is it new; the issue of price measurement has bedeviled economic statisticians since the inception of the CPI in 1919. It gained importance when former Fed Chairman Greenspan observed in the early 1990s that the upward biases in the CPI had powerful implications for the budget and entitlements. That realization helped launch the Boskin Commission — just one of a series of efforts to improve inflation metrics. It gained further significance when inflation declined to low levels, meaning that relatively small differences in inflation measures could have a significant effect on the economy and financial markets (see Greenspan’s “Problems of Price Measurement,” at the Annual Meeting of the American Economic Association and the American Finance Association, Chicago, Illinois, January 3, 1998 for a summary). In my view, the debate is hardly settled; that this dispatch is the fourth I’ve written with the same title in the past few years speaks to its ongoing character. But the issue now assumes new importance because the Fed is actively considering a move to a numerical objective for price stability in a bid to clarify policy goals. Against the current backdrop of rising inflation, however, I think that picking a numeric goal at this juncture could complicate policy communication rather than make it more transparent. Here’s why, along with the implications for financial markets. Fortunately, four popular measures of “core” inflation all tell the same story: Inflation is low by historical standards but rising. In the year ended in May, official estimates of core inflation ranged from 2.4% as measured by the CPI to just 1.8% measured by the so-called “market-based” PCEPI. The other two measures — the core PCEPI and the core “chained” CPI — peg inflation at 2.1% and 2.2%, respectively. Distortions plague all four such measures, so none is ideal. The good news is that various measures likely bracket the “true” level of core inflation. That’s because the core CPI tends to overstate inflation while the PCEPI tends to understate it. So regardless of the metric used, as long as the differences among them are clear to market participants and policymakers, it’s possible to pick one as a valid measure of inflation trends. However, policymakers should not think that those differences are constant: In the current inflation outlook, for example, the gap between the core CPI and the core PCEPI is likely to widen as rents — which have a bigger weight in the CPI — accelerate. The CPI overstates inflation partly because it is “a measure of price change for a fixed market basket of goods and services of constant quantity and quality purchased for consumption.” In reality, however, consumers substitute cheaper goods and services for those that rise in price. Despite tweaks — for example, revising the market basket every two years — the upward bias in the CPI persists. (The weights in the “chained” CPI implicitly allow for such substitution, trimming 0.2% from the fixed-weight CPI measure of core inflation.) But the CPI also overstates inflation because it puts too much weight on some items and too little on others. The main culprit in the CPI is housing. The key ingredient in housing costs — the infamous “owners’ equivalent rent,” or the implied rental value for homeowners — gets more than twice as much weight (30.3%) in the core CPI as it does in the core PCEPI (13.6%). Consequently, this one category accounted for more than all of the difference in the two measures of core inflation in the year ended in May. (Owners’ equivalent rent contributed about 1 percentage point to the 2.4% year-on-year change in the core CPI, while it contributed just 0.4 percentage point to the 2.1% rise in the core PCEPI.) I think that the weight for owners’ equivalent rent (OER) in the CPI is too high because it reflects data from the Consumer Expenditure Survey (CES). This survey employs subjective estimates of what homeowners think their residence would fetch on the rental market. In contrast, the more realistic PCEPI uses rent-to-value ratios of tenant-occupied units to the owner-occupied housing stock, and only includes space rent. According to a Fed study a few years ago, the CPI probably overstated inflation by about 0.6%, (see David E. Lebow and Jeremy B. Rudd, “Measurement Error in the Consumer Price Index: Where Do We Stand?” December 2001). Beyond the weight assigned to OER, there is another issue that affects both the CPI and PCEPI: Is OER a good measure of such costs? The recent divergence between home prices and rents, however measured, over the past five years has prompted some observers to suggest that the price of the asset should again figure in price gauges, as was the case prior to 1983. Conceptually, that would be wrong; the price metrics are designed to capture the cost of living, not the cost of an asset providing housing services. Statistically, however, it is plausible that OER understates owner “rents,” given the way they should capitalize into home prices over time. It is also plausible that OER understated rents in 2001-03 and currently overstates them, given sampling problems in cities lacking single-family rental units, but no one knows by how much (for further discussion, see David Greenlaw’s and Ted Wieseman’s “More Inflation Jitters,” Global Fixed-Income Strategy Bulletin, June 19, 2006). I have some sympathy for the notion that the 300 basis point plunge in OER between 2001 and 2003 exaggerated the downdraft in measured inflation — and thus the perceived risk of deflation — over that period. More controversial, I believe that the PCEPI understates core inflation. One reason is medical care services. The PCEPI includes medical care services paid for by employers, by government (Medicare, Medicaid and veterans’ benefits), and out-of-pocket by U.S. residents and nonprofit organizations. In contrast, the CPI only measures out-of-pocket expenditures by urban consumers. Medicare cost controls have suppressed medical care services inflation in the PCEPI to just 2.7% over the year ended in May. In contrast, the out-of-pocket measure in the CPI, while decelerating, is running at a 4.1% rate. But if anything, the CPI measure may understate out-of-pocket price increases. Per employee, healthcare costs ran at a 4.8% rate over the year ended in the first quarter. Facing those hikes, companies are passing along more of the cost of healthcare to employees in the form of increased insurance premiums, higher deductibles and copays. That is showing up as increased out-of-pocket costs in the CPI but not in the PCEPI. It therefore seems reasonable that medical care services inflation in the PCEPI — recognizing its broader coverage — could be between those two measures. Unpublished data from the Bureau of Economic Analysis suggest that government pays for between 33% and 40% of medical care. A reweighted average of the CPI and PCEPI medical care services measures suggests that inflation in this sector over the past year was about 3.6%, which would add about 0.2 percentage point to the core PCEPI. In our forecasts, we now present the “market-based” core PCEPI, which is “based on market transactions for which there are corresponding price measures.” It excludes most imputed expenditures, such as services furnished without payment by financial intermediaries except life insurance carriers. In our view, this measure is “cleaner” than the core PCEPI, and is likely less subject to potentially substantial revisions to historical data for those imputed components that recast one’s perspective on where inflation has been. In the 2005 annual revisions to the National Income Accounts, upward revisions to these imputed and presumably less-reliable components added about 50 bp to the core PCEPI. But neither measure is flawless. Should energy prices be excluded from underlying inflation measures? Even before energy prices began their recent long climb, two Federal Reserve Banks — Cleveland and Dallas — tried to design a better yardstick, suggesting that either the median or “trimmed mean” consumer or PCE price change better represent overall inflation. These alternatives use all prices as inputs and get at underlying inflation statistically. For example, the weighted median CPI selects the median monthly inflation rate among all components, and shows a persistently higher inflation rate than either core measure, partly because it includes energy quotes. The trimmed mean CPI and PCE measures show somewhat lower rates because they throw out outliers. These gauges paint the same qualitative picture as the core measures, but one quantitatively higher, indicating that inflation over the past year rose to 3%, 2.7% and 2.5%, respectively. So where does this plethora of price indexes leave the Fed as it weighs the pros and cons of specifying a numerical guideline defining price stability? In principle, almost all Fed officials seem lately to support a numerical objective. The logic is clear and sensible: Clear information about policy objectives arguably simplifies the public’s ability to anticipate monetary policy actions, it may help to anchor the public's inflation expectations, and it could help improve Fed accountability. In practice, however, there are many issues to review before acting. What should the number (or range) be? Over what time horizon should the Fed seek to achieve it? Which index should the Fed use as guideline? Does specifying a numerical objective also require the Fed to specify its “reaction function” to deviations from the objective? My answers: The long-run objective should be a single number; I prefer 2%. But for short-term policy monitoring purposes, a range rather than a point estimate is appropriate. A 12-24 month (medium-term) time horizon is probably appropriate. If the Fed chooses the core PCEPI, it should be prepared for annual revisions. And as I see it, for an explicit objective to have clear benefits, the Fed should specify how it will achieve it. These uncertainties mean that policymakers will want to review the issues with care before adopting a numerical objective. But there are two other factors that might also stretch out the process. Ironically for those who believe that a numerical objective will improve policy transparency, one potential delaying factor is the changing of the guard at the Fed. Incoming Governor Mishkin and Philadelphia Fed President Plosser will likely add to the ranks of those who favor an explicit objective, as they favor inflation targeting. And there are or will be two more vacancies on the FOMC; newcomers might also support an explicit objective. Yet some officials who support a numerical objective probably do not want that support quickly to open the door to inflation targeting as the logical next step. In addition, given recent communication missteps — sometimes involving vague statements about inflation expectations that were out of sync with market perceptions, sometimes involving rather precise short-term characterizations of past inflation instead of longer-term statements about future inflation — some officials may feel that clarifying communication strategy under the existing structure should have a higher priority.
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Trichet's Trick
Jul 07, 2006
Elga Bartsch (London)
Against our expectations, ECB President Trichet all but pre-announced a rate hike at the August 3 meeting at this week’s press conference by saying that the ECB “will exercise strong vigilance”. This particular phrase had already preceded both the June and the March rate hikes. Hence, in our view, a 25bp rate hike at the early August meeting now looks more likely than a move in late August. Previously, we and most market participants had expected another interest rate hike only at the late August meeting. The main reason for believing that the ECB was not going to hike interest rates in early August was that the early August Governing Council meeting was meant to be held only by teleconference (see Groundhog Day at the ECB, June 30, 2006). But during the Q&A session of this week’s press briefing, Jean-Claude Trichet announced that the Council decided to meet in person rather than by teleconference on August 3. More importantly, there will now also be a press conference following that Council meeting where the ECB president and vice-president could explain the reasons behind the rate move and, to the extent that it is possible and advisable, shed light on the implications for the future course of ECB action. While as usual insisting that the ECB wasn’t pre-committing ex-ante to a particular course of action, Trichet gave a very clear signal that interest rates will go up in early August with his ‘timing trick’ to call everyone back from the beaches to convene in Frankfurt. The ECB thus looks set to slightly accelerate the pace of its tightening campaign from the quarter-point-per-quarter seen so far. Given the persistent inflation overshoot, the rapid expansion of money and credit aggregate, the robust growth picture and, last but not least, the upward trend in inflation expectations, we would expect the ECB to hike at every other meeting for the remainder of this year. As a result, upside risks to our year-end refi rate forecast of 3.25% emerge. Taking these on board, we are revising up our year-end target for the ECB’s refi rate to 3.5%. But we still believe that the ECB’s tightening campaign will be ‘stopped out’ in 2007 by slower GDP growth, tighter fiscal policy, a stronger euro and, of course, less expansionary monetary policy. Contrary to the market, which is still pricing in another 50bp of ECB tightening next year, we still don’t expect further ECB interest rate increases in the course of next year. Against this backdrop, we leave our forecasts for 10-year Bund yields unchanged. We still look for a peak in yields at around 4.25% this autumn. The rise in yields should be followed by falling bond yields, we think, as it becomes clear that the tightening cycle is, at least for now, nearing its end. Eventually, we would therefore see 10-year Bund yields easing back below 4%. We still feel that the ECB is far away from hiking by 50bp. Asked about the prospect for a larger rate hike at the press conference, Trichet said that there was no sentiment worth mentioning in favour of a 50bp rate hike at the meeting. But a slightly faster pace than the quarter-point-per-quarter pace now looks likely for the remainder of this year, in our view. At this stage, October and December seems to be the most likely timeframe for further ECB tightening in 2006. A number of risk factors could potentially throw the ECB off course. These risk factors include an unexpectedly sharp slowdown in EMU GDP growth in 2H or a renewed shortfall of so-called hard GDP behind upbeat sentiment indicators. At only 1.4%, our 2007 GDP forecast remains below the ECB’s own staff projections and the market consensus, which are both at 1.8%. A sharp appreciation of the euro, which would take the common currency clearly above 1.30, would probably also cause the ECB to become more cautious. Finally, a reversal of the recent rise in inflation expectations seen in consumer and business surveys as well as in financial markets might make the ECB less concerned about the present inflation overshoot potentially spilling into higher consumer price inflation in the future.
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Stalling Momentum
Jul 07, 2006
Melanie Baker (London) and David Miles (London) and Vladimir Pillonca (London)
Recent data revisions suggest that real GDP growth was stronger at the end of last year and the beginning of this year than we had previously thought. Our central expectation is now for 2.4% growth in 2006, compared to 2.3% previously, but we now expect growth to be slower in the second half of the year than in the first half. We continue to worry about the outlook for consumer spending and, although our central case is a mild spending growth recovery, we still see the potential for even weaker consumer spending as one of the main risks to our central GDP outlook. We continue to think that a rate rise will look justified by the end of the year, but are now less confident that we will see a further rate rise in 1Q07. New central forecasts: stalling momentum Our central expectation had been that the UK would ‘crawl back’ to trend over this year and next, with stronger business investment growth and a mild recovery in consumer spending driving growth slowly higher in 2006. This view is still largely intact, but we now expect growth momentum to stall in 2H. • Our GDP model forecasts 0.7%Q GDP growth in 2Q after incorporating revisions to past data and re-estimating. GDP growth of 0.7%Q in 2Q06 would follow 0.7%Q growth in both 4Q05 and 1Q06. • Consumer spending and business investment growth are likely to slow in the second half of 2006. After what should prove a rather robust quarter for consumer spending growth in 2Q (partly on the back of World-Cup related spending), we expect a degree of pull-back in the second half of the year — we still think that a great many households need to be prudent in managing their finances and we remain sceptical that consumer spending growth can pick up very sharply this year. Business investment growth also seems likely to slow somewhat after a very strong 1Q. • At this stage, our central inflation forecast is unchanged at 2.1% in both 2006 and 2007, but we expect inflation to rise into the latter part of 2006/early 2007 then decline back towards the Bank of England’s 2.0% target. Monetary policy outlook — rate rise still likely. Against a backdrop of around-trend growth and above-target inflation, we expect the Bank of England to raise rates from current levels (4.50%), which we would consider marginally accommodative, to a level closer to neutral (we estimate that the neutral rate is around 5.0%). We continue to expect a rate rise in 4Q (likely to be in November, the month of the Inflation Report release), with a significant risk of a 25bp rate rise as early as August. However, we now have rather less confidence that, as growth momentum stalls, a second rate rise will look necessary. Balance of risks. The balance of risks around our central case forecasts looks, to us, biased on the downside for growth, but on the upside for inflation: Downside risks to our central growth forecast include the consumer, trade and the bond market. • Our forecast for a (albeit sub-par) recovery in consumer spending growth looks vulnerable on (at least) three fronts — 1) debt and debt service, 2) discretionary income growth and 3) the housing market. On 1), the already somewhat worrying picture on debt and debt service could easily deteriorate even faster in the event of either: i) a further rise in unemployment not also accompanied by employment growth (as it has been so far); or ii) a significant rise in inflation expectations and/or wage inflation which (all else equal) would likely prompt the bank to raise rates above 5.0%. 2) Discretionary income growth looks set to slow this year. We forecast nominal growth of 1.2% in 2006 after 2.4% in 2005 as rising utility bills increase ‘fixed’ household outgoings. 3) Housing valuations continue to look stretched and downside risks likely outweigh upside risks for house prices. Although we remain sceptical on the strength of the link between household spending and house prices, a sharp slowdown in the housing market could nevertheless have a significant negative impact on spending growth. • The contribution of net exports to GDP growth in the UK remains vulnerable to movements in sterling and the external growth outlook. • Bond yields remain somewhat vulnerable to a sharp upward correction, which would likely slow business investment. Real longer-dated bond yields are still some way below our estimates of equilibrium/fair value. Upside risks to our central inflation forecast. Upside risks, in our view, come from three main sources: 1) Pass-through of higher energy prices; 2) Rising import prices; 3) Lack of spare capacity. • Past rises in oil prices and current increases in utility bills may feed through into prices of other goods more widely. • Imports no longer have a deflationary impact on consumer price inflation. Since the beginning of 2005, goods import prices have been rising rather than falling year on year. • An economy with little spare capacity, as is the case in the UK, is vulnerable to upward inflation shocks.
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Risk Appetite versus Growth - A Forecast Update
Jul 07, 2006
Stephen Jen (London) and Luca Bindelli (London) and Charles St-Arnaud (London)
Currency forecast update There are two rather disparate, but related, themes that dominate the currency markets: (i) the global liquidity cycle and changing investor risk appetite and (ii) US and global growth. The latter is our central case view, while the former is our main risk scenario. In this note, we update our currency forecasts. Specifically, we maintain our central case assumption that the dollar will resume its cyclical decline, reflecting the real economic slowdown, and that liquidity-driven risk-reduction will perturb this downtrend, but will not reverse it. We still expect all of USD/AXJ to resume their downtrend, but we’ve slightly raised our year-end targets for them as well. What has changed? There have been two changes: one that is obvious and the second more subtle. Since our last forecast update, inflation in the US has surprised to the upside, and the Fed was forced into an awkward corner. This was partly a result of the comment made by Fed Chairman Bernanke at his April 27 testimony that the Fed might look through the last bit of the transitory inflation spike without responding with rate hikes. Not only has the consensus forecast of the peak in the FFR been raised from 5.00-5.25% to more than 5.50%, the spread in investors’ forecasts also has likely widened, as many investors have begun contemplating a 6.00% FFR. This forced a violent wave of risk-reduction in May and June. The second, more subtle, change is our increased confidence that we may be witnessing an inflection point in the US C/A deficit. Since February we have been airing this suspicion, and our US economist Dick Berner agrees that this may be an important change in the debate on the dollar. We have the following thoughts: • Thought 1. Getting the Fed call right is key. While the ECB’s and the BoJ’s actions are important, the call on the Fed is the critical one to get right. In our view, the market’s fixation on the Fed is justified, because it is the Fed’s action and posture that will dictate the global liquidity cycle and investor risk-taking attitude. For the sake of discussion, we will continue to use the threshold of 5.50% on the FFR as a ‘line in the sand’ for the two scenarios laid out above. However, it should be clear that this ‘line in the sand’ is conditional on several other considerations. In any case, the trajectory of the USD is far from pre-ordained, i.e., ‘the-dollar-will-fall-no-matter-what’ is not a view we endorse. • Thought 2. Risk-reduction is dollar-positive. We have just witnessed a very important real-life experiment of what might happen to the dollar with global risk-reduction. This negative relationship between the dollar and general risk-taking appetite will be useful to keep in mind, because there will likely be further bouts of risk-reduction, triggered by a more hawkish Fed, ECB or the BoJ. There are several considerations here. First, in our view, the USD is still a solid safe haven currency, from the perspective of emerging markets. Second, we believe that the US real money accounts are still out-of-balance as they may be ‘overweight’ risky assets, including emerging markets as well as major markets such as the Nikkei and the European equity markets. Third, most of the hedge funds in the world and investors from emerging markets are dollar-based. Also, investors from Asia and other emerging regions are dollar-based. When they retreat from other risky assets/markets, they move into dollar cash, not their own currencies. • Thought 3. The Fed does not want to see a repeat of 1994/95. First, the Fed has already tightening by 425bp, much more than the 175bp of tightening it had done before the ‘November 1994 surprise’. While the real rates and the long bond rates may have risen by less, this is still a significant enough amount of tightening to give the Fed ample reason to be cautious about the tightening implemented in the last nine months and which are still in the pipeline ready to act on the economy. Second, the inflation-wage circularity that underpins the true worries about rising inflation expectations is absent this time around. Third, there are plenty more downside risks to global growth and financial asset prices than upside risks. Based on what we know about the US economy, a FFR peak of 5.50% seems reasonable. If the US slows as expected, and lands so softly that it allows the rest of the world to continue to recover, the dollar should depreciate. • Thought 4. But the key risk is an exact repeat of the 1994/95 episode. What the Fed wishes may not come true, however. In fact, the less hawkish the Fed is now, the more likely it is that financial asset prices will be supported and the US economy will surprise on the upside. This could ironically set the Fed up for a repeat of 1994/95. Clearly, this is a ‘house of mirrors’ discussion, involving circular feedbacks between changing market expectations and the endogenous nature of the Fed policies vis-à-vis financial asset prices. At an inflection point in the US business cycle that is driven by asset prices, this kind of a ‘circular’ discussion is unavoidable. Our US economists have long warned about the core CPI drifting to 2.6% (from the current 2.4%), and about US domestic demand, led by capital expenditures, reasserting itself in 2H, before decelerating through trend growth to 3.0% by 2007. While predicting the collective investor psychology is a difficult task, the central case scenario that we see for the US economy could, in fact, surprise the market and potentially spook the long bond market in the US. Even if this inflation spurt eventually proves to be transitory, the Fed could have a tough time convincing the market that this is the case. Particularly if there are upside surprises to growth, long bonds may sell off more and the Fed could push the FFR toward the 6.00% mark. Risky assets and emerging markets would be sold again, and the dollar should rally, just as it did in May and June. This, as we have stressed, is our risk scenario, but one that is so distinct and probable that we believe it is one investor should keep in mind. The ECB is the Fed, lagged by six months By this we mean that the ECB will also come to a point where the inflation-growth trade-off will be a more difficult one than it is now, and the market will start to question whether the ECB might ‘over-tighten’. We may in fact be in this scenario by 4Q. In addition to the usual list of negative shocks which we believe will lead to a deceleration in Euroland’s growth, we remain puzzled by the divergence between the ‘soft’ and the ‘hard’ data. Partly because of the disparities between the ‘hard’ and the ‘soft’ data, and between the real and nominal variables, we believe Mr Trichet may be sensitive to the EUR. He has appeared to be less hawkish than his colleagues at the ECB, possibly because he does not want to fuel a powerful overshoot in the EUR that may in turn prevent the ECB from tightening as much as it thinks is necessary to rein in M3 and loan growth. For these reasons, we are retaining our modest outlook for EUR/USD, with an unchanged target of 1.24 by year-end. USD/JPY and EUR/JPY are likely to form a peak The BoJ has every economic reason to end ZIRP early, i.e., on July 14 or August 11. The general concern about the BoJ ending ZIRP too soon is exaggerated, in our view. The neutral rate in Japan is probably 1.50 to 2.00%. This is one of the fastest-growing G7 countries and its growth rate is running at twice the potential growth, with an output gap that has already closed. Nobody is arguing that the BoJ should normalize rates quickly, but ZIRP distorts incentives and the side-effects of ZIRP are perhaps not fully appreciated by investors and the MoF. Mr Fukui is a strong character, proud of his achievement in protecting the reputation and the independence of the BoJ. If anything, ending ZIRP early could earn him and the BoJ immense credibility. The impact of the BoJ tightening on exchange rates will be complicated. First, depending on what the Fed does, tightening by the BoJ may or may not drive USD/JPY lower. Our view is that it will, at a minimum, cap USD/JPY at around the current levels, but this assumes that the Fed will stop at 5.50%. Second, we have to also think about how Japanese investments overseas could be repatriated. Our expectation is that reflows from the NZD, the AUD and the INR markets may be material enough that these currencies will suffer. Similarly, with EUR/JPY trading at such an over-valued level, a BoJ in motion will likely cap EUR/JPY. Incidentally, Japanese exporters are enjoying immense profits with such a high EUR/JPY. It is curious to note how generous European exporters have been regarding EUR/JPY. Last but not least, we believe this may be the rough level from which investors could re-accumulate USD/JPY shorts. Commodity currencies to weaken with global slowdown Global growth is expected to decelerate from 4.7% this year to 4.0% in 2007. What is more important is that most of the slowdown will come from the two dominant ‘dollar zone’ countries: the US and China. These are also energy and commodity-intensive economies. Further, both the CAD and the AUD are still over-valued (the NZD is fairly valued now). We maintain our view that the USD will strengthen against the CAD, the AUD and the NZD later this year and in 2007. AXJ currencies to rally, albeit at a more gradual pace We retain our view that a lower USD/JPY and reasonably healthy risk-taking appetite will allow USD/AXJ to trend lower. However, with the higher FFR and higher inflation in the US, we are now more modest with our year-end targets. For USD/CNY, we retain our aggressive year-end forecast of 7.50. China is overheating, and it is far from clear what tools it could use to restrain growth. Even though USD/CNY suddenly, inexplicably, halted its descent on April 12, the economic reasons for USD/CNY to trade lower are more compelling now than six months ago. Bottom line The future path of the dollar is not pre-ordained: (i) the global liquidity cycle and changing investor risk appetite and (ii) US and global growth will dictate where the dollar will go. While we suspect there will likely be further bouts of risk-reduction in the near term, a soft landing in US demand will lead to a cyclical depreciation in the dollar, particularly against Asia.
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