A Final Dose of Inflation Insurance
Jul 10, 2006
Richard Berner (New York) and David Greenlaw (New York)
Forecast at a Glance
E = Morgan Stanley Research Estimates Once again, we are tweaking our Fed call. We now see the Federal funds rate peaking at 5¾% rather than the 5½% we thought likely last month. The reason: We think that an inflation-wary Fed likely will want to add a final dose of inflation insurance for an economy that may show more resilience than commonly thought. Correspondingly, while we’ve been neutral on bonds for a few months, we believe that better buying opportunities will emerge as 10-year Treasury yields approach 5½%. While the increase in inflation we’ve expected is largely cyclical, that does not mean it will automatically be fleeting. Indeed, both the arithmetic and the analytics point to slightly higher near-term inflation than a month ago. For three straight months, underlying inflation measured by the “core” CPI has risen by 0.3%, taking the year-on-year reading to 2.4%. The bad news is that core inflation so measured is likely to peak half a point higher than today’s rate — or 2.9% — and not until Q1 2007. Partly that is because the arithmetic is daunting. For example, if the core CPI rose by 0.2% in June as we expect, the year-on-year rate would be 2.6%. The monthly readings in March-June 2005 averaged just 0.1%; the March-June 2006 likely averaged 0.28%, or a 3.4% annual rate, and will replace them in the year-on-year calculations. Because monthly changes in June-September 2005 averaged 0.15%, unless core readings slow dramatically, there is more to come. Core inflation will slow, but gradually: We now estimate that core CPI inflation will run at a 2.6% annual rate between May 2006 and February 2007 even with the additional restraint we see from the Fed. Three factors are likely to push inflation up somewhat further. First, shelter costs — comprising 41.7% of the core CPI and including apartment rents, “owners’ equivalent rent,” or OER, and hotel room rates — are likely to continue rising faster than 2005’s 2.6%. We do think the pace will slow from the 4.1% annual rate so far this year, but fundamentals point to upside risks: Rental vacancy rates have declined as the demand for apartments has firmed by more than the increase in supply, utilities and taxes are rising, and strong travel demand is boosting room rates. To be sure, there are distortions in OER; rather than moving in opposition to apartment rents, it is accelerating in tandem. That is one reason that the CPI may overstate underlying inflation; such quirks are partly why the Fed prefers the core personal consumption price index, or PCEPI, which assigns a smaller weight to housing (see “Will the Real Core Inflation Measure Please Stand Up, Global Economic Forum, July 7, 2006). Regardless of which metric one chooses, however, there are two other cyclical reasons for expecting higher core inflation. They have been cornerstones of our inflation call: Dwindling economic slack has enabled companies to get back lost pricing power and pass through higher costs, and rising inflation expectations have filtered slightly into price- and wage-setting behavior, reinforcing that cyclical upward drift. The surge in operating rates in both manufacturing and non-manufacturing industries in the past four and a half years reflects a disciplined approach to capacity additions. Thus, a significant deceleration in economic growth from 5.6% in the winter quarter to an estimated 2.5% in the spring has yet to arrest those increases. As evidence, the factory operating rate in June likely rose by nearly 900 bp from its trough, the fastest rise in two decades. Correspondingly, after cooling last year, core intermediate producer prices have re-accelerated to a 6.3% rate. The ISM reports that the non-manufacturing operating rate rose by 550 bp over the same period, nurturing pricing power in transportation, distribution, construction, engineering and a host of other wholesale prices in services. In addition, we believe that firmer labor markets and the past increase in inflation expectations are beginning to promote faster pay gains. There is still heated debate about the validity of the acceleration in wages as measured by average hourly earnings (AHE), especially by comparison with the subdued character of wage and salary gains in the Employment Cost Index (ECI) (for discussion, see “Will the Real Wage Measure Please Stand Up?” Global Economic Forum, January 6, 2006). We think that the acceleration in the AHE to a 3.9% rate in the year ended in June is clear evidence of a quickening in pay. Although compositional shifts in employment plague the AHE, the rise of 3.7% on a fixed-weighted basis makes us comfortable with that appraisal. The good news is that inflation expectations have stabilized and that a reversal of the cyclical forces that boosted inflation will bring it back down. But it may take at least several months of sub-par growth to reduce the expansion of output relative to that of capacity. Importantly, we believe that the consensus judgment that the second-quarter deceleration in economic growth represents a lasting downshift to a below-trend pace is probably premature. Slower growth is definitely on the way, but we still think that it is a story for 2007 rather than for the second half of 2006. Indeed, while we estimate that growth in the quarter just past ran at about a 2½% annual rate, and incoming data for consumer and construction outlays, factory shipments and business surveys all have been lukewarm, that is mostly old news. Looking ahead, we feel even more comfortable than last month with our expectation that second-half annualized growth will run at or close to 3½%. Three factors seem likely to promote this above-consensus outcome. First, we think that wage and salary income growth is firming, offering significant support to consumer spending, and that official statistics may well understate its underlying strength. The latest employment canvass underscores the income dynamic. While job gains ran at a paltry 121,000 in June, and disappointed for the third straight month (monthly gains have averaged just 108,000 in the past three months), accelerating earnings and a rise in the workweek were powerful offsets. Indeed, a proxy for private wage and salary income rose by 6.6% in the year ended in June, or about 3.1% in real terms. That’s about a percentage point faster than in official wage income data. What’s more, booming tax collections suggest this proxy may also understate reality. Our colleague Ted Wieseman notes that in May and June combined, withheld taxes (as tabulated in the Daily Treasury Statement) surged 9.5% from a year ago. Exercise of employee stock options and income from self employment may account for some of this gap (indeed, the 2.6% year-on-year rise in self-employed workers reported in the so-called household employment canvass supports that notion). But upward revisions to official estimates of income growth may also close the data gap. To be sure, rising energy and especially gasoline prices crimped discretionary spending power by about $35 billion over the spring quarter, and we expect some further upward pressure during the summer hurricane season. If energy prices don’t rise by much more, we think real incomes will accelerate sharply in the second half of 2006. A second factor likely to promote above-consensus second-half growth is the vitality of capital spending. Rising operating rates, still healthy pent-up demand for capital goods resulting from corporate capital discipline, rising labor costs that may trigger additional capital-labor substitution, and persistently high energy quotes that create incentives to invest in energy-efficient equipment all add up to a healthy capex backdrop. While there is concern that recent market turmoil will dampen animal spirits, so far we find little evidence to support those worries (see “Has Market Turmoil Dampened Animal Spirits?” Global Economic Forum, June 23, 2006). It’s worth noting that Corporate America is now in the mature, expansion phase of the capex cycle, one that will ultimately help flatten operating rates and cap pricing power as growth in capacity matches production. Finally, we are betting that hearty global growth will for the first time in twenty years begin to contribute to US growth by improving the volume of net exports. Indeed, growth in overseas demand now appears to be outstripping that in the US, boosting US exports and slowing the growth of US imports. For example, courtesy of hearty growth in Canada and Mexico, US merchandise deliveries to North America rose by 8.4% over the past year. While US real final domestic demand rose by 3.8% over the past year, in Canada and Mexico the gains were 4.3% and 7.8%, respectively. The combination of further increases in inflation and some unexpected economic resilience seem likely to challenge both the Fed and market participants, who share the view that a lasting slowdown is under way. That’s especially true for the Fed, because by making their economic forecast a little more explicit but not making the future path of policy conditional on it, officials have muddied their message. But after a series of missteps, the Fed is starting to rebuild its credibility with a more consistent policy message. We read the latest FOMC statement, for example, as acknowledging that inflation had picked up, that upside risks remain, and that the Fed would respond to them. Against the backdrop of previous über-hawkish rhetoric, however, market participants read the statement as dovish. It will take time for Fed officials to communicate effectively that consistency. We expect Chairman Bernanke’s testimony on July 19 to clarify goals, the time horizon to meet them, and the Fed’s ‘reaction function.’ Such clarity could dampen market volatility. But the Fed Chairman likely will make it clear that he cannot describe the policy path because he doesn’t know it. Thus increased uncertainty over the future policy path may weigh on term premiums and risky assets; in our view, 10-year yields are headed to 5½%. Risks certainly abound, and simple enumeration seems to tip the scales down, because four of them are negative: Rising geopolitical risks represent supply shocks that are boosting energy quotes, likely creating another whiff of stagflation. Another potential supply shock could come from the summer hurricane season. Further financial market turmoil could dampen ‘animal spirits.’ And earnings growth next year seems likely to fall short of nominal GDP growth, although hearty global results may support overall earnings (see “The Dollar, Global Growth and Profits,” Global Economic Forum, May 15, 2006). Contrariwise, however, relative to the consensus, any sign of renewed economic strength could be a positive surprise.
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Will the Real Core Inflation Measure Please Stand Up?
Jul 10, 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 (although such costs may be understated) but not in the PCEPI. It therefore seems reasonable that medical care services inflation in the PCEPI — recognizing its broader coverage — should lie between the current PCEPI and CPI 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, given that 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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The Calm Before the Storm
Jul 10, 2006
Jeffrey Matsu (New York)
After months of near daily reports on avian flu outbreaks, the global spread of the H5N1 virus appears to have stabilized. The highly anticipated influx of infected wild birds along south-north migratory routes did not materialize this spring, leaving many to wonder whether the worst is behind us. Such complacency would pose a serious risk, in my view. It is likely that what we are witnessing now is not a burnout of the H5N1 virus, but rather a “calm before the storm” -- a period of genetic reassortment during which a far more lethal strain emerges. Gene mutation is a constantly occurring phenomenon in flu viruses, and it is one of the primary reasons why vaccines must be developed just prior to the start of each flu season. Every so often, however, a particularly virulent strain such as H5N1 emerges, capable of triggering a pandemic. While it is difficult to ascertain the exact timing of any low probability, high risk event, health experts at the World Health Organization (WHO) believe that the world is now closer to another influenza pandemic than at any time since 1968. Over the course of a decade, H5N1 has evolved into a more resilient and lethal strain with risks that have not been fully priced by most financial market participants (see my dispatch from 2 June 2006, “Surveying Pandemic Preparedness”). First isolated from an infected bird in 1996 in Guangdong Province, China, the virus has since crossed the species barrier to infect humans on three occasions: (1) 1997 in Hong Kong, with 18 cases with 6 fatal; (2) 2003, again in Hong Kong, with 2 cases with one fatal; and (3) late-2003 and ongoing with 228 cases and 130 deaths globally. The tipping point to a pandemic was made one step closer when the WHO recently announced the first laboratory-confirmed case of human-to-human transmission occurring in Indonesia. Influenza poses a serious threat to public health due to the ease with which the virus can be spread. In the US alone, normal influenza hospitalizes some 226,000 people leading to 36,000 deaths annually. Unlike other communicable diseases that require direct contact, either through the exchange of bodily fluids (e.g., HIV/AIDS) or mosquitoes (e.g., malaria), influenza is transmitted primarily via airborne droplets. As such, the emergence of an H5N1 strain that is transmissible between humans on a sustained basis would be exceedingly difficult to contain. Assuming it takes two months to develop a vaccine and at least several more months for commercially produced supplies to become widely available, the world would be on equal footing in its susceptibility to infection during the initial phase of a pandemic. Limited production capacity also implies that access to vaccines and antivirals will continue to favor wealthy industrialized countries, but this fails to consider that the most effective way of extinguishing an outbreak is at its source. Ensuring the preparedness of the developing world, particularly those countries in the likely epicenter of Southeast Asia, is therefore critical. Threats to global health security require a global response, and earlier this year, 33 countries and multilateral institutions stepped up to the challenge by committing $1.9 billion to combat the spread of avian flu. The US, Japan and EU pledged a combined $613 million in grants, while the World Bank pledged an additional $500 million in loans. Aside from bolstering early warning systems (i.e., surveillance and reporting) and reducing the opportunities for genetic adaptation of the H5N1 virus to humans, what is most needed is the scaling up of infrastructure and technology to expand vaccine production capacity. Ideally, this occurs via two channels: (1) build more production facilities; (2) switch to cell-based cultures. These measures will take at least five years to implement, so the time to act is now. Governments can address market failures through a combination of tax breaks, R&D assistance and guaranteed purchases of unused vaccine stocks. The pharmaceutical industry must also be a partner in this effort by providing poor countries with the lowest viable commercial price for such drugs. With other infectious diseases such as HIV/AIDS, tuberculosis and malaria still ravaging large segments of the world’s population, some have questioned the prudence of using limited health resources and funding in preparation for an event that we know very little about. Would funds allocated for H5N1 have a higher return on investment if channeled instead to address ongoing efforts to eradicate diseases for which inexpensive and known cures already exist? According to a report published by the WHO’s Commission on Macroeconomics and Health, roughly 8 million lives per year could be saved by spending just $34 per person each year on essential interventions against infectious diseases and nutritional deficiencies in low-income countries. This compares to annual per capita health expenditures of over $2,000 in high-income countries. Moreover, for every 8 million deaths prevented, 330 million disability-adjusted life years (DALYs) -- equivalent to $186 billion in direct economic benefits -- would be saved. Given that universal coverage of essential health services has already been achieved in most advanced economies, bolstering aid by just 0.1% of donor-country GNP could meaningfully bridge the financing gap for the world’s poorest. The Global Fund to Fight AIDS, Malaria and Tuberculosis estimates that a high incidence of malaria in Africa lowers GDP growth by 1.3% annually, and that the loss of productivity due to TB amounts to 4 to 7% of GDP. As the disease burden in these countries is lifted, labor productivity and economic growth will accelerate thereby breaking the poverty trap. While there is no denying the severity of these ongoing epidemics, the impact of a pandemic could be exponentially greater. In response, the WHO continues to maintain its Phase 3 “pandemic alert” status (on a scale of 1-6). High rates of mortality from communicable diseases remain the primary obstacle for economic development in most low income countries, but it has largely been reduced, if not eliminated, elsewhere. Pandemic influenza, however, contrasts sharply with most other infectious diseases in that there is nonlinearity between risk exposure and income levels. While advanced economies benefit from leading-edge science and medicines, they are also far more dependent on global economic linkages, which totaled $25 trillion in 2005. As a result, any prolonged shut-down of national borders and transportation networks could be sufficient to trigger a global recession. Given that industrialized countries account for over 75% of global GDP but just 15% of the world’s population, pandemic preparedness must occur alongside the fight against other infectious diseases, not in lieu of it. The cost of complacency could be a death toll exceeding 50 million and global economic damages in the range of $880 billion to $3 trillion (see “Pandemic Fallout,” 28 February 2006). Compared to just two months ago, there has been a 38% increase in the number of officially reported H5N1 human cases, and the mortality rate has reached a staggering 57%. While the absolute numbers remain modest (228 cases and 130 deaths worldwide since 2003), the outbreak of a pandemic virus could occur at any time and lead to an explosion of new infections within a matter of days. The international community, led by the G-10, must stand vigilant and committed to a long-term strategy that reinforces the importance of global preparedness. Success requires a re-doubling of efforts precisely when the battle appears to have been won.
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Review and Preview
Jul 10, 2006
Ted Wieseman (New York)
After some significant volatility that was driven in large part by a head-fake on the employment report by the soon to be obscure ADP employment survey, Treasuries ended the past abbreviated holiday week close to unchanged across the curve, with small losses at the front end and small gains at the longer end sending 2’s-10’s to its flattest levels in a few weeks. Contrary to our expectations coming into the week, the key early round of June economic data (employment, the ISM surveys, auto sales, and chain store sales) did not provide a strong confirmation of an end to the second quarter slowdown, when we now estimate GDP growth decelerated to +2.5%, down from our +3.0% estimate coming into the week thanks to downside in the May construction spending and factory orders reports. And while the details of several of the key reports were stronger than the headline outcomes — particularly the employment report, which was robust in all key components except the headline payroll print — certainly the mixed tone of the numbers pointed to a weaker starting point for the second half than we had been expecting. Now the key date circled on every investor’s calendar is July 19, when Fed Chairman Bernanke presents his semi-annual monetary policy testimony and the June CPI report is released. We continue to believe that upside in that inflation report combined with a reasonably strong employment report on August 3 will prompt another rate hike at the August 8 FOMC meeting, but the futures market’s pricing of not much more than an even chance of such a move at week’s end certainly seemed to reasonably capture the current uncertainty over the near-term economic outlook and Fed policy. After a fair amount of volatility in the three days the market was trading with any volume, Treasury yields ended narrowly mixed the past week, with a small flattening of the curve — both 2’s-10’s and 2’s-30’s fell 3 bp on a 2 bp rise in the 2-year yield to 5.175% and 1 bp dips in the 10-year and long bond yields to 5.13% and 5.175%, respectively. The 3-year and 5-year yields were both unchanged on the week at 5.13% and 5.10%. A slightly more hawkish near-term but more dovish medium-term Fed policy was priced in the futures markets. The August fed funds contract was off a half bp to 5.37%, pricing in about a 60% chance of a 25 bp rate hike at the August 8 FOMC meeting. The high rate November contract was off 4 bp to 5.52%, as a slight risk of a move beyond the expected 5.50% peak was priced back in. On the other hand, the amount of easing priced in next year was increased. In the eurodollar futures market, the maximum one-year inverted Dec 06 to Dec 07 spread fell 4.5 bp to a new all-time low of -18.5 bp, with the former contract off 4.5 bp to 5.64% and the latter flat at 5.455%. The key early June data released the past week were mixed, certainly disappointing our expectations for more across the board upside coming into the week and raising some doubts about the prospects for a second half reacceleration. We continue to look for GDP growth to pick up to about +3 1/2% in the second half after the estimated +2.5% in Q2, but obviously the first half did not end on as positive a note we were expecting. The key employment report taken as a whole was the week’s strongest report. While it certainly disappointed what had been growing expectations in the market for an across the board blowout report after the huge gain in the ADP employment survey — which having twice in the past five months wrongly predicted a very large payroll gain seems unlikely to ever again be the significant market mover it was this time — despite the disappointing headline payroll gain the employment report overall was robust (very much like the April report). Nonfarm payrolls rose a significantly less than expected 121,000 in June, but significant upside in other details of the data made for an overall strong report. The household measure of employment surged 387,000, widening an already large gap in growth between the two surveys. Over the past year, employment in the payroll survey has risen 1.4% and in the household survey (adjusted for the population break in the series) 1.9%, although much of this is because of definitional and coverage differences between the two surveys. Still, the stronger growth in the household survey is certainly more in line with recent very robust withheld income and payroll tax collections. In May and June combined, withheld taxes (as tabulated in the Daily Treasury Statement) surged 9.5% year/year; for the entire first half of 2006 they jumped 8.7%. The gap between withheld tax collections and reported employment and income growth in a year with no changes in tax rates is approaching extreme levels, which, in our view, suggests that employment and/or wage growth is due for an upward revision. Meanwhile, the unemployment rate was steady at 4.6% in June but only because of a surge in the rate for teenagers that was probably a seasonal adjustment problem (not uncommon this time of year as the seasonal factors try to time schools’ summer breaks). The adult unemployment rate fell two-tenths to a five-year low of 4.0%. The average workweek rose a tenth to 33.9 hours, leading to a sharp 0.4% advance in aggregate hours worked. Average hourly earnings surged 0.5%, lifting the year/year rate to a new cycle high of +3.9%. With the upside in hours and earnings, aggregate weekly payrolls, a proxy for total wage and salary income, jumped 0.9%. As a gauge of how strong that is, consider that to get the same rise in aggregate payrolls with a flat workweek and a more trend-like 0.3% gain in average hourly earnings would have required a nearly 700,000 gain in payrolls. Both of the ISM surveys also proved disappointing on a headline basis, but with some reasons for optimism in the details — in the manufacturing report in upside in the orders index and a generally upbeat tone to the comments in the text of the report, and in the nonmanufacturing version in the broadly based nature of the expansion. The composite manufacturing ISM diffusion index dipped to 53.8 in June from 54.4 in May, a significantly weaker performance than seen in the key regional surveys. A significant increase in the key orders index (57.9 v. 53.7) was offset by pullbacks in the production (55.1 v. 57.2), employment (48.7 v. 52.9), supplier deliveries (55.0 v. 57.6), and inventories (46.9 v. 48.0) gauges. Despite the pullback in the overall index, growth was slightly more broadly based by industry in June, with 14 of 20 industry groups reporting expansion, up from 13 in May, and the text of the report seemed relatively upbeat. The prices paid gauge fell marginally to 76.5 from 77.0. Widespread upside in metals and energy prices continued to be reported. Meanwhile, the nonmanufacturing ISM survey’s headline business activity index fell to 57.0 in June from 60.1 in May, a four-month low. Growth was very broadly based in June however, with 14 of 16 industry groups reporting expansion, led by transportation, business services, mining, retail trade, and construction, and only one sector, agriculture, reporting contraction. Key underlying activity measures weakened, with the orders index falling to 56.6 from 59.6 and the employment gauge to 52.0 from 58.0. The prices paid index fell 3.6 points, but remained very elevated at 73.9, with various building materials, metals, energy items, and paper products reported up in price. While there were bright spots in the employment and ISM reports, there certainly weren’t in the early measures of June consumer spending. Motor vehicle sales ticked up to a less than expected 16.3 million units in June from 16.0 million in May and mix remained weak. Chain store sales overall were similarly disappointing. A weighted aggregate of the biggest 30 or so chains we compile showed a 3.0% year/year gain in same-store sales in June overall and a 2.3% rise excluding drug stores, for each the second worst showings in the past year, only beating the Easter calendar shift distorted March. The ex drugs measure was about a half point weaker than already modest industry expectations for the month. Incorporating these results, we forecast a 0.1% decline in June retail sales overall and a 0.3% gain ex autos. A couple lagging releases for May also released the past week led us to cut our estimate of Q2 GDP growth to +2.5% from +3.0%. Construction spending posted a surprising 0.4% decline in May, with the main downside surprise in the private residential category, which declined 0.8% despite a 5.0% jump in housing starts reported in the month. And the factory orders report showed lower than expected inventories in May (only partly offset by an upward revision to April) as well as downward revisions to capital goods shipments in May and April, pointing to lower growth in business capital spending than we previously had estimated. There is fairly busy economic calendar in the coming week, but mostly releases of secondary importance. The main focus in the coming week will be on Friday’s retail sales report, but it seems likely the market will be largely in a holding pattern for the next week and half waiting for the July 19 monetary policy testimony and release of the June CPI report, after which the market will probably move more decisively in pricing in whether the Fed will raise rates again in August or pause. Indeed, over the next five weeks we could be poised for a global central bank buzz saw that might restart some of the prior risk reduction rush. The Bank of Japan could end ZIRP as early as Friday. The ECB has essentially pre-announced a rate hike on August 3. And we think that the CPI report on July 19 will help support another Fed rate hike on August 8, a prospect that Chairman Bernanke will at least have to leave open in his upcoming testimony in our view. Key data releases due out in the coming week include the trade balance Wednesday, Treasury budget Thursday, and retail sales and University of Michigan consumer confidence Friday: * We look for the trade gap to widen by about a half billion dollars in May to $64 billion, with exports and imports both up 0.8%. On the export side, industry data and manufacturing shipments figures point to little change in capital goods, but we expect to see some price related upside in industrial materials and a rebound in consumer goods after the sharp fall seen in April. On the import side, the gain should be more than accounted for by a second straight sharp jump in petroleum products to a new record high. Higher prices should account for some of this, but Energy Department figures also point to a significant rise in volumes. This upside should be partially offset by some price related softness in natural gas and a dip in non-energy goods imports based on relatively sluggish growth in inbound shipments through the key West Coast ports. * We estimate the federal government ran a $23 billion surplus in June, flat versus the same month a year ago. However, this comparison masks ongoing underlying improvement in the fiscal picture as both estimated tax payments by individuals and corporate receipts posted another round of sharp increases. These swings should be offset by a further rise in Medicare spending tied to the new prescription drug program and a calendar quirk that will accelerate some July payments into June. For the fiscal year as a whole, we see the budget deficit tracking at $310 billion — or 2.4% of GDP. * We look for a 0.1% decline in June retail sales overall and a 0.3% rise ex autos. Both motor vehicle sales and the chain store reports were a bit disappointing, leading us to cut our estimates for June retail sales. Indeed, we look for below trend results in key discretionary categories such as general merchandise and apparel. And the auto dealer component is expected to show a dip since the seasonal adjustment factors for retail sales appear to be somewhat harsher than those applied to the unit sales figures, which showed a small gain. Also, a flattening out of prices at the gas pump following a couple of months of hefty increases points to some softening in the service station category. The one notable exception to the anticipated softness is in restaurants, where company reports point to a solid rise. Finally, we look for retail control to be +0.3% in June and see real consumption tracking at +2.1% for the quarter as a whole.
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Tightening the Fiscal Belt
Jul 10, 2006
Eric Chaney (London) and Elga Bartsch (London) and Vladimir Pillonca (London)
The three ‘big fiscal sinners’ of the euro area — Germany, France and Italy — are moving toward fiscal austerity, we think. Although details are lacking, we believe that the direction taken by the three largest economies of the euro area is clear. It will have important consequences on GDP growth in the short term, but also on the other lever of economic policy, i.e., monetary policy. Because of electoral calendars, France was the first to take the fiscal bull by the horns, when French Finance Minister Thierry Breton asked a group of experts led by BNP Paribas chairman Michel Pebereau to estimate the ‘true’ government debt, i.e., including pension liabilities, in July 2005, in order to increase the pressure on his cabinet colleagues ahead of the budget process. Then, Germany took a decisive and concrete step when Chancellor Angela Merkel convinced her coalition cabinet that Germany had to move toward sound public finances. Now that Italy has a new cabinet, it is the turn to the country carrying the highest public debt of all Europe to join the fiscal normalisation camp. With an overall budget deficit on its way to rise to 4.3% of GDP this year, before the corrective measures announced in the mini-budget, Italy was indeed running the risk of a credit rating downgrade. In this note, we review the fiscal situation in each of these countries, which, taken together, make up 70% of the euro area GDP. Germany: The largest tax hike in post-war history There is not much that the grand coalition seems to agree on these days when it comes to reforms, except the need for a further consolidation of public finances. The government has already pushed a major tax package through parliament in May, including a three-point VAT hike and a rise in the top income tax rate from 42% to 45%. In addition, it looks increasingly likely that, over and above a 0.4% rise in pension contributions, healthcare contributions and possibly also contributions to the statutory long-term care system will be hiked by 0.5% of gross wages and salary in 2007. This past week, the Cabinet approved the 2007 budget. The budget will aim at bringing the federal budget deficit down from €38.2 billion to €22.0 billion. This will hopefully allow the German government to put the budget back in line with the Golden Rule of the German Constitution. The Constitution stipulates that, in any given fiscal year, the government cannot ex-ante borrow more than it invests except for special circumstances such as a macroeconomic disequilibrium. And it is in fact the Golden Rule rather than the Stability and Growth Pact that is giving the government a headache. In order to meet the rule, the federal net borrowing requirement needs to come down to around €22 billion. Hence, even if better-than-expected tax revenues brought the general government budget deficit back below the 3% ceiling of the Stability and Growth Pact, this is unlikely to induce the finance minister to go back on his consolidation promises. We therefore expect the general government deficit to fall from 2.9% of GDP this year to 2.3% next year. All in all, we estimate the cyclically adjusted primary budget balance to improve by nearly 1% of GDP on the back of what amounts to the largest tax hike in post-war history in Germany. Italy: Very ambitious objective, no tax hikes (yet?) As we write, the details of the four-year economic plan or DPEF are not fully disclosed. But the overall picture is that Romano Prodi’s cabinet aims at cutting the budget deficit by a substantial 2.5% of GDP, in addition to this summer’s mini-budget 0.5% of GDP cut over 2006 and 2007. The 2007 budget is expected to contain several structural initiatives, as stressed by Italy’s economic minister, Tommaso Padoa-Schioppa. The combined scale of these measures is significant, to say the least. The primary aim of the budget is to rationalise some areas that are crucial for the fiscal outlook: pensions, healthcare, public employment and local bodies. One of the aims of the fiscal plan is to reduce Italy’s budget deficit from over 4% of GDP this year to under the 3% limit by the end of 2007. This raises two issues. First, can the government cut the deficit by such a large amount without triggering another recession and running into political trouble? Second, is it possible to achieve fiscal stabilisation without raising taxes? To the first question, our answer is that Mr. Prodi’s cabinet cannot afford another recession and will thus take a more gradualist approach. At this stage, we expect the general government deficit to drop to 3.5% of GDP next year, already a large step in the right direction. To the second one, Mr. Vincenzo Visco, Italy’s vice-minister for the economy, has already answered: he does not intend to increase VAT, “unless it was to become the last resort to avoid a fiscal disaster”. A series of schemes to curb tax evasion has been announced, but we think that much more is needed in terms of rationalisation of government expenditures and benefit levels to achieve the government ambition to place Italy’s debt to GDP ratio on a steady downward trajectory. France: Working on a virtual budget The French case is dominated by the prospect of the presidential and general elections in May-June of next year. Although the Treasury is already very busy at elaborating the budget for 2007, the end game will be highly sensitive to the results of these elections, in our view. At this stage, fiscal rigour is the buzzword in Bercy, although not as stringent as suggested in the Pebereau report. For the central government, the target could be a nominal spending freeze, i.e., a reduction in real terms and, consequently, a further reduction in discretionary spending, since public servant payrolls and pensions are mostly on quasi-automatic trajectory, even if the government wants to cut marginally the number of civil servant, again, next year. As for the second part of the budget, i.e., the ‘social protection’ budget, which now goes through the Parliament in October-November, things are less clear. The burning issue is the recurrent deficit of the healthcare fund and we do not see this government, weakened by its failure to reform the labour market, taking risks with doctors or with nurses and other hospital staff. Accordingly, we expect the French deficit to remain close to 3.0% of GDP next year, as slower growth partially offsets the fiscal tightening embedded in the central government budget. Three fiscal scenarios for Euroland Wrapping together the recent budgetary developments, we see the aggregate general government deficit dropping sharply next year, to 2.1% of GDP from 2.4% this year, on the back of large reductions in Germany and Italy. The negative impact on demand implied by fiscal policies is already embedded in our GDP growth forecast (1.4% in 2007 after 2.3% this year), which explains why our central projection does not show a faster decline: slower growth will generate less tax income for governments, other things being equal. This also explains why, in opposition to future markets, we anticipate that the ECB will cut the refinancing rate in order to support demand. We have also looked at two alternative scenarios. In the ‘virtuous scenario’, private households would compensate the tax hikes by reducing their savings, a behaviour that would signal a high degree of confidence on the long-term fiscal outlook. In the ‘cloudy’ scenario, households would not trust the long-term commitments of policy makers and would keep their savings rate unchanged. In the former case, the euro area budget deficit would drop significantly below 2% of GDP (1.8%) while, in the latter, it would get closer to 3% of GDP, at 2.7%. If coming true, the ‘cloudy’ scenario might initiate a vicious circle of depressed domestic demand and governments raising taxes in a hurry to avoid a fiscal debacle.
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Trichet's Trick
Jul 10, 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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2Q GDP Estimated to Rise 7.5% on Strong Production
Jul 10, 2006
Deyi Tan (Singapore)
The advance estimate released by the Ministry of Trade today shows the economy expanding by 7.5% YoY in 2Q (versus +10.7% YoY in 1Q). On a sequential seasonally adjusted basis, the economy rose 1.1% QoQ annualized, slowing from the high of 7.0% in 1Q, which was on the back of benign biomedical volatility. Meanwhile, 1Q GDP growth was revised slightly from 10.6% to 10.7% YoY. 2Q headline predicated on strong production numbers in June. The 2Q advance estimate is computed mainly based on April and May data, as well as the government’s expectation of what will pan out in June. The manufacturing sector is expected to grow 10.2% YoY in 2Q. With April-May industrial production rising 6.7% YoY, this implies that June production is expected to rise 16.4% YoY. Momentum in services eased. The services sector is estimated to have decelerated to 6.8% YoY, from 8.2% in 1Q, with momentum in most services sectors easing. Construction still to show mild contraction in 2Q. House prices and office rentals have continued to show a steady acceleration and construction momentum of residential and non-residential buildings appears to have responded to that as growth in the former reversed from negative to positive territory in 1Q. However, construction as a whole is still not expected to register an expansion in 2Q (-0.3% YoY), possibly on weak civil engineering construction. Divergence in external and domestic demand to underpin moderation. To date, April-May trade data show that external demand, while strong, might be peaking in 2Q. On the other hand, we believe that momentum in domestic demand could continue accelerating on the back of a faster pace in wage rises, a good labour market, the S$2.2 billion (1.1% of GDP; out of S$2.6 billion) progress package, which has been disbursed in 2Q, and government construction projects worth 5.3% of GDP in the next five years.
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