United States
Review and Preview
Jul 24, 2006

Ted Wieseman (New York) and David Greenlaw (New York)

Treasuries posted small 5-year led gains over the past week, but only after moving through a huge range.  This was driven first by a fourth straight ugly inflation report and then by Chairman Bernanke’s testimony making clear that he is not especially concerned about the recent inflation surge and is instead aiming to halt the rate hiking cycle imminently to avoid over-tightening.  The volatility was yet another stark illustration of the failure of the current Fed to explain its reaction function to incoming information in a way investors can understand.  After stressing repeatedly that policy was data dependent, last month we first had the market dramatically scale back rate expectations after the weak May employment report was released, only to be shocked into a complete reversal by hawkish remarks from Fed Chairman Bernanke a day later.  And this month we had what seemed to be a completely reasonable response to yet another miserable inflation report -- nearly fully pricing in an August rate hike and some risk of another hike beyond that -- only to be baffled ninety minutes later by the Fed Chairman’s lack of concern about the inflation news and forced into yet another massive reversal to end the week having priced out the likelihood of a move in August, reduced the odds of the funds target reaching 5.50% at any subsequent meeting to about 70%, and fully priced in a rate cut in 2007.

For all the Fed’s talk of being “data dependent,” it seems clear now that it is not in any real sense.  It has forecasts for growth and inflation for the next year and half that for now seem highly resistant to incoming information.  The official FOMC forecast for 2006 growth of 3 1/4% to 3 1/2% on a Q4/Q4 basis is implausibly low after a first half that ran near 4 1/2%, and the core PCE inflation forecast of 2 1/4% to 2 1/2% is, at best, at the low end of plausibility given that we are already very likely to have been at 2.3% in June (when the numbers are reported August 1), and the underlying upward momentum, now four months running, has been undeniable and broadly based.  If the Fed is determined to halt the rate hiking cycle in August regardless of the data, we think it could prove a significant mistake.  We think the Fed Chairman has turned soft on inflation at the wrong time, a choice that is likely eventually to lead to a notable steepening of the yield curve (though surprisingly not much so far), a more stimulative financial environment, rising inflation expectations, and a possible acceleration of economic activity with an accompanying intensification of inflation pressures.  Perhaps we should keep in mind the Fed’s aborted attempt in 1994 to call the end of the rate hiking cycle, when the FOMC declared in August that the rate hikes up to that point were “expected to be sufficient at least for a time to meet the objective of sustained noninflationary growth” only to quickly realize how wrong this assessment was and, trying to play catch up, hiked rates 75 bp in November, a blunder that saw the 2-year yield rise 100 bp in three months and nearly threw the economy into recession in 1995.

After a wild ride -- with the 2-year yield trading through a 23 bp range -- benchmark Treasury yields ended the past week little changed, rallying 1 to 3 bp, with 3 bp rallies in the 3-year and 5-year to 5.02% and 4.99%, respectively, leading the way.  In general, the curve barely budged, a very surprising reaction from our perspective given the lack of Fed vigilance in response to bad inflation news, with 2’s-10’s actually down 1 bp and 2’s-30’s flat on a 1 bp rally in the 2-year yield to 5.08%, a 2 bp decline in the 10-year yield to 5.04%, and a 1 bp dip in the long bond yield to 5.10%.  Near-term Fed rate hiking expectations were sharply scaled back, and medium-term rate cutting expectations ramped up in the futures markets.  The August fed funds contract after hitting a post-CPI high rate of 5.425% -- pricing in a 90% chance of rate hike at the August FOMC meeting -- ended 2 bp stronger on the week at 5.33%, putting the odds at only around 40% to 45%.  The peak rate November contract gained 2 bp for the week to 5.42% after a peak post-CPI rate of 5.565%.  These huge reversals (that mostly occurred within the span of 90 minutes) dwarfed even the big flip-flops seen the last time Chairman Bernanke surprised investors with his response to a data release after earlier hawkish remarks, the Monday after the weak May employment report was released. 

The Dec 07 to Jun 08 eurodollar contracts led the eurodollar futures market, rallying 7 bp and sending the inversion in that market to new extremes. The Dec 06 to Dec 07 spread fell 5.5 bp to -24.5 bp, and the Mar 07 to Mar 08 spread 4.5 bp to -19.5 bp, both all-time lows.  The closing rate on the Dec 07 contract of 5.29% is getting close to pricing in a 5% year-end 2007 fed funds target . TIPS underperformed on the week, so, like the curve, the inflation indexed market showed a surprising lack of concern about the Fed’s inflation vigilance, though clearly the sharp pullback in oil prices was a more immediate concern for TIPS investors.  The key market-based measure of inflation expectations the Fed has identified, the 5-year/5-year forward TIPS breakeven inflation rate, was about unchanged on the week at just below 2.6%.  This is up about 20 bp year to date, but down from the April peak near 2.75%.

Fed Chairman Bernanke’s semi-annual monetary policy testimony to the Senate Banking Committee predicted a sustained slowdown to trend growth, some modest further upside in core inflation but little risk of anything beyond that, a slight moderation in core inflation next year to a level still above the Fed’s implicit target range, and gave a clear indication that the Fed is more worried about tightening too much at this point than being behind the curve.  Given the recent extended string of upside inflation surprises, this was a very surprisingly dovish message.  In light of the badly deteriorating inflation picture, we had thought the Chairman would feel the need to bolster Fed credibility by at least talking tough on the Fed’s inflation fighting resolve, even while continuing to leave future policy decisions data dependent.  Instead, he spent most of his time talking about why the ongoing inflation surge is not a problem -- identifying four key risks (energy prices, labor costs, inflation expectations, and too strong growth), but then making the case that none was likely to be a problem -- and attempting pretty clearly to lay the ground for a near-term halt in rate hikes.

Judging from the testimony and minutes from the June meeting, it seems clear that the Fed would like to pause in August, but we still think the incoming data over the next several weeks might force them to rethink this.  Obviously, the incoming inflation news has been ugly for a while, and this should be further reinforced by a projected 0.25% gain in core PCE price index on August 1, which would take the year/year rate up two-tenths to +2.3%, already near the midpoint of the FOMC’s full year forecast.  The significant second quarter slowdown that the Fed seemed convinced was happening at the June FOMC meeting doesn’t seem to have happened at all.  We expect the GDP report on Friday to show growth near +3 1/2% in Q2, leaving first half growth at a very strong +4 1/2% annual rate.  The ECI report, also due out Friday, seems overdue for some catch-up, with a variety of other indicators pointing to a significant acceleration in wage and salary income growth.  And we look for a fairly robust employment report on August 4.  Such a run of data would seem to make a solid case for a rate hike on August 8, but it remains to be seen how strongly entrenched the FOMC’s faith is in its forecast and how much the incoming economic news matter in shaping it.

Whether the Fed goes in August or not, we expect that upside in both growth and inflation in the second half will bring in more tightening at some point down the road. Pausing in August would seem to risk causing the Fed to fall behind the inflation curve.

Economic data released the past week showed accelerating inflation pressures at both the consumer and producer level, very strong growth in manufacturing activity in June, with accompanying pressures on “resource utilization” that the Fed used to think was an inflation risk, but signs of a cooling in July in early regional surveys, and a continued slowdown in new home construction as builders try to get bloated inventories under control, with weakness seen in both housing starts and homebuilder sentiment.  The week’s key release (though apparently of only limited interest to the Fed) was a fourth straight ugly CPI report.  The overall consumer price index rose 0.2% in July for a near cycle high 4.3% year/year gain, restrained by a 0.9% pullback in energy prices.  The core, however, jumped 0.3% for a fourth straight month, the worst such run in over 11 years. The year/year core rate rose to +2.6% from +2.4%, the high since late 2001, while on a year-to-date basis it has accelerated to +3.2% from +2.2% in all of 2005.  The key shelter category was again a major contributor to the upside, with owners’ equivalent rent (OER) and regular rent both up 0.4%.  Upside across other categories, however, was also widespread.  Airfares continued to surge, rising 3.1% in June for a 24% annualized gain the past six months.  Personal care rose 0.5%, the largest gain in the seven-year history of the series.  Apparel was flat, making for a rare four straight months without a decline.

While a normalization in OER this year after this key category was artificially depressed last year by surging utility bills (for technical reasons related to the stripping out of utility costs when converting the rent sample into OER) has been a major contributor to recently surging core inflation, it has certainly not been the only cause.  In the first half of 2006, the core CPI excluding OER rose at a 2.5% annual rate, up from +2.0% in all of 2005.

Inflation trends at the producer level remained poor as well, and with the economy continuing to operate at or beyond full normal capacity, improved business pricing power should continue to lead to further pass-through of cost pressures.  The producer price index jumped 0.5% in June, boosted by the largest increase in food prices (+1.4%) in over two years.  Excluding food and energy, the core measure gained 0.2%.  So far this year, the core PPI has accelerated to +3.1% annualized from +1.4% in all of 2005.  The slight moderation from this underlying core acceleration in June reflected some upside in car (+0.4%) and light truck prices (+0.9%) on lower than normal discounting, offset by moderation in various other categories, notably women’s apparel.

Pipeline inflation pressures continued to build.  The core intermediate index rose 0.7% and core crude 1.7%, with the latter now running at a record high +34% year/year, largely on surging steel scrap prices.

The “resource utilization” risks to inflation worsened in June in the industrial sector. Industrial production surged 0.8% in June, with the key manufacturing gauge rising a robust and broadly based 0.7%. The strongest factory sector was motor vehicles and parts (+3.3%), a gain that seemed quite a bit stronger than implied by industry assembly reports. Excluding motor vehicles, manufacturing output gained 0.5%, with good gains across most industries, consistent with broad gains in hours in the employment report. The overall capacity utilization rate rose 0.6 pp to 82.4% -- the high since June 2000, 8.5 pp above the recession trough, and 1.7 pp above the average of the past thirty years. Similarly, the manufacturing rate rose 0.4 pp to 81.1% -- the high since May 2000, 9.1 pp above the recession trough, and 1.6 pp above the average of the past thirty years.

Rising and tightening operating rates have increasingly promoted business pricing power to push through increases in raw materials prices and recently accelerating labor costs.

After this robust showing in June, regional surveys pointed to some cooling in July. On an ISM-comparable weighted average basis, the Empire State manufacturing survey fell to 53.3 from 58.2, and the Philly Fed dipped to a similar 53.9 from 55.2. Based on these results, our initial estimate for the national ISM in July is for a decline to 53.0 from 53.8. A more positive advance indicator came from the jobless claims report, with initial claims plummeting during the survey week for the July employment report after some likely spurious upside the prior week caused by seasonal adjustment problems with auto retooling shutdowns and the New Jersey government shutdown. Our preliminary forecast for nonfarm payrolls is July is +175,000.

The upcoming week has a number of notable data releases, highlighted by GDP on Friday, which we expect to show that the until recently widely anticipated Q2 slowdown didn’t happen. Also on Friday, we expect the employment cost index to show some catch up with a variety of other indicators pointing to a significant acceleration in wage and salary income growth. Treasury supply will be very heavy in the coming week, with a $7 billion reopening of the 20-year TIPS Tuesday, 2-year auction Wednesday, and 5-year auction Thursday. We expect the 2-year and 5-year sizes (which will be announced Monday) to be unchanged at $22 billion and $14 billion, but given the ongoing surge in tax revenues that has extended into July, cuts would not be a shock. All year, 2-year and 5-year auctions have seen relatively quite weak demand from final investors, and we can’t imagine interest is going to be spurred by these rate levels. There are no Fed speakers scheduled in the coming week, but the Beige Book prepared for the upcoming FOMC meeting will be released Wednesday. Key releases on the data calendar include Conference Board consumer confidence and existing home sales Tuesday, durable goods and new home sales Thursday, and GDP, ECI, and Michigan consumer confidence Friday:

* We expect the Conference Board’s measure of consumer confidence to dip slightly to 105.0 in July. The ABC and University of Michigan gauges diverged a bit in early July. Also, we have had some mixed signals on the labor market front of late. From our standpoint, this points to little change in the Conference Board measure in July.

* We forecast June existing home sales of 6.60 million units annualized.   The NAR’s pending home sales index registered a slight uptick in June.  However, this was the first positive move since January, and there is obviously still some underlying moderation evident in the pace of sales.  So, we look for about a 1% decline in resales during June.

* We look for a 3.2% rise in June durable goods orders, as a sharp jump in the volatile aircraft category is expected to lead to a solid rebound in overall bookings. Meanwhile, the core category -- nondefense capital goods excluding aircraft -- should post a trend-like advance of 0.7%.  This would be consistent with the recent improvement in the ISM orders gauge.

* We forecast June new home sales of 1.15 million units annualized.  Despite gloomy assessments from the homebuilding community, the Census Bureau’s tabulation of sales of newly built residences has shown three consecutive months of surprising gains. We suspect that some of this upside is attributable to a quirk in the data -- specifically, new home sales are tallied at the time of contract signing and there is no adjustment for subsequent cancellations. Since there are widespread indications of buyers walking away from deals as the market has softened, the new home sales figures should be viewed with some caution.

* The latest round of incoming data pushed our forecast of Q2 GDP growth up by nearly a full percentage point to +3.4%. Specifically, readings on foreign trade, retail sales and inventories all led to upward adjustments to the growth picture. In comparison to the prior quarter, consumption, capital spending and residential investment appear likely to show clear moderation but positive contributions from net exports and inventories should provide some offset. Finally, on the price front, the key core PCE price index is expected to be up 2.9% which would represent the sharpest quarterly gain in nearly 12 years.

* We look for a 0.8% rise in the employment cost index in the second quarter. The average hourly earnings gauge points to some acceleration in wage gains, even after adjusting for compositional shifts in work force. So we look for ECI growth to show at least a slight uptick.  However, this would still leave the year/year rate at a rather subdued +2.9%. The key private wage component is expected to be +0.9% in the quarter. Meanwhile, we look for the benefits category -- which accounts for about 30% of the overall ECI -- to nearly match the Q1 reading of  +0.5%, as cost shifting continues to help restrain health care-related costs.

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France
Consumer Spree; Mind the Hangover
Jul 24, 2006

Eric Chaney (Paris)

For the second month in a row, French consumers took the markets and analysts by surprise: instead of a widely expected correction, real consumer spending on manufactured products jumped 1.7%M in June (5.6% on a year-on-year basis, the same as in May).  With spending up 1.5% on a quarterly basis in the second quarter, overall household consumption (including food and services) is likely to have increased by around 1.0%Q, a pace only comparable to Spanish spending patterns within Europe.

This raises several interesting issues:  1) With sluggish wage and employment growth, where do French consumers find the means to spend so much?  2) Since spending was probably boosted by the World Cup, how bad could the following hangover be?  3) To what extent should strong consumer spending translate into GDP growth?  4) Looking forward, how sensitive will the French consumer sector be to rising interest rates?

My broad view is that, beyond particular circumstances, the French consumer sector is well supported by low real interest rates, rising housing wealth and, to a lesser degree, job creation.  Once the post-World Cup hangover is absorbed, and with only limited interest rate increases in sight, a modest slowdown, not a downturn, should follow.  However, strong consumption does not necessarily imply similarly strong GDP growth.

Breaking the piggy bank

With real wage income up 2.0%Y and real spending on manufactured products at 5.6%Y, there is no doubt that French consumers are continuing to draw on their savings, mostly through consumer credit.  On our estimates, overall consumption of goods and services was tracking 3.1% at the end of June, on a four-quarter change basis, while real disposable income was up 2.4% over the same period, according to Insee estimates.  Practically, this implies that the personal savings rate is declining at an annual rate of 0.5 pp, broadly in line with the trend seen since the 2002 saving rate peak (16.9%).  Empirical studies show that the savings rate is sensitive to a few main macro variables: real income volatility (savings acting as a kind of shock absorber), inflation (a positive correlation, also known as the real balance effect), real interest rates and housing wealth, with the two latter unsurprisingly having a negative correlation with the savings rate (see, for instance, Sensitive Consumers, Thomas Gade, 3 July, 2006).  In a context of broadly stable and low inflation and steadily growing real disposable income, these two macro factors can be highlighted.  On the other hand, low real interest rates and rising housing prices are clearly pushing households to take more consumer credit.  Back in March, consumer credit was up 7.5%Y, and we suspect that it could have accelerated to double-digit growth in the last three months.  In addition, residential property prices, although slowing, were still up 14.3%Y in March, thus fuelling a significant real wealth effect.

 

 

Fans of football, electronics and…good deals

In June, sales of home equipment goods jumped 3.2%M, pushing the year-on-year rate to 22.3%, its highest ever recorded rate (all measures are in volume terms).  Electronic goods rose a further 4.6%M on the heels of 9.3%M in May, a consequence of the popularity of the second phase of the World Cup.  Note that not only flat screens and DVD recorders, but also PCs and 3G cell phones sold like hot cakes.  Yet, good things cannot last for ever: On our metrics, spending was 1.8% above the underlying trend in June.  We now expect spending to contract in each of the next three months.  This would bring spending levels slightly below trend, before a re-acceleration at the end of the year.  With 2Q consumption of manufactured products up 1.5%Q, we re-estimate household consumption growth to 0.9%Q, from 0.7%Q, but now anticipate a negative reading in 3Q (-0.1%Q), caused by a contraction of spending on manufactured products. 

Strong consumption does not necessarily imply strong GDP

The domestic manufacturing sector is unlikely to benefit from this spending spree, since most of electronic goods are imported.  On the other hand, value added in the retail sector is likely to be stronger than expected, at least in the second quarter, but this effect is relatively marginal.  Accordingly, we do not change our already above consensus call on 2Q GDP growth (0.8%Q) and, for the same reason, continue to expect robust growth in the third period, at 0.6%Q, which is slightly above the 0.5%Q trend of French GDP growth.

The case for a soft landing

Beyond the rollercoaster caused by the World Cup, the key drivers for consumer spending will be, as usual, wages and employment and, in addition, real interest rates and housing wealth.  As for the former, a less supportive European environment next year, with significant fiscal tightening in France’s main export markets, Germany and Italy (see Next on Fiscal Diet, Eric Chaney, July 17, 2006), is likely to weaken foreign demand and thus employment.  In addition, rising interest rates should make credit more expensive and accelerate the slowdown in housing prices.  However, none of these factors should be sufficient to trigger a sharp slowdown, in my view.  Only a significant change in the French budgetary policy stance would change this prognosis, and we do not see it happening before a new cabinet emerges from the June 2007 general elections at the earliest.  Consequently, consumer spending will continue to be supported by two tail winds — relatively cheap credit (we expect the ECB to raise the refi rate no higher than 3.5%) and rising housing prices (even though they may decelerate to single-digit growth over the course of 2007).  All things being considered, we expect household consumption to grow 2.4% this year and 1.8% next year.  By European standards, this would still be a robust performance.

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Sweden
Low Rates Fuel Monetary Overshoot
Jul 24, 2006

Thomas Gade (London) and Elga Bartsch (London)

Rising risks of a monetary correction
Money supply in Sweden is currently expanding at an annual rate of 17%Y. Being way above the long-term average of 6%Y, the question is how much longer this strong growth can last. We have estimated a fundamental model for money demand. We find that the monetary aggregate in Sweden currently is significantly above its long-term fundamental equilibrium value. We therefore see increased risks of a potential correction in money growth going forward.

The exceptionally high money demand growth reflects, at least partially, very low interest rates and above-trend real GDP growth. These two factors seem to be fuelling lending growth, which correlates with overall money supply growth. The rise in overall lending growth during more recent years seems to be driven by a sharp acceleration in lending to non-financial corporations.

To judge the sustainability of the present strong money supply growth, we have estimated an equilibrium path for money supply based on fundamentals such as GDP, interest rates and inflation. However, even taking these fundamentals into account, money supply is presently considerably above its equilibrium value. Our model points to a sharp deceleration in money demand growth, which could even be dipping into negative territory in early 2007.

Surging corporate lending
Strong overall lending masks very different trends in retail lending and corporate lending.  The rate of lending growth to the household sector has broadly been high through the last decade, reflecting the strong house price dynamics over the period. Meanwhile, lending to non-financial corporations has been much more volatile. On the back of a marked expansion in investment spending, corporate borrowing has led the recent run-up in money supply growth. We use overall money supply, M3, as an indicator for lending dynamics.

A fundamental model for money demand…  In order to gauge how the current level of money supply in Sweden compares to the equilibrium level, we have estimated a simple money demand function. The model allows us to identify potential deviations from the long-run equilibrium and project how they will likely be corrected in the future.  The approach we use is often employed in monetary economics to establish the usefulness of money supply as an indicator for future inflation. In line with the academic literature, we model real money demand as a function of real GDP, interest rates and inflation. We use the ten-year bond yield as a metric of the opportunity cost of holding money and measure inflation by the GDP deflator. The model is specified as a so-called error correction model. This two-stage specification allows decomposing the model into a long-term equilibrium and short-term dynamics, including the correction of potential deviations from the long-term equilibrium.  The model shows that Swedish money supply is considerably above its long-term equilibrium value at present.

…points to significant monetary overshoot…  According to our empirical model, money supply is currently three standard deviations above our estimate of its long-term equilibrium value in light of the current level of GDP, interest rates and inflation.  An overshoot of such magnitude is unprecedented in Sweden. We would therefore expect money supply to start correcting towards its (rising) equilibrium value during the coming quarters. On our calculations, the historical adjustment pace has been approximately 17% per quarter. This would mean that a full adjustment of money supply back to equilibrium would take about five quarters to complete.

…and suggests potential monetary correction.  Plugging our forecasts of real GDP growth, long-term interest rates and inflation into the estimated money demand function, we are able to project the likely future dynamics of broad money growth.  In line with our macro scenario, we assume that prices will continue to rise gradually at a non-annualised pace of 0.4%Q and real GDP to expand at a quarterly rate of 1%Q in 2Q before gradually slowing to a trend rate of 0.6%Q thereafter. Yields on 10-year government bonds are likely to rise by a total of 75bp in the remainder of the year and then remain broadly constant.  Based on these fundamentals and the specific correction feature of the error-correction type of model, M3 money growth could decline to 2.2%Y by year-end before dipping into negative territory in early 2007. If past trends are an indication, then the sharp slowdown in money supply growth can be expected to coincide with a slowdown in lending activity.

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Asia/Pacific
Inflation Is Here to Stay
Jul 24, 2006

Andy Xie (Asia)

Global inflation accelerates: Global inflation is at a 10-year high.  The sources of inflation are broad-based, including overheating in emerging economies, rising commodity prices and tight labor markets in developed economies.  By virtue of its global nature, inflation is likely to be strengthened by all these factors and keep climbing.

Global monetary conditions remain loose: Although the global real policy rate has climbed above zero in the past two years, it is still close to zero versus more than 2% five years ago.  Monetary conditions are not restrictive, and global inflation is likely to climb further in the absence of additional tightening.

Global policy rate needs to rise by 2% or more: The rise in the global policy rate has to be 2% or more to return to neutral.  To combat inflation, the rise needs to be considerably more.  Rate hikes around the world will likely surprise on the upside.

Commodity speculation pushes up inflation: Low real interest rates encourage commodity speculation.  Commodity inflation so far in 2006 may have injected two percentage points into the global inflation pipeline.  Only higher interest rates can stop commodity speculation.

Central banks have to respond to the facts: Major central banks have been dovish in their recent statements (e.g., the Fed, the BoJ and the PBoC).  However, regardless of the wishes of the central bankers, the facts will eventually catch up with them.  The more dovish they are now, the higher the level at which inflation will peak and the greater the rate hikes that they will have to make.

 

Major central banks have surprised the market with their dovish statements (e.g., the Fed, the BoJ and the PBoC), despite data that show rising inflation and overheating.  The dependence of the global economy on financial markets may have caused the dovish tendency, as central banks are concerned about any damage to economies from financial market adjustments to a hawkish stance.

 

However, dovish positions cannot change the fact that global inflation is at a 10-year high and rising.  Although the global real policy rate is no longer negative, it is still close to zero.  The economies of China and India and commodity markets are overheating, and if the global policy rate remains at such low levels, further overheating can be expected.

The dovish stance of the major central banks increases the risk of a global hard landing as it encourages overheating in the economies of developing countries and commodity speculation.  This is likely to cause global inflation to peak out at higher levels than would otherwise be the case.  There is also a risk that central bankers will suddenly panic when they realize that their low interest rate policies are completely out of sync with the facts; they may then overcompensate by raising rates sharply and trigger a crash.

 

Easy monetary conditions fuel inflation

Global inflation is at a 10-year high and probably reached an average of 2.9% for China, the Euro-zone, Japan, the UK and the US combined in June 2006, from an average of 1.2% in 2002.  Recent data from all over the world suggest that the rising inflation trend is still intact.

 

The global inflation debate focuses on the source of inflation.  The rise in oil prices is considered the main culprit.  Rising rents are another.  However, this sort of thinking misses the big picture.  Inflation is picking up because of an easy monetary environment.  The money stock in the world is too high for price stability.

 

Central banks have been able to keep monetary policy loose without worrying about inflation for a decade.  Deflationary shocks (e.g., emerging market crisis, 9-11, China’s SoE reform and Japan’s banking reform) have kept inflation down despite the easy monetary environment.  As the effects of these deflation shocks end, the current money stock becomes inflationary.  The rise in oil prices, for example, just reflects excess money supply turning into inflation through strong demand or speculation.

 

Central banks around the world have been raising interest rates for two years.  Gradualism in monetary normalization has made the tightening less effective.  While the policy rate is rising, inflation is too.  I estimate that the real policy rate is still about half a percentage point from the rate that would be sufficient to contain inflation and speculation.

 

Central banks are creating problems for themselves

Despite mounting evidence of high and accelerating inflation, major central banks have made dovish statements, which have confused financial markets.  The BoJ talked down the prospect of further rate hikes after it first raised rates.   The Fed keeps telling the market that inflation will come down even though this contradicts the facts.  The PBoC increased the deposit reserve ratio by a mere 0.5% after a barrage of data showing an overheating economy.

 

Do central banks know something that the markets do not?  I don’t think so.  Central banks are sounding dovish because they are concerned about the knock-on effect on the economy of the response by financial markets to higher interest rates.  Financial markets have become so large relative to the economy that their behavior determines economic strength.  In particular, the property market has become another financial market as a result of financial innovations.  Central banks are trying to manipulate financial markets to achieve a soft landing.

 

However, what central banks are doing may backfire.  Their dovish stance fuels commodity speculation, which is a major source of inflation.  As the real policy rate is close to zero, already rampant speculation will only get worse.  The stance that central banks are adopting is just encouraging speculators to double their bets.  While central banks try to manipulate financial markets to their advantage, the result could be much more inflation, which would force aggressive rate hikes and the possibility of a crash.

 

Inflation is likely to keep rising

Inflation is a monetary phenomenon.  Deflationary shocks held back its effect on CPI inflation.  However, products and services with supply constraints have incurred rapid inflation for years.  From trophy properties, Ivy League education, fine Bordeaux wine to antiques, prices have inflated along with money supply.  It just takes time for the inflation to spill into the broad economy.

 

The economies that previously caused deflation are now all experiencing rising inflation.  The commodity boom has recapitalized the emerging economies that suffered crises five years ago.  After using export income to repair their balance sheets, they are now spending money rapidly.

 

China’s export prices have been rising for two years, according to Hong Kong’s data on Chinese imports.  Rising prices of raw materials and increasing wages are contributing to this trend.  China was a major force in limiting the inflation in tradable prices, which kept inflation low in OECD economies despite high services inflation.  The changing trend in China’s export prices has a profound impact on the global inflation trend.

 

Japan’s consumption recovery should also add to global inflationary pressure.  Japanese companies are converting temporary workers into permanent workers and are offering permanent jobs to first-time job seekers.  This increases labor costs and boosts consumption.  The Japanese economy is certainly not deflationary for the global economy.

 

The counterargument on all the above factors is that productivity is still high.  When the money stock is too high (i.e., the money supply to GDP ratio is well above the historical average), accelerating productivity acts like a deflation shock, temporarily holding back the inflationary effect.  However, ceteris paribus, the productivity growth rate is lower when an economic cycle has matured, as it has now.  The effect is similar to the removal of a deflationary shock.

 

I expect a massive sell-off in bonds

Central banks, and particularly the Fed, seem to have become puppet masters for financial markets.  Low inflation has made asset prices more dependent on liquidity than fundamentals.  Therefore, a big chunk of global demand depends on inflated asset prices.  This game works as long as inflation is not a problem.  When inflation appears as it is now, central banks can no longer deal with the demand problem by simply pumping in liquidity.

 

Most central banks still do not believe that inflation is a serious problem, even though they pay lip service to it.  They are waiting for the base effect from rising oil prices to taper off and believe that inflation will just disappear with time.  I think this view is naive.  Oil price inflation reflects excessive liquidity, which has pumped up demand and speculation.   The latter will keep pushing up prices as long as the real interest rate is near zero and liquidity is plentiful.

 

Bond markets still believe that inflation is not a serious problem, a demand slowdown due to a cooling housing market and high oil prices will lower inflation, and central banks will cut interest rates in 2007.  I believe that economic weakness would be insufficient to bring down inflation as long as the global real interest rate remains at such low levels.  The world needs above-average real interest rates to keep the growth rate below trend for a prolonged period and reduce inflation.

 

The global macro economy is undergoing a transition from below-trend inflation and above-trend growth to above-trend inflation and below-trend growth.  When the bond market accepts this, the bond yield could rise by 100bp or more, in my view.

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