The Fed Link
Aug 02, 2006
Serhan Cevik (London)
Like the Federal Reserve, the Bank of Israel is moving closer to the end of the tightening cycle. After enjoying an unusual period of volatility moderation and low interest rates, the world economy is now struggling with multiple shocks — rising geopolitical tensions, the commodity bubble and financial risk aversion. Today, the problem is not just ‘noise’ created by the waves of volatility in capital markets, but also stems from the increasing variation in real economic variables. In other words, at the peak of the global business cycle, market participants get conflicting signals on growth and inflation. However, we are still of the view that the focus will soon shift away from ‘inflation scare’ to the sustainability of economic growth. In the case of America, for example, the latest national accounts have already intensified this evolving debate. From whatever angle you look at it, the lagged impact of monetary tightening is coming through and will keep shaping the outlook for the global economy and financial markets. That said, like our American colleagues expecting the Federal Reserve to pause after raising short-term interest rates to 5.75% in October, we believe that the Bank of Israel is also moving closer to the end of monetary normalisation, even against the heightened tensions in Lebanon and the Palestinian territories.
What happens in the US is still crucial for the Israeli economy, in our view. Israel’s declining risk premium may have simplified the monetary policymaking process in recent years, but the country’s business cycle remains closely linked to investment spending in the US (and the rest of the world). This is why we need to keep an eye on emerging trends in the global economy — and not just focus on domestic developments. Rising interest rates and the threefold increase in oil prices have finally started putting downward pressure on the US economy, lowering real GDP growth from an annual rate of 5.6% in the first three months of this year to 2.5% in the second quarter. This is of course an advance estimate, and we may see a higher reading after the usual revisions. Furthermore, the 8% drop in non-military federal government spending, following the post-Katrina surge in the first quarter, depressed the aggregate figure. Nevertheless, the slowdown in economic activity is clear and broad-based, affecting consumer spending as well as capital expenditures. But is this enough to stop raising interest rates? Our US economics team, albeit looking for the moderation of growth towards a more sustainable pace, does not think so. Indeed, inflation is still running well above the comfort zone, as the price index for personal consumption expenditures excluding food and energy increased at an annual rate of 2.9% in the second quarter, up from 2.1% in the first quarter. Moreover, especially with deteriorating productivity growth, unit labour costs increased by 3.4% year on year, following a 2.2% rise in the first quarter. In our view, all these gauges suggest the broadening of inflation pressures, even as the US economy slows at a marked pace, and therefore may justify further ‘fine-tuning’ of monetary conditions. Israel is experiencing a similar cycle, as both growth and inflation have risen to their peak. Israel’s consumer price index posted an annualised increase of 2.3% in the second quarter of the year, down from 3.1% in the previous period. However, the year-on-year inflation rate still stands, at 3.5%, above the upper bound of the central bank’s target range. Furthermore, the CPI excluding the dollar-linked housing component accelerated from 3.1% in the first three months to 3.8% in the second quarter. This is not a surprising result, since the shekel’s appreciation against the dollar was the key factor stabilising inflation rates in the past couple of months. Even though favourable base effects will lead to a drop in annual inflation in the remainder of this summer, the shekel’s undervaluation is not enough to dismiss inflation pressures arising from the sustained narrowing of the output gap, in our view. Of course, the escalation of hostilities now strains the economy, especially through hurting consumer and business sentiment, and is likely to lead to a slowdown, depending on the extent and duration of military campaigns. Still, the risk of contraction is extremely low and the current pace of demand expansion may require a further adjustment in interest rates. The normalisation of monetary conditions is good news, not a threat to the economy. The difference between short-term interest rates in Israel and the US is not the best measure of risk premium, but still provides an interesting background. On average, this ‘gap’ was 810bp in the 1990s and then declined to 165bp by the end of 2004. And last year it disappeared altogether for the first time, even becoming ‘negative’ for a week or two. In our opinion, this is not really a mystery, but a secular result of fiscal consolidation, structural reforms and an undervalued exchange rate. Still, such an exciting convergence of interest rates might lead to serious challenges, especially when Israel faces military shocks and the current level of short-term interest rates is just above the level of neutrality. This is why even though our call for further tightening of the monetary policy stance has long been based on macroeconomic factors, not geopolitical speculations, managing the risks associated with exogenous developments requires an additional cushion.
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Reality Check - Is Japan OK?
Aug 02, 2006
Robert Alan Feldman (Tokyo)
The negative case: Investment It is possible to make a case that Japanese fundamentals are weakening. This case is based on a number of indicators that recently suggest softness or a lack of continuity in policy. The first set of data on the negative side relate to the shining star of recovery so far, business investment. The growth rate of capex in the national accounts has zigzagged downward since hitting the peak in 1Q05. The August 11 announcement of preliminary figures for 2Q06 will be a key test of whether the decelerating path continues. A growth rate at less than the 1.6% Q/Q in our forecast would imply a deceleration of the Y/Y growth rate below 6.5%, and hence further evidence of zigzagged deceleration. A second concern is the momentum of increase in return on assets (RoA). In 2004, the smoothed RoA for all industries in the Ministry of Finance’s corporate statistics rose by about 0.2%-pts per quarter. In 2005, it rose by about 0.1%-pts per quarter. In 1Q06, however, the rise was only 0.06%, suggesting a further slowdown. The September 4 release of data for 2Q06 will be key in looking at this factor. So long as recurring profits grow by about 10%Y/Y, the pace of RoA improvement over the last year will be maintained. The final two worries on capex concern dispersion among industries. First, manufacturing firms have done better than non-manufacturers; indeed, while margins at the former rose from 5.1% to 5.4% in the four quarters to 1Q06, those at non-manufacturers have stalled at 3.2%. Second, small firms continue to lag. While RoAs at large firms have surged more than one standard deviation above their pre-1990 average, RoAs at small firms remain at about 0.4 standard deviations below their pre-1990 average. Moreover, machinery orders through agencies — an indicator of small firm capex — are barely above the average of Y325 billion/quarter of 2003. Finally, there has been a small upturn in bankruptcies, another indicator of the health of small firms. Unless upcoming data suggest more convergence between manufacturing and non-manufacturing, and between large and small firms, then worries about capex sustainability will persist, in my view. Consumption worries too A frequent worry heard from investors concerns the course of consumption. A common view is that Japanese growth is not sustainable unless consumption takes over from investment as the leading source of demand growth. Some of the data are not at all encouraging. The biggest shock comes from the consumption and disposable income data from the Household Survey. Both have been worsening persistently over the last few quarters, with nominal consumption down by 3.0% in 2Q06 and disposable income down by 3.6%. Sampling problems with these data are well known, but the trend is nevertheless worrying. Although not nearly as bad, sales at large-scale stores have remained persistently negative, despite the upward move of aggregate consumer prices. A promising rise of department store sales figures into positive growth has now been reversed. Even convenience store sales remain sluggish. Outside stores, growth of travel bookings has been patchy this year, after positive Y/Y growth in every month of 2005. Housing starts data are also a source of concern. Although overall housing starts are up by about 9%Y/Y in recent figures, owner-occupied housing starts are only up about 2%. Domestic auto registrations have been notoriously weak, down by 4.6%Y/Y in 2Q06, in part due to the continued rise of gasoline prices, by 8% in 2Q06. The policy context Another fear voiced by investors is that the era of reform may be over, as PM Koizumi steps down in September. Some signs are indeed worrying. For example, one of PM Koizumi’s ideas for tax reform has been to de-link gasoline and road use taxes from road building usage, and put these tax funds into general revenues. However, while PM Koizumi was visiting the US recently, the LDP committee dealing with the issue decided to postpone a decision until after PM Koizumi leaves office. Aggressive enforcement actions in the financial sector and egregious leaks of information are taken by some observers as signs that the old system is coming back. Moreover, PM Koizumi’s presumed successor, Cabinet Secretary Shinzo Abe, is an unknown quantity in terms of economic policy. While his statements in magazines and his recent books suggest an economic philosophy very similar to PM Koizumi’s, major tests lie ahead, such as whether Abe will actually win the race to succeed Koizumi, the appointments to the Cabinet, and actions to curb bureaucratic foot-dragging. Global concerns The global economy is another source of worry. The weak US GDP growth figure for 2Q06 will intensify worries that a US slowdown could harm Japan, both directly through exports to the US and indirectly through a slowdown on Chinese exports to the US that echoes onto Japanese exports to China. Oil prices remain a major worry, as does global investment sentiment in the face of continued wars in the Middle East. The positive case: Look more broadly It is easy to make a negative case if one dwells only on adverse data, as above. However, a balanced judgment must be based on a broader data set. For business investment, the forward-looking indicators are positive. The Bank of Japan’s quarter survey, the Tankan, has shown strong plans for investment by firms. Standard indicators of the investment outlook also look good. Overall machinery orders, for example, continue to do very well, in both manufacturing and non-manufacturing areas. The operating rate in manufacturing stands at 10-year highs, and the BoJ Tankan reports that both large and medium-size firms feel a shortage of capacity for the first time since 1992. The pace of technology improvement remains high, implying that replacement of older capacity will have to be rapid. Moreover, accelerating M&A has meant that new investments are needed to reorganize firms. On consumption, indirect data tell a more positive story. True, the consumer sentiment survey blipped down in 2Q06, but remains higher that at any time since 1994 (except for 4Q05 and 1Q06). The downward blip in 2Q06 is likely attributable to equity prices, which have a very strong correlation with consumer sentiment. Moreover, the labor market continues to show improvements. The ratio of new job offers to new job seekers continues to rise, while the unemployment rate continues to fall. Despite adverse demographics, the labor force has been stable since mid-2003, indicating that workers are encouraged to re-enter the labor force. Finally, growth of wages per hour has risen into positive territory, as the BoJ Tankan diffusion index for labor markets shows tighter conditions. In the political realm, I remain optimistic, for several reasons. First, Cabinet Secretary Abe has articulated a clear economic philosophy, and is using a somewhat populist approach — not as populist as PM Koizumi, but clearly showing concern for those hurt by reform. His approach, however, is focused on helping people gain new skills rather than on welfare payments per se. Second, the anti-reform forces in the LDP have not been able to find a credible candidate to run against Abe. Third, the electoral threat from the opposition Democratic Party of Japan is serious enough that LDP infighting should be minimal. Still positive on Japan On balance, I remain positive on the outlook for Japan, despite the adverse case that can be built on selective use of adverse data. The capex outlook is strong on balance. Labor markets are strong enough to support consumption well, even as near-term data have weakened. Policy continuity is highly likely in an Abe government. And even global concerns are less troubling to Japan than to other countries.
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July Inflation in Line with Expectations
Aug 02, 2006
Deyi Tan (Singapore)
July inflation came in at 15.2%YoY, marginally higher than our expectation of 15.1% but lower than the market expectation of 15.3%. On a sequential basis, prices rose 0.5%MoM, unchanged from June. Meanwhile, core inflation also stabilised at 9.6%YoY (versus 9.6% in June). Inflation deceleration evident in most segments. Most segments saw decelerating inflation. However, this was most significant in the food segment (+15.8%YoY versus +17.0% in June) with the contribution (+3.7%-pt versus +3.9%-pt in June) from the food segment accounting for most of the inflation decline we see in July. Transport price inflation remained stable at 30.8%YoY. Meanwhile, other segments such as processed food (+11.6% versus +11.7% in June), housing (+12.7% versus +12.8%), clothing (+9.6% versus +9.8%), healthcare (+7.0% versus +7.3%) and education (+7.7% versus +8.0%) saw milder price pressures. Inflation trajectory in line with expectations so far. The inflation data that has panned out so far are in line with our expected trajectory. For August, we look for inflation to come down to the neighbourhood of 14% before falling into single-digit territory by October. 25bp or 50bp of cuts on August 8? The further moderation in inflation opens up grounds for rates to be cut on growth concerns on a more aggressive basis in 50bp steps instead of the usual 25bp. We believe that currency stability remains the central bank’s key concern. Currency movements have been favourable so far. However, amid the uncertainty surrounding the fed funds rate decisions, we believe that Bank Indonesia would likely choose to err on the side of caution at this point by cutting in 25bp steps instead of having to risk credibility from potential future reversals in taking 50bp cuts.
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July Inflation Dropped on Base Effects
Aug 02, 2006
Deyi Tan (Thailand)
July inflation dropped markedly to 4.4% YoY (versus +5.9% YoY in June) as the impact from the complete rolling back of fuel subsidies kicked in last July. This was below market expectations of 4.6% YoY. When base effects affect headline YoY% significantly, sequential numbers provide a better picture of inflationary pressures. On that front, the inflationary picture still remained subdued at 0.2% MoM (versus +0% last year). Meanwhile, core inflation also fell to 2.0% from 2.7% previously. On a sequential MoM basis, core inflation is flat. Prices in transport segment edged down on base effects. In terms of the specifics, as we mentioned previously, prices in the transportation segment rose a base-affected 8.3% YoY (versus +13.9% YoY in June) and accounted for most of the deceleration we see in July. Nonetheless, the deceleration is also mirrored in other segments but to a lesser degree. Food prices rose 4.2% YoY (versus +4.6% YoY in June). Housing inflation came off slightly to 2.3%. Meanwhile, price rises in clothing (+0.3%), healthcare (+1.5%), recreation & education (+0.9%) and tobacco & alcoholic beverages (+9.9% YoY) were sustained at their June pace. Monetary policy implications. We believe that the latest data on the inflation front likely support the government’s stance to keep rates at 5%, which it deems as a level that is appropriate for economic stability and supporting sustainable growth in the long run.
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