A Higher Inflation Objective?
Aug 11, 2006
Richard Berner (New York)
The Fed is not an inflation-targeting central bank and has yet to articulate a “numerical objective for price stability.” Yet it’s widely accepted that Fed officials implicitly aim at core inflation measured by the personal consumption price index (PCEPI) excluding food and energy in a range of 1-2%. Then-Governor Ben Bernanke articulated the case for this range, or “comfort zone,” early in 2003. He argued that it was low enough to ensure policy credibility, but high enough to allow a cushion both for disinflationary shocks and measurement bias (see “‘Constrained Discretion’ and Monetary Policy,” remarks before the Money Marketeers of New York University, February 3, 2003). Based on the experience of the 1980s and 1990s, such a range seemed a reasonable working goal, and other Fed officials at least tacitly agreed. This implicit objective got further support as recently as this February, when the Fed agreed to a “central tendency” projection for inflation in 2007 of 1¾-2% — a projection that Fed watchers largely viewed as an implicit target.
That was then. Now, I think that the Fed may implicitly be choosing a slightly higher inflation objective than previously thought — perhaps 1½-2½%. The reasons: The cost of reducing inflation seems to have increased, and the current presumed 1-2% “comfort zone” may leave too little margin for error and for disinflationary shocks. Now, choosing a higher inflation objective need not undermine policy credibility; after all, no economic research I’m aware of has demonstrated that a slightly higher numerical objective for price stability leads to worse overall economic outcomes. Indeed, I will argue in what follows that it could improve them. Moreover, the “Bernanke comfort zone” is only a de facto target range. While many at the Fed have expressed support for a numerical objective for monetary policy, no specific proposal is yet on the table. But if market participants have assumed that the Fed’s reaction function includes such a target, and if an implicit change is afoot, it will have significant implications for monetary policy, for the economy and for global financial markets. Let’s look at the two-part rationale for such a change that I sketched above. The first part derives from the apparent increase in the “cost” of reducing inflation. Many central bankers and economists agree that the so-called Phillips Curve, which relates inflation to slack in the economy, has flattened in recent years (for a good summary of this new orthodoxy, see W. Melick and G. Galati, “The Evolving Inflation Process: An Overview,” BIS Working Paper 196, February 2006). Courtesy perhaps of good monetary policy and other factors like globalization, the steady drop in the jobless rate and rise in operating rates hasn’t pushed up inflation by as much as it might have in the past when that curve was steeper. That’s a double-edged sword, however; it means that officials may have to tolerate a longer period of below-trend growth and a bigger rise in joblessness to get inflation back down again. If valid, the flatter Phillips Curve theory means that the cost of reducing inflation once it goes up — the “sacrifice ratio” — is likely higher than before. Of course, in theory, such a change by itself is no reason to prefer a higher inflation objective; Milton Friedman taught central bankers in 1968 that there was no long-run benefit to cheat in favor of extra output by tolerating permanently higher inflation. A flatter Phillips Curve (in the short run, of course) and a higher sacrifice ratio in isolation simply mean that policymakers may have to tolerate a cyclical overshoot in inflation for longer in order to spread that cost out over time. Investors could view the Fed’s forecast of 2-2¼% core PCEPI inflation over the four quarters of 2007 as a reflection of that temporary tolerance. In support of the new 2007 inflation projection as a forecast and not a new target, Chairman Bernanke asserted at his semi-annual monetary policy report to Congress in June that inflation should be back in the comfort zone in 2008. So why do I think the higher cost may be part of the rationale for a higher inflation objective? Partly because in practice the Fed is ironically a victim of its own success: Inflation is still relatively low, and at a 2½% rate of inflation the Fed will find it hard to explain to Congress and the public why it should put a million people out of work for two years to reduce inflation by half a point. But there is a second, more important part to the rationale for a higher inflation objective. I suspect that officials aren’t certain any longer that the current comfort zone allows sufficient margin for error and for any shock that would push inflation lower. To begin, most inflation gauges still have some upward bias, though it’s not clear how much (see “Will the Real Core Inflation Measure Please Stand Up?” Global Economic Forum, July 7, 2006). As a result, actual inflation may be 20-60 bp lower than today’s indexes suggest, and one of them — the “market-based” PCEPI — puts core inflation at 2%. So actual inflation could be lower. Policy actions aimed today at bringing inflation down by 2008 could result in a downside overshoot, just as the actions in 2002-03 are partly responsible for today’s overshoot to the upside. And if such “unwelcome” declines in inflation materialize, policymakers could face the threat of the “zero bound” — inflation falling lower than nominal interest rates, which cannot go below zero, would inadvertently make policy restrictive. That “zero bound” for rates is why central banks should never choose zero as the lower bound for an inflation objective. Together, these factors legitimize the argument that the appropriate long-term target could be 2% and the monitoring range around it could be +/- 50 bp. In fact, the interplay between these two factors is important. If the relationship between inflation and slack in the economy was more potent, the cost of correcting mistakes would be lower and it would be easier to sell the public on lower inflation. But because that’s likely not the case, and because policymakers suspect they need a bigger cushion against downside risks, they may have trouble selling themselves on the idea that the target should be 1-2% — at least not until they have thoroughly vetted all these issues. Tactically, therefore, the Fed may be less inclined to reduce inflation from current levels than we or market participants presume. And as I see it, given the lack of resolution on these important issues, a numerical objective for inflation, much less inflation targeting, now seems less likely than when Ben Bernanke became Fed Chairman. All this is a little bit of déjà vu. Alan Greenspan famously refused to put a number on price stability, preferring to define it as that rate of inflation at which inflation no longer entered into corporate or household decision-making. He argued that price measurement was too imprecise and changeable to define it numerically. When then-Fed Governor Janet Yellen pressed Greenspan for a number in a July 1996 FOMC meeting, Greenspan admitted that 2% might be the right rate by current measures. He might be proved prescient. The implications for financial markets of these developments are significant. First, the discussion illustrates the current lack of clarity on what exactly is the goal and what are the means to achieve it. One consequence: We and market participants may be misreading the Fed, but for different reasons. In our view, even if the Fed decides not to raise rates further, it will likely stay restrictive longer to bring inflation down. In contrast, many market participants believe the Fed will soon be forced to rescue a faltering economy by easing. But both of these views could prove wrong if policymakers are revising inflation preferences higher. And if those objectives are now also more uncertain, term premiums should rise, the yield curve should steepen further, TIPS should still be attractive, and the dollar should weaken. Make no mistake: There’s nothing wrong with defining price stability as a higher objective than 1-2%. But the goal and the (conditional) policy response to get there must be clear. That’s not some abstract idea; most observers hunger for consistent straight talk from the Fed about the goal and the strategy for getting there. The risk for policy is that it could allow “base drift” — the tendency to let bygones be bygones — infect the policy process. The parallel risk for markets is that any re-rating of Fed preferences might swing abruptly, adding to market volatility.
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One More Rate Rise Likely
Aug 11, 2006
Melanie Baker (London) and David Miles (London)
Following the Bank of England’s rate rise at the beginning of August, its recent quarterly Inflation Report gave us more detail on the rationale for that move. All in all, the Bank of England’s (BoE) August Inflation Report and press conference were consistent with expecting one more rate rise from the BoE. Our central expectation is that interest rates are raised 25bp to 5.0% in 4Q06 (although with a significant chance that this occurs slightly later, in 1Q07). The BoE’s new inflation forecasts were consistent with its decision to raise rates in August. It raised its inflation profile, particularly in the near term (in large part because a 0.25pp upward effect from university tuition fees is included). However, at the two-year horizon, the BoE’s inflation forecast is only very slightly higher than it was in May (and the BoE has already effectively raised rates in response to this). The central forecast looks close to the target at the two-year horizon. That forecast incorporates a ‘market profile’ for rates which has them rising to 5.0% over the next year or so. Hence, expecting one more rate rise from the BoE is consistent with the BoE’s central forecast of inflation roughly at the 2% target at the two-year horizon. Inflation ‘volatile’ in coming months, with 50-50 chance of writing a letter to the Chancellor. The BoE’s forecasts showed inflation close to the 2.0% target at the two-year horizon (the important horizon in terms of the interest rate outlook). However, the profile shows CPI inflation very close to 3.0% at around the end of this year to the beginning of next year. Once inflation moves more than 1pp above the target (which has yet to happen in the period since Bank of England independence) the BoE governor must write a letter to the chancellor. In the press conference, Governor King suggested that the probability of this happening around the turn of the year was around 50-50. In general, the Report and the press conference stressed that there was a great deal of uncertainty regarding the near-term inflation outlook (not least from the fact that the ONS has yet to decide how it will incorporate changes in university tuition fees into CPI inflation). Nothing so far suggests that another rate rise is imminent. This is particularly so given the market interest rate profile ‘priced in’ to the BoE’s central forecasts, where inflation returns to target at the two-year horizon with a full 5.0% base rate only incorporated by 2Q08. Since the Inflation Report forecasts were formulated, interest rate expectations have risen further (following the rise in base rates) and several other asset prices have moved too. This of course means that if the MPC were to repeat the forecasting exercise now, the forecasts would look slightly different (perhaps with the central expectation of inflation declining more quickly to the target). The MPC minutes (released on August 16), where attention would have been focused on the immediate rate decision, should give us a few more clues about how far away another rate rise might be. A split vote? With Bank of England communications there is always a risk of reading far too much between the lines, but we would suggest that the somewhat ‘defensive’ tone of the press conference may reflect a split vote for the recent rate rise. However, the Inflation Report was missing the sentence that has appeared in several recent reports when discussing risks to the inflation and growth outlook that “there is a range of views among members”. We will find out next week with the publication of the Minutes. Overseas growth may disappoint the BoE. The BoE’s growth forecasts are slightly stronger than those in the May Inflation Report and look somewhat stronger than our own numbers. One particular area where the BoE may be disappointed is overseas growth, where it expects a continued rebalancing in world growth from the US towards the euro area over the “early part” of its forecast period (broadly beneficial for UK export growth). Morgan Stanley’s own forecasts show euro area growth slowing rather sharply from the beginning of next year. Bottom line. This report is consistent with our long-held view that a neutral (non-accommodative, but not restrictive) level of rates in the UK is around 5% and that this is where we should expect policy to move over the next few months.
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The Death of Doha
Aug 11, 2006
Serhan Cevik (London)
Trade talks reached an impasse, threatening the future of multilateral arrangements. After going through several breakdowns, five years of multilateral negotiations seeking to make global trade freer reached an unfortunate impasse, as 149 members of the World Trade Organisation could not find the middle ground. Our chief economist, Stephen Roach, argues that the failure to reach agreement in the Doha round would not hinder the expansion of world trade and therefore does not really matter for the global economy (see Doha Doesn’t Matter, August 4, 2006). However, even though the collapse of the so-called ‘development round’ may not be necessarily the end of trade negotiations and is certainly not the end of globalisation, it is still a real disappointment on one of the most neglected aspects of world trade — agriculture — and for the world’s poor. While the global economy has benefited from greater openness and growing trade in manufacturing and services, trade-distorting practices in farming sectors in the rich ‘West’ have kept less-developed countries off the world’s markets. Furthermore, an absolute disagreement on the next stage of global integration would threaten the future of multilateral talks and could indeed lead to fragmentation under intensifying protectionist tendencies. The stalemate is a result of disputes over agricultural tariffs and subsidies. Trade negotiations — a mix of high-level political manoeuvrings and perplexing technical aspects — always involves a lot of arm-twisting and horse-trading and even break down several times before producing a concrete agreement. For example, the Uruguay round dragged on for eight years, coming to the brink of collapse on a number occasions. Nevertheless, since these multilateral negotiations have strengthened the process of globalisation, the failure to bring the Doha round to a successful conclusion, especially because of special-interest politics, would make it difficult to maintain the momentum going forward. Although everybody was expecting a stand-off on the most contentious issue of liberalising farm trade, the timing could not have been worse. With looming elections in the US and Europe, political leaders are unwilling to upset farm lobbies that have a disproportionate political clout and become even more powerful ahead of elections. Indeed, the stalemate in the latest trade negotiations is mainly a result of disagreements over tariffs and subsidies on agricultural products in the developed world. Rich countries insist on maintaining tariffs to protect farm lobbies. OECD governments provided about US$280 billion in subsidies to the agriculture sector last year, accounting for approximately 30% of all farm receipts in these countries. If we just focus on truly industrialised countries excluding ‘emerging’ members like Korea, Mexico and Turkey, the ‘subsidy superpowers’ of the world actually raised the spending on agricultural support from an average of US$230 billion a year in the 1990s to US$240 billion in 2005. This is a staggering amount compared to the size of less-developed economies and curtails global trade. Trade-distorting subsidies in the rich world hurt the world’s poorest countries. Agriculture’s share in world trade has fallen steadily from 38.5% in the 1950s to about 7% in the early 2000s, representing a mere 4% of global GDP. However, it accounts for up to 60% of GDP and employs as much as 70% of the labour force in the poorest countries. This is why agricultural protectionism in the world’s rich countries hurts the developing nations and pushes a growing number of people into slums with limited capacity for income mobility (see Slum Farms, July 11, 2006). The effects of distortionary policies are clearly evident in international trade figures: first, the volume increase in agricultural trade in the post-war period has lagged behind the increase in manufactured goods (3.5% a year versus almost 10%); and second, agricultural exports of the rich nations have expanded far faster than those from less-developed countries. In our view, this should not be a surprise, since the pattern of import tariffs has been unfavourable to the developing world. According to the World Trade Organisation, the weighted average of import tariffs in developed countries on agricultural exports from less-developed countries actually doubled from 3.3% in 1990 to 6.6%, while tariffs on agricultural exports from the European Union declined from 7.9% to 4.6% in 2002. Greater integration with the global economy is the best chance for the world’s poor. Multilateral liberalisation lowered the average import tariff on manufactured goods from over 40% in the late 1940s to less than 5% today, leading to a 25 times increase in global trade flows. This dramatic growth, outstripping the rise in world GDP, has been one of the most important factors raising hundreds of millions out of poverty around the world. Unfortunately, a failure to liberalise farm trade would stall further integration in the global economy and deprive less-developed countries from the best chance to accelerate income growth and improve the political climate. By the way, reducing farm subsidies and eliminating protectionist barriers are not just altruistic behaviour to alleviate poverty, but also make economic sense for developed countries and can help addressing popular resentment in developing nations that has become a major risk for the whole world.
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Exports Are Still Strong
Aug 11, 2006
Andy Xie (Hong Kong)
Asian export data suggest that the global economy remains very strong, despite the skittish sentiment towards the US economy. The bottom line is that the global monetary environment is still highly stimulative, as global real policy rates are less than half of their historical norms. Inflationary pressure is on the rise. The export prices of China, Taiwan and Korea are accelerating. In addition to rising commodity prices, rising land and labor costs are feeding into export prices. This suggests that, without further tightening, the current trade boom is overstretched and will bring more inflation. I expect the current global cycle to come to an end with much more tightening. Big central banks, the Fed in particular, are reluctant to tighten and want the market to believe that inflation will drop off without further tightening. I believe that inflation will continue to accelerate and that the market will stop believing the Fed in the coming months. Global trade boom continues The current trade boom is the longest in history. Exports from Northeast Asia have been growing at near or above 20% since mid-2002. The cycle has lasted twice as long as the norm in the past. The combined exports of China, Taiwan and Korea grew by 20% YoY in July 2006, the same as at the start of the year. The trade growth in this cycle is just astonishing. The combined exports of China, Taiwan and Korea in July 2006 were 2.3 times those in July 2002, equating to annual growth of 24% over the four years. The value of China’s exports is now about 7% below that for the US. Even if global trade cools substantially in the coming months, China is likely to become a bigger exporter than the US in the next year. Global monetary environment is too stimulative There are many factors that have made the current trade boom so large. Globalization is one. However, loose monetary policies around the world are even more important. Deflationary shocks have kept the inflationary effect of the loose monetary policies in check. Emerging market crises, the tech bubble bursting, China’s accession to the WTO, and Japan’s banking reforms have been the main deflationary shocks. As the effects of these unique factors pass, the inflationary effect of the excess money supply is becoming apparent. Even though most central banks have been raising interest rates, their gradualist approach has kept real rates low, as inflation has been creeping up with interest rates. Hence, monetary tightening has been very limited so far. Current global policy rates are still below half of their historical norms. Because the monetary environment is still very stimulative, the global economy and trade are still very strong. The market has been jittery about the US economy in the past few weeks. Asian export data, however, still suggest a strong US economy. Inflation will keep accelerating The world has an inflation problem because the current stock of money is too high for price stability. Its inflationary effect was temporarily checked by deflationary shocks. As the deflationary shocks end, inflation will keep rising — unless central banks tighten sufficiently to decrease money supply. The Fed maintains that inflation will come down with a weaker economy and the base effect of oil inflation running out. I don’t buy this. Oil inflation simply reflects excess money supply fueling speculation. Without a decline in money supply, oil speculation is likely to continue. And, if the speculation in oil stops, other inflationary sources will replace it, in my view. The bottom line is that there is too much money in the world to be consistent with price stability. I suspect the Fed knows that inflation is picking up and is prepared to accept higher inflation. However, it wants the market to believe otherwise to prevent a wage-price spiral — i.e., it wants to engineer a one-time jump in price levels to avoid decreasing money supply. It may succeed. However, if the market sees through this ploy, I believe that the consequences could be catastrophic. The bond market could crash, and with it the global economy. Asian export prices are rising. This is not just about rising commodity prices. Rising labor and land costs and a weak dollar are contributing to rising prices. Trade has been a force keeping global inflation in check. This is no longer the case, though, and trade inflation could now lead global inflation. I believe that inflation is likely to surprise on the upside around the world. The risk to financial markets in coming weeks is that US inflation shocks on the upside and the market expects the Fed to hike again.
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Ideal Growth Pattern
Aug 11, 2006
Takehiro Sato (Tokyo)
Greater-than-expected deceleration, but domestic private demand continues to create ideal growth Headline real GDP growth in April-June was +0.2% QoQ (annualized +0.8%), weaker than our reading. However, this was still the sixth straight quarter of positive growth, and the details were also better than they appear, as domestic private demand remains the driver. The weaker headline re-confirms that economic momentum has continued its gradual deceleration since hitting a peak in October-December 2005. However, this mostly stems from public demand, net exports and residential investment, and personal consumption has held solid contrary to our forecast and the consensus outlook. Capex also continues to be robust, and it is becoming increasingly clear that domestic private demand is leading economic growth. For example, personal consumption rebounded unexpectedly by +0.5% QoQ over the +0.2 QoQ showing in January-March, although we had anticipated a slowdown due to bad weather and sampling problems in the Household Survey. Going forward, we believe that personal consumption will likely remain solid in light of structural improvement in the labor market. Also, capex appears to have made strong gains of +3.8% QoQ as pent-up demand from plans that were brought forward in the second half of the last fiscal year was released some time in the April-June quarter. Going forward, we expect infrastructure-related demand from telecommunications/energy and non-manufacturing industries to underpin capex, which is likely to remain the key driver of the economy. Meanwhile, the GDP deflator remains in negative YoY territory at -0.8%, but marginally improved over January-March’s -1.2% level. The major downside factor was strong growth for the import deflator, reflecting high crude oil prices, but the domestic demand deflator posted the first positive YoY growth of +0.1% in eight years since January-March 1998. The public and residential investment deflators continue along a growth path, while the personal consumption and capex deflators have just about stopped falling. In July-September, we think that crude oil price hikes will likely spur the import deflator to continue rising, which would in turn maintain downward pressure on the GDP deflator. However, our house view is for a major decline in crude oil prices through the second half of 2007, and with continued improvement in the domestic demand deflator ahead, we still look for the GDP deflator in F2007 to return to a positive level, the first such occurrence since 1997 (reversing the switch in positions of the real & nominal GDP). Furthermore, with the positive QoQ showing by the GDP deflator, nominal growth of +0.3% QoQ outpaced real growth. Thus, on QoQ comparisons, the switch in nominal/real GDP growth seems to have already reversed. The market is currently fretting that persistently high energy/raw materials prices and the US economic slowdown will tug Japan into a soft patch reminiscent of the latter half of 2004. However, this seems unlikely, in our view, as (1) the labor market is tightening due to structural factors, and (2) the asset market and prices, both barometers of the economy, have improved remarkably since 2004. Although concerns remain over a US slowdown and external demand, the Japanese economy is well-buffered to negative demand shocks, and we think economic momentum in July-September onward should continue to be firm, stemming primarily from domestic private demand. Policy implications The rebound in the domestic demand deflator and the marginal reversal in the switch between nominal/real GDP growth leave open the possibility of a declaration of an escape from deflation as the swansong for PM Koizumi. However, this will likely be a non-event for the economy and markets, as such a declaration is really only a formality, and a far cry from the declaration last year of the escape from the soft patch. Meanwhile, assuming the 1.5% potential output growth rate, today’s GDP data is a slight headwind for the BoJ due to the expansion of the deflation gap. Thus, we maintain our main scenario of a January rate hike after the December Tankan, instead of November after the October Outlook Report. At the same time, however, there is a tailwind for the BoJ as well: partly from the possible delay of the consumption tax rate hike thanks to the rebound of the fiscal situation, and partly from the weakening of the yen on a real effective base. Going forward, the BoJ is likely to continue a measured pace of rate hikes regardless of tightening measures by the US. Market implications The stock market is firming as expected, due to better-than-expected corporate profits in April-June. In light of brisk domestic demand, we look for further upward forecast revisions in the medium term, even in the midst of energy and raw materials price hikes. For the long term, we think recurring profit growth will still continue in double-digits. As indicated by our strategist, we also think that a return-reversal effect is likely in the market, with TOPIX heading toward 1,700. Meanwhile, the bond market has digested almost all the negative news by the lifting of the zero rate policy in July, as expected. The BoJ, however, has a tailwind despite the slowdown in the economy as mentioned above, and the long-term yield is likely to edge higher to 2%+ towards autumn, when the market expects earlier additional rate hikes.
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