Another Post-Bubble Shakeout
Aug 25, 2006

Stephen Roach (New York)


Five and a half years ago the equity bubble popped.  Within six months, the US economy went into mild recession, and the global economy was quick to follow.  Today, America’s housing bubble is finally bursting.  Is the die cast for another bubble-induced downturn in the US and global economy?

All asset bubbles are alike.  Sure, there are obvious differences between equities -- a financial asset -- and homes -- a tangible asset.  But to me, the Shiller definition says it all: A bubble is an outgrowth of powerful amplification mechanisms -- both real and psychological -- which create an unsustainable condition whereby “… price increases beget further price increases” (see Robert Shiller’s Irrational Exuberance, second edition, Princeton University Press, 2005).  The rise and fall of the US housing market fits the Shiller script to a tee.  House price appreciation surged to a 27-year high in 2005, and as of the first quarter of 2006, prices were still rising by 20% or higher in 53 metropolitan areas across the United States.  Both pricing and demand were feeding on each other through classic Shiller-like amplification mechanisms. 

As always, the upside of a speculative bubble lasts for longer than you think.  But when it finally goes, it invariably unwinds with greater force than widely expected.  That seems to be the way the chips are now falling in the US housing market.  Demand for homes is falling like a stone and inventories of unsold dwellings are ballooning -- up 40% for existing homes and 22% for new homes in the 12 months ending July.  These are the classic quantity adjustments that set the stage for price destruction -- the endgame of any asset bubble.  So far, home values just seem to be leveling off at still lofty price points.  As the bid-offer gap widens in an excess inventory and rising interest rate climate, price declines will come as they always do.  This bubble is not different.

Construction activity is the last shoe to fall in a housing downturn.  Due to sunk fixed costs of land and property acquisition by developers, homebuilding typically continues into the inventory overhang phase of the cycle.  Such is the case today -- with residential construction activity still holding at relatively high levels through mid-2006.  However, once this last gasp of project completions runs its course, the construction downturn should gather force.  Given the magnitude of the current inventory overhang, the downside of the building cycle could be both deep and prolonged -- lasting possibly a couple of years and entailing peak-to-trough declines of at least 25%.  For a sector that boosted US real GDP growth by about 0.5 percentage point per annum over the past three years, it is now poised to subtract about one percentage point per annum over the next couple of years -- a swing of 1.5 percentage points off the overall US growth rate.

Of course, the construction impact is only part of the story.  There is also the wealth effect from the housing bubble to consider.  Since the dawn of the Asset Economy in 1995, growth in real disposable personal income accounted for only about 85% of the cumulative growth in personal consumption expenditures.  The balance came from wealth effects of a seemingly endless string of asset bubbles -- first equities, then property.  The property-based wealth effect became especially important in driving consumer demand in recent years.  Over the 2004-05 period, real personal consumption grew at a 3.7% average annual rate -- more than 50% faster than the 2.4% average annual gains in real disposable personal income over the same period.  The gap between household incomes and spending is traceable to the extraction of equity from an increasingly frothy housing market.  According to Federal Reserve estimates, mortgage equity withdrawal exceeded $700 billion (annualized) in the first half of 2006 -- more than enough to provide an “extra” stimulus to consumer demand as well as to provide a substitute for income-based saving.  In the frothy house price climate of the past five years, the property-based wealth effect probably boosted growth in total consumer demand by at least 0.5 percentage point per year.  In a stable to falling home price climate, that impetus could fade quickly to zero -- and possibly go into negative territory if saving-strapped American households elect to start saving out of labor income again. 

All in all, a post-housing bubble shakeout could entail a haircut of at least two percentage points off the overall US GDP growth rate -- 1.5 percentage points via the construction effect and another 0.5 percentage point from the wealth effect.  The overall impact could even be larger if households elect to rebuild income-based saving balances -- hardly unusual in light of the looming retirement of some 77 million baby-boomers.  The repercussions of multiplier effects through construction-related hiring shortfalls could also compound the problem.  For a US economy that has been growing at a 3.2% average annual rate over the past three years, a two percentage point haircut does not guarantee a recession.  But it certainly could end up being a close-enough call that might trigger a recession scare in financial markets.  The hope, of course, is for the exquisitely well-timed handoff -- a seamless transition from asset-dependent consumption to other sectors, such as capex and net exports.  I remain suspicious of such claims of built-in resilience.  If the US consumer slows, the demand expectations that typically drive capital spending will also weaken.  So, too, will the growth dynamic of America’s export-led trading partners -- thereby undermining support for US exports, as well.  In short, for a wealth-dependent US economy, the bursting of another major asset bubble is likely to be a very big deal. 

It is also likely to be a big deal for an unbalanced global economy.  In 2000, when the equity bubble burst, the gap between current account surpluses and deficits was less than 4% of world GDP.  This year, as the housing bubble bursts, that same gap is likely to be around 6% of world GDP.  The disparity between current account surpluses and deficits -- and the added point that the US accounts for about 70% of all the deficits in the world -- underscores the increased dependence of the rest of the world on the US.  For that reason, alone, a bursting of the property bubble poses equally serious risks for America’s key trading partners and for the rest of an increasingly integrated global economy. 

Ironically, at just the moment when it has become evident that the US housing bubble has burst, the key architects of this sad state of affairs -- America's central bankers -- are cavorting at their annual retreat in Jackson Hole, Wyoming.  Denial has long been deep at this Fed love-fest.  A year ago at this same conference, considerable adulation was heaped on the post-bubble legacy of the Greenspan Fed -- namely, that the US central bank was correct in dealing with the equity bubble after the fact (see Alan Blinder and Ricardo Reis, “Understanding the Greenspan Standard” available at  This, of course, is consistent with Greenspan’s own self-professed verdict of vindication for the Fed’s post-bubble clean-up strategy (see his January 3, 2004 speech, “Risk and Uncertainty in Monetary Policy”) as well as a similar argument presented at an earlier Jackson Hole gathering by then Princeton professor Ben Bernanke (see the 1999 paper by Ben Bernanke and Mark Gertler, “Monetary Policy and Asset Price Volatility”).  Missing in this self-serving depiction is an assessment of the consequences of aggressive post-bubble monetary easing tactics.  The injection of excess liquidity is key in that regard -- sufficient in the current instance for one bubble to beget the next.  In that important respect, the housing bubble was a direct outgrowth of the Fed's post-equity bubble defense strategy.  And now the US, as well as a US-centric world economy, must come to grips with what its central bank has wrought -- yet another post-bubble shakeout.

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Is Potential Growth Downshifting?
Aug 25, 2006

Richard Berner (New York)

The US economy’s potential growth rate rose significantly over the past decade, fueled largely by an improvement in underlying productivity growth.  Labor productivity in the past ten years nearly doubled to 2.8% from 1.5% in the previous decade.  The so-called US productivity “miracle” helped restrain inflation, boost returns on investment, and fuel rising living standards — at least in the aggregate. 

Previously, I argued that a coming slowdown in productivity growth would be entirely cyclical as employment gains caught up with the pace of economic activity (see “The Coming Productivity Undershoot,” Global Economic Forum, March 20, 2006).  That may now be changing.  While I remain a productivity bull, I’m more concerned about the downside risks to potential growth.  Rethinking the secular or longer-term forces affecting the trend has me worried that the trend in productivity has slowed somewhat and will continue to do so, and demographics are turning a little less favorable for potential growth.  Although I think any such changes will be small — perhaps reducing the medium-term trend in potential output by 25 basis points — they would have important implications for inflation, monetary policy, and financial markets. 

My concerns about potential growth do not simply reflect the recent downward revision to measured output and productivity growth over the past three years.  That recasting of the data, which shows about 0.3% less annual growth in both output and output per hour worked, still left nonfarm productivity growth at a hearty 3% over 2003-2005 — a rate that might still be consistent with a 2½%-plus trend.  Nor does my fretting reflect the 1.5 percentage-point decline in the unemployment rate since early 2003, although some conclude using one rule of thumb that potential growth could be 2½% or less.  I think the slow growth of labor supply in this expansion has altered such cyclical rules of thumb, as many who entered labor markets in the late 1990s have exited, bringing participation rates down and tightening labor markets (see “Will Labor Markets Tighten Further?” Global Economic Forum, April 3, 2006).

Instead, my concerns center on three forces that might have begun to reduce the trend in potential growth: First, the slow recovery in business investment might have limited the rate of ‘capital deepening’ that played a key role in boosting productivity growth in the 1990s.  The recent downward revisions to GDP were concentrated in real growth in equipment and software outlays, thus reducing perceived additions to the productive capital stock.  The revised data show that such outlays ran at an average annual rate of 7.3% during 2003-2005, or 250 basis points below what the previous data indicated.  While corporate capital discipline was needed to reverse the excesses of the bubble years, these recast data show that spending has bordered on shortage. 

Second, the jump in energy prices might have made energy-intensive capital obsolete, in turn curbing productivity gains as occurred in the 1970s.  Now, in my view we’re not revisiting the stagflationary ‘70s; many factors crushed productivity growth in that dismal period.  Unlike three decades ago, much of the rise in energy prices in the past five years has been the product of booming global demand rather than shocks to supply.  And the recent increase was smaller and more gradual than those shock-induced spikes that followed a long period of stable energy prices.  Still, the recent change in relative prices may have created some dislocations in the US economy that are playing out in modestly lower productivity growth.

Finally, labor force growth has begun to level off.  Over the past decade, growth in the working-age population has cooled to an annual rate of 1.2 percent.  In contrast, when the first baby boomers entered the work force in the 1970s, they propelled growth in the working age population to a rate of 2% percent.  Their children are just attaining working age, but they are less numerous, and immigration appears to be slowing.  Thus, demographers project a further deceleration. 

In addition, the labor force participation rate has declined by 1.1 percentage points from its peak six and a half years ago, following a four-decade-long uptrend.  At work are three significant structural changes (see “Are Labor Markets Tight?” Global Economic Forum, July 22, 2005).  First, the aging of the population is shifting the composition of the labor force to those who have had lower participation rates.  Second, the long upswing in female labor-force entry began to abate in the late 1980s and ended in the late 1990s.  Many women are apparently deciding to leave the labor force to start families or to spend more time with their children.  Third, teenage labor-force participation has been in decline for nearly 30 years as teens put more emphasis on school, both in the summer months and during the school year.  None of these three factors reducing the labor force is likely to change. 

Separating these new secular developments from cyclical evolution is difficult.  Indeed, I still believe that some proportion of these developments is cyclical and thus may not limit potential growth.  For example, I strongly believe that corporate capital discipline over the last several years has limited gains in capital spending as managers sought to purge the spending excesses of the 1990s and boost returns on capital.  The implication in this underperformance is that there is pent-up demand for investment, that the capital spending revival has a long way to go, and that capital deepening will sustain productivity gains.  Likewise, while energy prices soared by 150% over the past five years, the rise has been sufficiently gradual so that businesses were able to adapt and cut costs elsewhere.  Moreover, the increase in the relative price of energy should spur new, more energy-efficient investment that will renew efficiency gains and add to energy supply.  Finally, the slowing in labor force growth has had a cyclical element, and both faster pay and the need to work longer could lift it. 

But the possibility that these developments are more lasting cannot be dismissed.  The pent-up investment demand could be deferred if business conditions turn sour.  The adaptation to higher energy prices may stretch out over many years.  And the labor-force developments may be less responsive to wages and longevity and more deeply rooted in demographic changes and work force quality than I had thought. 

If valid, the implications of this darker view are clear.  Lower potential growth, if not recognized, could boost inflation.  Lower trend productivity gains imply faster growth in “normalized” unit costs, especially if labor markets remain firm.  And lower potential growth, both retrospectively and prospectively, implies that there is less slack in the economy, which may pressure resource utilization, bolster pricing power, and reinforce the rise in inflation underway. 

Of course, if the Fed recognizes the downshift in potential growth, inflation need not rise.  But there are challenges on both sides.  Assuming that productivity trends are intact when in fact they’ve changed would risk cheating in favor of extra output and, in turn, possibly lead to higher inflation.  Conversely, assuming a downshift in productivity growth that hasn’t occurred risks putting people out of work and depriving them of work experience that could nurture skills and productivity.  Likewise, it risks reining in needed investment that would produce efficiency gains.  Since these trends aren’t clear, the classic risk-management approach to policy dictates both gradualism and willingness to reverse mistakes.

These developments also pose challenges for financial markets.  Secularly, as I see it, neither lower potential growth nor lower trend productivity gains are in the price for stock or bond markets.  And many market participants are now assuming that policymakers will succeed in capping inflation smoothly without undue harm to the economy.  That certainly is the goal of every policymaker at the Kansas City Fed’s annual symposium in the mountains of Wyoming.  Given the uncertainty over changing economic structure, the path to achieving it may be bumpier than market participants expect.

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ECB Forecasts - What For?
Aug 25, 2006

Elga Bartsch (London)

Conclusion: The chances of another ECB rate hike at the upcoming meeting on August 3 are very slim, in our view. But along with the markets we will be watching out for the ‘vigilance terminology’ to re-appear in the introductory statement to the press conference which will follow the Council meeting this coming week and which would then be seen as paving the way for another rate hike at the October meeting.

What’s new: This coming week the ECB will also release revised macroeconomic forecasts. In the light of the stronger-than-expected second quarter GDP figures and the likely upward revisions to past data, it seems probable to us that the ECB will revise up its staff projections for real GDP growth and possibly also for HICP inflation in the euro area.  Unfortunately, the ECB’s forecasts have only played a minor role in the bank’s communication strategy in the past.

Implications: In my view, the ECB Council should consider complementing the model-based projections of the ECB staff with a survey of the personal forecasts of ECB Council Members. By publishing a canvass of Council Members’ conjectures, the ECB would enhance markets’ understanding of the macroeconomic debate within the Council and wean markets off the linguistic examination of the press conference.

This coming week the ECB will hold its second monetary policy meeting this month. The unusual timing of having two monetary policy meetings in the span of one month has arisen because the early September meeting has been brought forward by a week.  As was widely expected, the ECB raised interest rates by 25bp to 3% at the previous meeting on August 3. The chances of another move at the upcoming meeting are thus very slim. The tone of the press briefing following the early August meeting suggested to us that the Council intends to step up the pace of its tightening campaign in the second half of this year (see ECB Watch: Nudging ‘Em Higher, August 3, 2006). We will therefore be watching out for the ‘vigilance terminology’ to re-appear in the introductory statement to the press conference. In the current tightening cycle, the need to “exercise strong vigilance” has been used by the ECB to signal an imminent rate hike.

In addition, the ECB will release revised macroeconomic forecasts this coming week. In the light of the stronger-than-expected second quarter GDP reports and the likely upward revisions to past data, it seems probable to us that the ECB will revise up its staff forecasts for real GDP growth and possibly also for HICP inflation in the euro area.  In our view, full-year GDP growth is likely to be closer to 2.5% than to 2.0% this year. Hence, the ECB’s previous assessment of an expected rate of expansion of 2.1% now looks overly cautious especially after the first data points for August business sentiment and consumer confidence painted a relatively robust picture. So, how much attention should financial markets pay to these forecasts? And how relevant are they for the ECB’s own decision-making? Lastly, could these forecasts be used more effectively in the ECB’s communication with markets?

But let’s remind ourselves of some of the idiosyncrasies of the ECB’s forecasts. To start with, they aren’t called forecasts, but projections. This is because the estimates are based on a number of technical assumptions for a range of key variables shaping the macro economic backdrop. These key variables include the price of crude oil and other commodities, the euro’s exchange rate and euro area interest rates. To assume that these variables either remain fixed at recently observed levels (in the case of the exchange rate) or develop in line with expectations priced into the futures market (crude oil and interest rates) makes sense from a technical point of view. It does not, however, necessarily reflect the most likely future path of those variables. Furthermore, the estimates are the projections of the ECB staff, not the forecasts of the ECB Governing Council. The Council only uses them as one factor, among many, in its monetary policy considerations. 

The June staff projections show GDP growth at 2.1% this year and 1.8% next year, while HICP inflation is expected to average 2.3% in 2006 and 2.2% in 2007. The projections were based on an exchange assumption of 1.27 for EUR/USD, a crude oil price of USD 74 p/b and three-month EURIBOR rates averaging 3.9% next year and ten-year government bond yields 4.3% over the same period. Based on recent price action in financial and commodity markets, the technical assumptions underlying the projections probably won’t change very dramatically. The biggest shift is probably on the interest rate front, where the futures markets is now pricing in one rate hike less from the ECB by the end of next year than it did in June, and ten-year government bond yields have dropped around 10bp.

The June projections showed HICP inflation remaining above the ECB ceiling for price stability over the entire forecast horizon at least on average. In addition, the bank’s monetary indicator models, which intend to capture longer-run inflation trends, seem to hint at a further acceleration in euro area inflation to around 2.75%.  If it wasn’t for the fact that the ECB Council keeps distancing itself from the projections, the fact that the bank’s central projection shows inflation above 2% as far as the crystal ball can see could well have come as a bit of a shock to financial markets. True, the ECB hasn’t adopted an inflation forecast targeting framework like the Bank of England has, for instance, where such an above-target projection usually garners substantial market attention. Instead, the ECB has adopted very rightly, I think a two-pillar strategy in which traditional inflation forecasts are cross-checked against monetary developments.  At the current juncture, cross-checking should reinforce any inflation concerns stemming from traditional inflation projections.  In my view, the fact that the ECB happily projects inflation to stay noticeably above the price-stability ceiling of “less than but close to 2%” is an additional cause for concern.

Along a similar line of reasoning, Bundesbank President Axel Weber indicated on Tuesday that he wouldn’t rule out that inflation would also stay above the ECB’s ceiling of 2% in 2008. This would potentially make 2008 the ninth year running in which the ECB would tolerate an inflation overshoot. Like my colleague Richard Berner, Morgan Stanley’s US Chief Economist, I have begun to wonder whether the bank’s inflation tolerance level might have started to creep higher (see A Higher Inflation Objective? August 11, 2006). Official staff projections for 2008 will likely only be released in December. In previous years, preliminary internal estimates have occasionally been leaked to the press during the autumn.  But usually the ECB waits until the ‘big’ forecasting round ahead of its December meeting, which also involves the staff of the national central banks, before releasing 2008 estimates. By December, we and the ECB will also have a much better idea about the 2007 budget and the extent to which it will lead to a tightening in fiscal policy in the euro area next year.

From a fundamental point of view, it is understandable, I think, that the ECB Council contrary to the Bank of England, the Swedish Riksbank or the Norwegian Central Bank does not want to underwrite the staff projections.  First and foremost, there is the ECB’s two-pillar strategy, in which an inflation forecast is only one element entering monetary policy decisions. Initially, the ECB’s two-pillar approach was poorly understood and attracted much criticism. At the outset, it therefore made sense to emphasise the difference between the ECB’s approach and the inflation forecast targeting approach pursued by many other central banks. Seven years on, however, these teething problems are likely to have been overcome.

Second, the start of monetary union itself introduced considerable forecasting uncertainty over and above the uncertainties stemming from general structural shifts such as globalisation, also faced by other central banks. When facing major uncertainties due to a structural break, one should look at all available information without being bound by a specific forecasting framework or a big macroeconometric model.  In the euro area, the jury on the best forecasting method and model is still out.

This is why, in my view, the ECB Council should consider complementing the comprehensive model-based projections of the ECB staff with a survey of the personal forecasts of the ECB Council Members.  The semi-annual report of the Federal Reserve to the US Congress, for instance, gives a range of forecasts for GDP growth, the unemployment rate and the core CPI as projected by FOMC members. In addition, the report gives a so-called central tendency, which removes the more extreme forecasts.  The FOMC projections are based on members’ individual views as to the appropriate future path of monetary policy (which, alas, are not published).  The survey of the personal forecasts of FOMC members are complemented by a summary of the so-called Green Book, containing an outline of the forecasts of the staff of the Board of Governors in the FOMC Minutes. 

In my view, publishing such a survey of the personal forecasts of ECB Council Members would add to the market’s understanding of the ECB’s thought process. The ECB Council would simply need to ballot members on their personal forecasts of growth and inflation. Having a range of the forecasts would give market participants a better understanding of the dispersion of views within the Council. This would be valuable information, complementing the ECB staff projections where the bands reflect the uncertainty based on statistical forecasting errors seen in the past.  Together, the ranges could reflect the subjective and the objective uncertainty surrounding the forecasts. Having a central tendency of the forecasts or better, the median would give financial market practioners’ a good feel for the macroeconomic consensus in the Council.

As Council Members would be free as to how they arrived at their forecasts in terms of the underlying methods, much of the aforementioned model uncertainty would be addressed by pooling individual forecasts. Especially in the presence of structural breaks, pooled forecasts tend to perform better than individual expert forecasts. This notion was first raised by JM Bates and Nobel Prize-Winner CWJ Granger (see The Combination of Forecasts, Operations Research Quarterly 20 (1969), 451-468), who showed that pooled forecasts beat even the best individual forecast. This might appear counter-intuitive at first sight, given that the pooled forecasts will likely also include some not-so-accurate ones. In the real world, what works best as a forecasting tool changes all too frequently. This, by the way, is precisely why monetary decisions are usually made by a committee and not by a single individual. And, as an aside, this is why when having a blank on Who Wants to Be a Millionaire? your best option is always to ask the audience a question.

When it comes to the macroeconomic outlook underlying the ECB interest rate decisions, more transparency would be highly desirable, I think.  As the ECB Councils tends to be concerned about leaks and their potential repercussions the main reason why the Council doesn’t take a formal vote on interest rate decisions the ballot could be secret. A canvass of the personal forecasts of ECB Council Members would enhance markets’ understanding of the macroeconomic debate within the Council as well as the range of views held by Council members. The ECB’s own research has found that communicating the different macroeconomic views within the Council enhances markets’ ability to anticipate interest rate decisions correctly (see M. Ehrmann and M. Fratzscher, November 2005, How Should Central Banks Communicate?) and would also help to wean markets off linguistic examination of the press conference.

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Credibility Challenges
Aug 25, 2006

Oliver Weeks (London)

Hungary’s official draft convergence framework contains essentially the same fiscal path leaked the previous week, but higher short-term inflation.  With the budget deficit projected to fall to 3.2% of GDP in 2009 and public debt (including pension costs) falling to 70.4% of GDP, euro adoption in 2012 might technically be possible under this programme.  In practice, we continue to think that 2014 is the earliest feasible date since fiscal policy seems likely to be loosened again in the run-up to the 2010 election.  Slower fiscal tightening and a coming inflation spike will also test the Monetary Council, but with growth likely to slow sharply, we still do not expect an aggressive monetary tightening cycle. 

Some slippage of fiscal promises.  The government continues to face the credibility challenges associated with owning up to past deceptions while insisting things are different this time.  The latest upward revisions to the near-term deficit forecasts will further reinforce the doubts of some — a few weeks ago the plan was a 5.9% of GDP fiscal deficit for 2007 and 3.4% for 2008, against 6.8% and 4.3% in the current draft.  The lower 2007 GDP forecast (2.2%) appears to be one cause of the change, but the new presentation of three tightening scenarios, and apparent rejection of the most aggressive, suggests to us that the government has shied away from some of its earlier promises.  We are also surprised by the absence of promised privatisation revenue to reduce the debt ratio in the near term.  But even with a much stricter interpretation of the Maastricht criteria, we think it will be hard for the ECB to argue that debt needs to return to 60% of GDP for euro qualification, given the precedents in this area.  Likely reform fatigue in 2008-9 remains the main risk for the EMU timetable, in our view. 

Growth slowdown still likely to hurt.  While the plan still looks slightly optimistic to us, it does represent a significant adjustment.  Our own GDP forecasts (3.8% for 2006 and 1.5% for 2007) are still lower than the government’s downwardly revised estimates.  Germany’s fiscal tightening and tighter monetary conditions in the Eurozone are likely to heighten the pain.  Hungarian construction output is already contracting sharply, while consumer confidence as measured by the GKI index is down to -48.2, a level last seen in early 1996.  While there may be downside risks to revenue growth, the major short-term fiscal measures have largely been approved and the government’s majority remains firm.  The draft programme adds a commitment to cut public sector employment by 20,000 while freezing wages in 2007 and 2008.  The prime minister also promised a new real estate tax and longer-term reform of the pension system.  Meanwhile, the local elections on October 1 look increasingly important to us.  With Socialist party support already 14 points behind Fidesz, there is a risk that a heavy defeat brings a backlash from deputies, many of whom also sit as local mayors and councilors.  For now, we think it more likely that further details of cuts are unveiled after the elections.  Any winding back of reform would risk entrenching the inflation that the first stage is already unleashing. 

50bp more likely next week, but NBH may remain cautious in medium term.   Near-term inflation readings would also be a challenge for the credibility of the Monetary Council, recently reinforced by July’s unanimous hike.  The government’s new inflation forecasts (6.2% and 3.3% average for 2007 and 2008) may reflect faster planned energy price liberalisation, but remain below the most recent central forecasts of the National Bank (6.5% and 4.0%, published in the June minutes).  The timing of further gas price rises remains unclear, but with household gas prices at the beginning of 2006 only 56% of the EU average, more rises seem inevitable.  With the NBH also due to raise its EURHUF assumption by 5%, further rises to its inflation projections seem inevitable on Monday.  Importantly, the new near-term budget deficit projection also appears well above the centre of the NBH’s 5.8-7.0% assumption (though the NBH assumes little tightening in 2008).  We now think that a 50bp hike is more likely than 25bp at Monday’s meeting.  Yet, with administrative prices still the main driver of a 2008 inflation target overshoot, we still suspect that the Council may be reluctant to sustain an aggressive tightening cycle.  In the short term, the inflation spike, uncertainty around the local elections, a likely long overdue downgrade from Moody’s, and the heavy net bond issuance needed to fund the 2006 deficit may keep risk premia high.  However, with the labour market likely to loosen as layoffs kick in and growth poised to slow sharply, the risks of genuine second-round inflation effects seem limited to us, and the Council may be wary of taking the blame for the slowdown.  For now, we are raising our 2006 rate forecast only marginally to 7.75%. 

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How High Could Rates Go?
Aug 25, 2006

Andy Xie (Hong Kong)

*China’s neutral interest rates may be 3-5% higher: China’s real rates are 3-5% lower than those in other Northeast Asian economies during similar phases of high growth.  Rates may need to rise by that much to cure its overheating.

*Rising savings rate checks inflation temporarily: The government’s dominance in the economy has driven up the gross savings rate by eight percentage points in four years. This is holding back inflation.

*Inflation is shifting to where there are temporary bottlenecks: Property, skilled labor and oil are where low interest rates or excess money supplies are turning into inflation.  As long real rates remain, the cost push from bottleneck inflation should gradually increase inflation.

*China’s monetary environment may only normalize in 2008: China is growing three times faster than the US, has lower interest rates and is raising rates slower.  Its monetary environment is likely to remain stimulative until 2008.

Summary and conclusions

China’s growth environment most resembles that of Korea and Taiwan in the 1980s, but its real rates are 4-5 percentage points lower than in either market at that time.  This suggests that China’s interest rates should rise by that much to contain its overheating.

Despite exceptionally low real rates, China’s inflation rate is still relatively low.  Two special factors may explain this.  First, the low inflation is partly an illusion as, while China’s household sector is not overheating, the government-driven investment sector is. 

Second, China’s government sector has numerous channels with which to tax the household sector to fund investment, which depresses consumption demand and increases supply capacity.

As China expects little short-term harm from the overheating, the tightening is likely to be mild and should do little to ease the overheating.  This could lead inflation in the US to rise more than expected, and the Fed to tighten much more.  The effective tightening on China would then come from a slowing US economy.

Interest rates are too low relative to growth

China’s development model bears the greatest similarity to that of Japan, Korea and Taiwan.  Thus, the level of interest rates in these economies during their high growth phase could shed light on where China’s rates should be.

China’s current growth phase most resembles that of Korea and Taiwan in the 1980s.  Its export sector resembles Taiwan’s OEM model; its fixed investment sector is similar to Korea’s chaebol model; and China has pushed the export-investment growth model further than both.

Real interest rates in China, loosely defined as nominal rate minus GDP deflator, are 4-5 percentage points lower than that in Korea or Taiwan in 1980s.  This gives us a rough sense on where China’s interest rates should be.

In the 1960s, Japan experienced a high growth rate similar to China’s today.  Its real rates were lower than Korea or Taiwan’s in 1980s, but are still much higher than China’s now.  The Japan example suggests that China’s rates should rise by three percentage points, in my view.

Government power can hold back inflation temporarily…

In an investment-led economy, inflation is not the only indicator of overheating; it may not even be the primary indicator.  In the East Asian export/investment-led growth model, an all-powerful government is a necessary condition.  But, government power can substantially distort the behaviour of macro indicators. 

Inflation in particular can be kept artificially low, and does not necessarily reflect the aggregate demand-supply balance.  One distorting factor is the government’s ability to raise the savings rate.  In that regard, the Chinese government is far more powerful than Japan or Korea’s.  Beijing controls most key assets like natural resources, land, banks, telecommunication, utilities, etc.  It can change prices to raise national savings.

China’s gross savings rate has risen to an estimated 50% of GDP in 2006 from 41.8% in 2002 when the current growth cycle took off.  The rising savings rate has shifted demand growth to investment, which is less inflationary as it creates capacity.  Most inflationary pressure tends to come from raw materials as China has limited ability to increase its supplies.  Between 2002 and 2005, China’s GDP deflator averaged 4.9%, compared to 2.3% for CPI inflation.

While the GDP deflator is a better indicator of inflationary pressure in China’s model, it is still relatively low.  China’s economy is growing at a double-digit rate.  The one-year deposit rate is only 2.5% — after a 20% interest income tax, it is 2%.  Other economies with such attributes would have a double-digit inflation rate.  As the economy overheats, China can therefore shift demand to investment, which leads to more capacity and is less inflationary.

…but inflation will find a way

Raising the savings rate has the effect of making monetary growth less inflationary.  It can seem to belie the conventional wisdom that too much money leads to inflation.  But, a rising savings rate just pushes inflation from consumption to where there are temporary bottlenecks.

Property, for example, takes three years to complete and, hence, prices can inflate despite rising construction.  And, as price momentum sucks in more buyers, the completed properties that went into production three years ago are insufficient for current demand.  Hence, prices keep rising and more buyers are sucked in. 

As price and volume rise strongly and together, market analysts interpret the market as driven by ‘fundamentals’.  It is actually just a monetary phenomenon.  I believe that most excess money supply in the world and in China has gone into this sector.

Skilled labor is another bottleneck that has attracted the second-biggest share of excess money supply.  While China’s college graduates have seen starting salaries decline during the boom, experienced managers have seen their salaries reach international levels.

Oil is another area where inflation shows up.  Most oil is supplied by government-owned entities that do not increase supplies quickly in response to rising prices.  Hence, it has the potential to attract a big chunk of the excess money supply to inflate the oil price.

While money supply may not inflate CPI first due to technical reasons, it goes to where the bottlenecks are.  The rising prices in these bottleneck areas increase costs for the whole economy.  The market misinterprets this inflation as being cost-push and expects it to go away over time.  Rather, it is how money turns into inflation in a globalized economy.

‘Cost-push’ inflation eventually turns into a wage-price spiral as workers realize that real wages are declining.  We are not yet at this point in China.  However, several economies are already close to or in such a situation already.

Tightening on China will come externally

China’s tightening pace is too slow to have a meaningful effect on demand.  China is growing three times as fast as the US, has lower interest rates, and is raising interest rates slower.  China is years away from a normal monetary environment, in my view.

Instead, I believe that China will continue to use administrative measures to stabilize the economy when it threatens to boil over.  But, administrative measures work through the fear factor, and its impact is not long-lasting.  The government has to frighten the market every three or four months.  Its effect is to keep the economy from boiling over without curing overheating.  China’s overheating will end when all the excess liquidity has turned into buildings.

Meaningful tightening on the Chinese economy will come from slowing exports, when the US’s housing bubble deflates and its interest rate is kept up by high inflation.  China’s export production is about 20% of the economy in value added and contributes 3-4 percentage points directly to GDP growth.

When its exports stop growing, China could still tap into excess liquidity to sustain investment growth — i.e., its interest rate will not normalize right away with an export downturn.  China’s interest rates may rise to or above neutral level only in 2008.

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Confirms Ultra-stable Prices
Aug 25, 2006

Takehiro Sato (Tokyo)

Key points

What’s new: Revision of nationwide core CPI data to a 2005 benchmark had more of an impact than we anticipated at -0.4pp for July and an average -0.5pp for Jan-Jul, and this resulted in shortfalls for our reading estimates, with July nationwide core CPI at +0.2% YoY and mid-August Tokyo metropolitan core CPI at +0.0%. The revised US-style core moved into negative territory at -0.3% for July nationwide and -0.2% for mid-August Tokyo. We expect this surprisingly large impact from benchmark revision to temper the upward trend in prices.

Conclusions: Thorough revisions have raised the probability of our scenario for price stability with a healthy economy driven by a quiet productivity revolution. We project a near-term peak for nationwide core in Jul-Sep at +0.3% YoY followed by a moderate decline from Oct-Dec. The F2006 estimate based on our crude oil and FX outlook is +0.2% (+0.2% for C2006).

Policy and market implications: Market expectations for another rate hike in 2006 are likely to disappear. Meanwhile, we maintain our outlook, which was already cautious, for two rate hikes totaling 50bp in 2006-07 at half-year intervals (Jan-Mar and Jul-Sep 2007). However, the BoJ is also benefiting from 1) an ultra-weak yen on a real effective basis and 2) the possibility of a substantial delay for tax hikes with the recovery in tax revenue. The rate-hike time horizon hence might extend into F2008, although it will move at a very slow pace.

Risks: Crude oil and yen ‘wild cards’ could still push prices higher.


Larger-than-expected impact from revisions and negative reading for the US-style core index

Core CPI readings missed our forecast and consensus estimates at +0.2% YoY for the nationwide index (July) and +0.0% for the Tokyo metropolitan index (mid-August) based on the 2005 benchmark. Revision of nationwide core CPI data to a 2005 benchmark had a bigger impact than we expected, though our stance was more aggressive than the consensus view, at -0.4pp for July and an average -0.5pp for Jan-Jul. We expect the surprisingly large impact from benchmark revision to temper the upward trend in prices.

We currently project a +0.4% YoY reading for nationwide core CPI in August, which is somewhat high even following the benchmark revision, since the crude oil and forex rate ‘wild cards’ could continue exerting upward pressure, mainly on energy prices. We also lower F2006 (2006) and F2007 (2007) estimates for national core CPI based on our crude oil and forex rate outlook to +0.2% (+0.2%) and +0.1% (+0.2%) respectively (a reduction of 0.3-0.4pp from the previous forecast).

We think that monetary policy will be affected, given the substantial downward revisions and evidence of sluggish non-energy price activity, particularly a slump in the US-style core index explained below.

Recap of impact of CPI revisions

Revisions had a bigger impact than we expected, though our stance was more aggressive than the consensus view, at -0.4pp for July and an average -0.5pp for Jan-Jul. The most affected categories were: 1) leisure and entertainment (CPI revision impact for July: -0.18pp, mainly durable goods such as flat-panel TVs and DVD recorders); 2) transportation and communications (-0.17pp, mainly mobile phone service fees and mobile phone prices); 3) miscellaneous expenses (-0.10pp); and 4) furniture and households goods (-0.02pp; mainly household durable goods). Overall housing costs rose 0.1pp YoY (versus 0.0% prior to the revisions) despite a downward adjustment for the imputed rent of owner-occupied homes. Food products, utilities, clothing and shoes, and insurance, medical and educational services were largely unchanged by the revisions.

We had estimated the likely pre-and-post revision gap in the core CPI inflation rate as a result of August revisions at about -0.3ppt, almost consistent with the BoJ’s estimate. This took into account: (1) the substitution effect (impact on prices from the shift in consumption categories: +0.09ppt); (2) quality shift + new product impact (impact from replacing new products where prices have fallen sharply: -0.05ppt); (3) impact from imputed rents revision (-0.14ppt); (4) impact of benchmark resetting (about -0.1ppt  from altered levels for the various components arising with the shift from 2000 to 2005 as the benchmark year); (5) the outlet effect (consumers shifting purchases to superstores); and (6) charge sample revisions (reflecting the latest discounts in mobile phone charges, for example). However, the substitution effect and quality shift and new product impact caused a larger-than-expected decline in index leveling the actual revisions. The adjustment for mobile phone service charges altered the sample retroactively to November 2005, resulting in a negative impact comparable to sample replacement for fixed-line phone service charges in November 2004.

Current situation and changes in core indices besides Japan-style core data: (1) baseline (core of core), (2) US-style core, and (3) trimmed mean estimator:

The Japan-style core index tends to be higher than the following three core concepts even after the revisions due to the inclusion of some food and energy products. We compare the current situation and outlooks for core indices besides Japan-style core data using the new standard.

1) Baseline (core of core): The baseline core, which excludes broadly defined public services and energy products, fell 0.14% YoY at the nationwide July and 0.18% for the Tokyo region in August, widening slightly from -0.12% in June and -0.17% in July, respectively. Pre-revision baseline readings were +0.23% at the nationwide level in June and +0.28% for the Tokyo region in July. Benchmark revisions pushed the baseline back into the negative YoY territory.

2) US-style core: The US-style core CPI data dropped to negative readings of -0.3% at the nationwide July and -0.2% for the Tokyo August, similar to the baseline core. However, the news is not all bad since the national decline rate has narrowed 0.1pp each month since May. The Tokyo metropolitan reading bottomed out at -0.6% YoY in January 2006, but widened 0.1pp in August without showing a boost from July price hikes for cigarettes, tissue paper and other items.  We think that the negative YoY reading for the revised US-style core CPI has some implications for macro policy by exposing the unique nature of the Japan-style core index receiving support from higher energy prices. Government officials might use this data to criticize the BoJ’s reversal of quantitative easing and ZIRP while US-style data remain negative.

3) Trimmed mean estimator: The trimmed mean estimator (+/-10%) monitored by the BoJ along with Japan-style core readings (excluding perishable food products) as a supplemental price indicator was +0.14% YoY nationwide for July. This result was roughly unchanged from June’s +0.13%.

Core inflation rate forecast using revised benchmark

Taking a bottom-up approach, it appears that increased public sector productivity will put downward pressure on prices such as a strategic reduction in electricity rates stemming from deregulation and a downward trend in telecommunication fees, and the price of crude (a wild card) coupled with a weakening yen are the major factors exerting upward pressure on prices. August has seen a continued sharp rise in the retail price of gasoline. In light of trends in the Tokyo metropolitan area, we estimate that Japan’s core inflation rate (based on the revised benchmark) will remain high at 0.4% in August (+0.35% before rounding).

However, going forward the core inflation rate will reflect the impact of utility (broadly defined) rate changes, an impact that is becoming clearer. We expect that the core inflation rate based on the revised benchmark will be 0.3% YoY in July-September, 0.3% in October-December, and 0.2% in January-March. That is, our view that growth will peak in F1H06 is unchanged. The average for F2006 should be 0.2% (and 0.2% for C2006).

Monetary policy scenario: BoJ’s rooms for discretion widened despite the downward revision of inflation rate

In light of the core inflation rate forecast above, we expect an extremely measured interest rate policy going forward. The new CPI data do not necessitate revisions to our policy scenario, since it already projected a very slow pace for rate hikes. We expect two increases in 2007, one in the first quarter and one in the third, totaling 50bp.

On the other hand, the current rise in tax revenue and uncertainty about future government policy makes it increasingly likely that tax increases will be pushed back to F2009 or later. This will work to the BoJ’s advantage in its attempts to achieve a neutral interest rate. Meanwhile, the yen is currently down considerably in real effective terms, and this will also benefit the BoJ. The yen has weakened considerably against European currencies amid capital outflow to Europe, even though rate disparities should be narrowing over the medium term. We hence think conditions exist that will enable the BoJ to raise rates without thinking much about rate disparities, despite the shift to accommodative US monetary policy.

Given the above, the time span for raising interest rates could be longer, with the policy rate topping out around 1.5% in 2008. Even then, the policy rate will still be lower than the current neutral rate of about 2.5-3%. Accordingly, we expect a continued accommodative situation for Japan’s monetary condition.

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