United States
Inflation Risks
Oct 16, 2006

Richard Berner (New York)

The spring inflation scare seems to have ended, and both market participants and analysts seem to be breathing easier about inflation risks, judging by breakeven inflation readings and forecasts of declining inflation through 2007.  Small wonder: Core inflation readings moderated in July and August, and the plunge in energy prices reduced both breakeven inflation and headline inflation.  Some of those energy price declines may filter into lower core inflation.  That’s reflected in ten-year TIPS spreads, which have stabilized at about 235 basis points (bp), down from 265 bp this summer, and in the Blue Chip consensus forecast that overall inflation measured by the CPI will decline steadily to 2½% or lower over the course of 2005.  Many forecasts, including the Fed’s and our own, reasonably assume that a period of below-trend growth and a Fed that works to bring down inflation expectations will ultimately rein in core inflation towards the Fed’s presumed 1-2% comfort zone, measured by the PCE price index excluding food and energy.

Near-term, however, I still think that upside inflation risks dominate.  Among the reasons: Inflation expectations are elevated and are edging higher again, slack in the economy has dwindled, and costs are still accelerating.  Moreover, the firming in rental housing markets still seems likely to push up rents at a faster pace over the next few months.  And a looser relationship between economic slack and inflation — the so-called flattening in the Phillips curve — suggests that even weaker growth may not trim inflation quickly. 

Importantly, in my view, the inflation process begins with expectations, which the Fed shapes over time.  Key factors like domestic economic slack, costs, and global influences can reinforce or offset the process (see “Inflation Model Uncertainty,” and “Globalization and Inflation,” Global Economic Forum, June 3, 2005 and June 19, 2006, respectively).  While many models of inflation include a markup over costs as a key determinant, the work of Milton Friedman and Edmund Phelps — the latter this year’s winner of the Nobel Prize in economics — long ago convinced central bankers of their critical role in shaping inflation expectations.  The new realization that the Phillips curve is flatter than before— itself likely the product of a successful monetary policy — puts an even greater onus on the Fed to keep inflation expectations in check or to reduce them.  Put simply, the looser slack/inflation relationship works both ways — other things equal, it means that it “costs” more output to bring down inflation.  As a result, it may mean that the Fed still has work to do. 

The good news is that, as a group, Fed officials are well aware of this dilemma, that they are also concerned about upside risks to inflation, and that their hawkish commentary has begun to affect market pricing.  For example, the minutes from the September FOMC meeting noted that even then core inflation remained at “an undesirably high rate” and “members continued to see a substantial risk that inflation would not decline as anticipated by the Committee.”  Since October 4, a chorus of Fed officials have characterized the risks of higher inflation as greater than the chances of a shortfall in growth.  And even those who are more sanguine about inflation prospects, like San Francisco Fed President Yellen, reminded listeners that the decline depends on the Fed: “We know full well that maintaining credibility requires that we act when necessary to keep inflation under control.”  As a result, market pricing has reduced the chances that the Fed would ease as soon as December or January from 50% two weeks ago to nil today.

What do I mean by saying that inflation expectations are elevated?  Certainly that’s not true in historical context, judging by survey yardsticks.  Measured by the University of Michigan’s canvass of consumers, both 1-year ahead and 5-10 year-ahead median inflation expectations at 2.9% and 3.1% in early October were exactly equal to their 15-year averages and close to their averages over the past five years..  It’s only with reference to the experience of the past three years that expectations are elevated, but there too, only slightly so. 

More worrisome, however, smoothing for the volatility in such surveys shows that inflation expectations are rising.  Both 12- and 36-month averages of either 1-year or 5-10 year inflation expectations have edged higher over the past 18 months, and all stand at 4-year highs.  Moreover, for the first time in two and a half years, long-term inflation expectations exceeded short term.  Likewise, after declining about 15 bp from their August highs, distant-forward (5-year, 5-year) breakeven inflation in the past two weeks has retraced about half of that decline, standing at about 258 bp.  To be sure, those readings are volatile and the uptick could simply reflect technical factors in the TIPS market. 

As I see it, those moves do not evince a loss of Fed inflation credibility; rather they reflect the recent, cyclical increase in inflation.  And they could still be consistent with the notion that inflation expectations are “contained.”  At a minimum, however, these data suggest that inflation may not come down quickly and that such increased inflation expectations could show up in consumer and wage-setting behavior.  Thus, they should be warning flags for both investors and the Fed. 

A second set of warnings comes from indicators of slack in the economy.   While the slack/inflation connection may be less potent than in the past, it’s certainly not zero.  The economy’s potential growth rate has probably downshifted from 3½% to 3%, reflecting a slight reduction in productivity’s annual trend growth rate to 2½% and shrinking labor force growth.  If so, there is little slack in the economy as measured by the so-called output gap, or the difference between actual and potential growth (see “Is Potential Growth Downshifting, Global Economic Forum, August 25, 2006).  (While the estimated 0.6% upward revision to payrolls (and probably also to hours worked) between March 2005 and March 2006 could mean that productivity’s trend is slightly below 2½%, I think it more represents belated evidence of a cyclical undershoot in productivity (see “The Coming Productivity Undershoot,” Global Economic Forum, March 20, 2006).)  Meanwhile, operating rates in industry and services, respectively, stand well over the historical norms, and the quickening in growth that we expect in the next several months likely will elevate them further. 

Firming rental housing markets also present upside inflation risks.  The combination of job gains, lower housing affordability, and falling apartment vacancy rates likely will continue to fuel accelerating rents up to a 5% rate this year.  Flaws in the way those increases proxy for “owners’ equivalent rent” in some MSAs distort the core CPI as well as other consumer price measures.  But the rent increases themselves are genuine, and not just the perverse result of the housing slump. 

Finally, the cost picture has deteriorated somewhat.  The decline in energy costs will help reduce costs, but materials and labor costs have accelerated.  Strong global growth and limited gains in supply have promoted a reacceleration in “core” intermediate good prices to an 8.3% year-over-year rate.  And while current data overstate the acceleration in unit labor costs — courtesy of suspected strong increases in stock options exercise and bonuses, they show a 5% gain in the second quarter from a year ago — the acceleration is unmistakable.  My guess is that underlying unit labor costs have accelerated to 3½-4%, a six-year high.  The combination of elevated expectations and less slack in the economy will allow more firms to pass that cost acceleration on to their customers.

In the end, the inflation call all comes down to the Fed.  Market participants’ faith in the Fed’s anti-inflation resolve is legitimate, because Fed officials have earned enormous inflation credibility over the past 27 years, and they are not about to let it slip away by allowing inflation to rise significantly.  Nonetheless, with inflation running above the Fed’s presumed comfort zone for the third year in a row, there is ambiguity about the Fed’s preferences.  If officials were simply aiming at a higher inflation objective, investors could make such a one-time adjustment (see “A Higher Inflation Objective?” Global Economic Forum, August 11, 2006).  If, contrary to my expectations, Fed officials were more tolerant of the current rate of inflation and it became embedded in inflation expectations, that could set off a cycle of rising inflation.  The need to insure against such a deterioration is clearly behind Richmond Fed President Jeffrey Lacker’s two recent dissents in favor of additional tightening.  In any case, our interest rate strategy team now sees TIPS as cheap inflation insurance (see “US Cross Rates RV: Balancing 3Q Excesses with 4Q Reality,” October 11, 2006).

As I see it, there are two sets of risks for investors, but they are asymmetric.  One is that inflation declines more quickly than I expect, courtesy of declining energy quotes and a global slowdown; that’s not far from what investors are counting on.  There are some hopeful signs in that regard: For example, the National Federation of Independent Business Small Business canvass reports a sharp drop in early October in the percentage of respondents planning to raise prices — from 29% to 22%.  And in answer to Richmond Fed President Lacker’s concerns, research at the San Francisco Fed suggests that the Fed’s credibility may prevent the recent rise in core inflation from affecting inflation expectations.  But investors should also heed the other, more likely set of risks.  If the energy price declines fuel stronger growth and if inflation does remain stubbornly high or rises, further Fed action will be needed.  That’s not yet in the price.

Important Disclosure Information at the end of this Forum

United States
Review and Preview
Oct 16, 2006

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

Treasuries posted significant losses across the curve the past week. This extended the rout that started the day before the employment report after Fed Vice Chairman Kohn warned investors against underestimating the Fed’s inflation fighting resolve in a speech coming the evening after yields and Fed pricing in the futures market reached their recent extremes on October 4. The reversal that started at the end of the prior week on Kohn’s comments and the employment report continued in the latest week as incoming data and reports suggested improving growth heading into the fourth quarter and the Fed continued to say, most notably in the minutes from the September FOMC meeting, that not only are near-term rate cuts not under consideration but additional hikes are still a real risk. The market had clearly been ignoring the Fed’s clearly stated tightening bias for some time as it continued to price in more and earlier rate cuts. But the release of the minutes from the September FOMC meeting, a continued nearly uniform message from Fed speakers stressing inflation risks, and increasing signs suggesting that the worst of the mid-year slowdown is past and growth may now be poised to accelerate meaningfully moving into 4Q finally seems to have driven the point home to investors. As a result, the dramatic recasting of Fed expectations that started late the prior week reached a notable culmination Friday, as a marginal risk of a near-term rate hike was actually priced in, the possibility of a rate cut by the end of the first quarter of next year all but ruled out, the total amount of easing expected in all of 2007 scaled back sharply, and the expected low point for the fed funds target in early 2008 moved up from 4.50% to about a toss up between 4.75% and 5.00%.

These adjustments came even as the sluggishness of growth in 3Q appeared to be more pronounced than we estimated coming into the week.

Incorporating wholesale and retail inventories, international trade, retail sales figures and new data on motor vehicle production and inventories, we cut our 3Q GDP forecast to +1.9% from +2.5%. But the significant underlying strength in September retail sales, a notably more upbeat Beige Book than has been seen for some time, a sharp rise in early October consumer confidence and updated motor vehicle assembly schedules that suggested that the worst of the auto industry correction will be felt in 3Q and not 4Q as we previously thought raised our confidence in an upturn in the fourth quarter. If anything, we now see upside risks to our +3.3% 4Q GDP forecast.

Benchmark Treasury yields rose 10-13bp over the past week to about four-to-five-week highs, and the curve flattened a bit. This was the market’s worst week since mid-June and brought the cumulative back-up in yields in the six trading sessions since the trough on October 4 to 22-27bp. The 2-year, 3-year and 5-year yields all rose 13bp to 4.87%, 4.80% and 4.78%, respectively, the 10-year yield increased 11bp to 4.81%, and the long bond yield backed up 10bp to 4.94%. Since the extremes on October 4, when a rate cut in 1Q was almost fully priced in and a trough in the funds target of 4.50% or possibly even lower was seen in early 2008, Fed pricing has seen an equally dramatic reversal.

The January fed funds contract sold off 2bp in the latest week to actually crack above 5.25%, ending Friday at 5.255%. The possibility of a rate cut in 1Q has now been all but abandoned, with the February contract off 4.5bp to 5.25%, the March contract down 6bp to 5.245%, and the April contract off 9bp to 5.225%. In the eurodollar futures market, the Dec 06 to Dec 07 spread rose 13bp on the week to -38bp, with the former off 3bp to 5.39% and the latter plunging 16bp to 5.01%. The low rate Mar 08 contract sold off 16bp to 4.995%, having backed up a whopping 35.5bp since the low rate of 4.64% on October 4.

Two key Fed releases the past week in the run-up to the October 24-25 FOMC meeting (which seems likely to be as much of a non-event as September’s meeting) helped shake investors from their stubborn prior belief, against a clearly stated Fed bias in the other direction, that rate cuts were imminent. First, the minutes from the September FOMC meeting, while containing no surprises from our perspective and being fully consistent with the statement released after the meeting and all subsequent Fed speeches and interviews, somehow badly surprised investors in its focus on inflation risks. Core inflation remained at “an undesirably high rate” and “members continued to see a substantial risk that inflation would not decline as anticipated by the Committee”.

And while “available evidence indicated that inflation expectations remained contained”, there was concern about the impact on inflation expectations and Fed credibility in general if inflation did not soon start to come down soon. In contrast, risks to the growth outlook were recognized, but not perceived as being nearly as significant as for inflation. With the worst of the housing correction expected to occur over the second half of this year, “relatively subdued growth” was expected “over the balance of the year”, but growth was “likely to strengthen next year as the housing correction abated, with activity also encouraged by the recent decline in energy prices and still-supportive financial conditions”. Although there was “considerable uncertainty” about the “ultimate extent of the downturn in the housing sector and the degree to which the slowing in housing activity and the deceleration in home prices would affect consumption”, members were encouraged that to this point “the drop in housing market activity appeared not to have spilled over significantly to other sectors of the economy”.

Subsequently, the Beige Book prepared for the upcoming FOMC meeting had a notably more upbeat tone than the prior couple reports. The gist of the report was consistent with our expectation that we have passed the worst of the mid-year slowdown and are poised for stronger growth.

Across the country, “economic activity continued to expand” since the last Beige Book. Notably, four Districts reported stronger growth in September and only two weaker. In the prior two Beige Books, five or six Districts had reported slower growth and none faster. Probably most disturbing in the report for a market that had been convinced that a housing collapse threatened to throw the economy into recession were yet more signs that the worst of the downturn may be over, with so far minimal spillover into other sectors of the economy or consumer spending. However, “nearly all Districts reported that housing market conditions continued to soften”, and a number of Districts “noted that activity increased in some markets”, with Minneapolis, Dallas, New York, St. Louis, Richmond and Atlanta all seeing regional pockets of strength amid a still weak overall situation. In the September Beige Book, in contrast, housing market conditions were seen as “uniformly weak” across the country. Following the better-than-expected new and existing home sales reports a couple weeks back and recent improvement in mortgage applications, this somewhat improved tone on housing in the Beige Book added another indication that the worst of the housing market recession may be over, ironically no doubt helped significantly by the plunge in rates that fears of a housing market collapse had largely been the cause of.

There were a lot of cross-currents from various data releases the past week bearing on third quarter growth, but ultimately they netted to lead us to cut our 3Q GDP forecast to +1.9% from +2.5%. Wholesale inventories again surprised on the upside in August, as did sales; the booming wholesale sector remains one part of the economy that has seen no slowdown whatsoever, boosting our GDP estimate a bit. Retail ex auto inventories in August were in line with expectations and had no effect.

The trade report was negative on balance, but with important compositional divergences — the much wider-than-expected trade gap in August pointed to a significantly larger drag from net exports, but a surge in capital goods imports pointed to partly offsetting upside in capital spending. Underlying details of the retail sales report were robust across key discretionary categories, but a weaker-than-expected result for the broad “retail control” grouping still led us to cut our consumption estimate modestly. Finally, new data on September motor vehicle assemblies and inventories and revised production schedules for 4Q led us to significantly revise our estimate of the timing of the drag from planned auto production cuts in the second half, shifting the bulk of the expected hit to 3Q from 4Q.

The trade deficit posted rose to a record US$69.9 billion in August from US$68.0 billion in July, with exports (+2.3%) and imports (+2.4%) both posting strong gains. Upside in exports was led by capital goods, which rebounded sharply, as expected, after a strange plunge last month that was out of line with capital goods shipments figures. Food, industrial materials (led by metals) and consumer items also posted good gains. On the import side, the biggest contributor was a strange surge in energy products to a new record high that was mostly price related. Obviously, this appears to have been a timing issue, and the plunge in energy prices should sharply depress imports next month. A big gain in capital goods and decent rises in autos and consumer goods also boosted imports.

Based on the surprising deterioration in the overall trade gap (though less so in real terms), we now see net exports subtracting 1.0pp from 3Q GDP growth, up from our prior estimate of a 0.4pp subtraction.

Fundamentally, we still believe on a medium-term basis that robust, domestic demand-led global growth and moderating US demand and import substitution will lead to a trend swing towards positive contributions to US growth from net exports. This clearly did not materialize in the third quarter, but we expect this story to begin playing out in 4Q. On the other hand, the significantly larger-than-expected rise in capital goods imports pointed to stronger investment, and we raised our forecast for 3Q business investment to +14% from +11.5%.

Retail sales fell 0.4% overall and 0.5% excluding auto dealers in September, as sales at gas stations plummeted a record 9.3%, a far larger drop than could readily be explained by falling gas prices.

Excluding autos (which were strangely flat despite the previously reported solid rise in unit sales) and gas, sales jumped 0.8%, the strongest rise since January. In line with the solid upside in chain store sales results, strong gains were posted by several key discretionary categories, including clothing (+3.0%), general merchandise (+1.1%), restaurants (+1.0%), and sports, books and music stores (+1.1%). Even the building materials category (+0.6%) posted a surprisingly robust gain despite company reports that plummeting home sales are significantly pressuring home improvement activity. Even though we are suspicious of the result for the gas station category in September, these data will be used in the initial calculation of 3Q GDP, due at the end of the month. Based on the much lower-than-anticipated outcome for retail control (-0.6% versus an expected 0.0%), it now looks like real consumption spending will post a smaller gain than previously estimated, and we cut our forecast to +3.2% from +3.5%.

Finally on GDP, based on data from auto industry sources on September production and inventories and assembly schedules for the fourth quarter, we made some significant adjustments in our expectation for the timing of the hit to second half growth from the auto sector. Based on our calculations, the most recent production schedules suggest significant declines in (seasonally adjusted sequential) assemblies in September and October followed by sizable increases in November and December. Netted over 3Q and 4Q, the results of our calculations suggested a significant drag from the motor vehicle sector in 3Q and little impact in 4Q, the reverse of what we were previously assuming.

Building in these data, we sharply cut our projection for motor vehicle inventories in 3Q, which had the effect of reducing our estimate of the overall inventory contribution to 3Q growth from about zero to -0.5pp.

While we now project sub-2% growth in 3Q, details of the past week’s data and other incoming information for early in 4Qr continue to point to an acceleration heading into 4Q. Indeed, our +3.3% estimate may be conservative at this point. Clearly, the shift in the timing of the auto drag we now estimate points to corresponding upside in 4Q relative to our prior forecasts. More broadly speaking, while overall growth in 3Q appears to have been sluggish, underlying demand was not. Despite a huge decline in residential investment, which we estimate will knock a full percentage point off of 3Q GDP growth, we still estimate that final domestic demand gained a solid 3.2% on upside in consumption, business investment and government spending, double the +1.6% rise in 2Q. And at this point, all signs point to further consumer-led strength in 4Q. Underneath the suspect collapse in gas station sales, consumer discretionary spending across key categories was very strong in September. And with retail gasoline prices continuing to plummet into October — according to the Energy Department’s survey, regular unleaded gas prices fell to an average of US$2.26 a gallon last week, down US$0.78 in the past nine weeks to the lowest level since February — consumer spending power and sentiment are sharply rising as we move towards the crucial holiday shopping season.

On the sentiment front, the University of Michigan's consumer confidence index surged 7 points in early October to 92.3, the highest reading in over a year. The current conditions index gained 10 points to 106.1, while the expectations gauge rose 5 points to 83.4. The report attributed the rise to optimism about wage gains, inflation and interest rates and noted that the highest proportion of respondents in two years said that recent economic news they had heard about had been favorable, with reports of stronger employment and stock prices mentioned. This surge in sentiment in the Michigan survey was also replicated in the ABC News/Washington Post weekly poll, which jumped 5 points in the latest week (an extremely large weekly move for this series) to -8, the highest reading since April.

The inflation components of the Michigan report must have been disconcerting to the Fed. The median one-year ahead inflation forecast dipped two-tenths to +2.9% as gasoline prices continued to plummet, but the 5-year ahead forecast actually rose a tenth to +3.1%, just below the decade high of +3.2% hit most recently in August. This was the first time in two-and-a-half years that long-term inflation expectations exceeded short term expectations. So, despite the complete collapse in gasoline prices in the past two months, consumers’ longer-term inflation outlook has remained sticky at a high level. Market-based measures of inflation expectations have been somewhat better behaved, but also sticky and relatively elevated. The 5-year/5-year forward TIPS breakeven inflation spread rose a bit the past week, but still ended up very close to 2.5% for a fourth straight week. Since gasoline prices began their collapse in early August, this gauge has only come down about 10bp, though it is about 20bp below the peak hit in May. A 2.5% level for this measure would not appear to be consistent with the market’s believing that the Fed is committed to achieving its 1-2% core PCE price inflation ‘comfort zone’, a divergence alluded to by Richmond Fed President Lacker in a speech the past week. (“We don’t have any perfect measures of inflation expectations, but what we do have suggests that market participants do not foresee a rapid fall in core inflation.”) Assuming roughly a 50bp CPI/PCE gap and the mid-point of the Fed’s de facto inflation target, a 2% 5-year/5-year forward rate would be more obviously consistent with market confidence in the Fed’s inflation fighting resolve.

Focus in the coming week will be inflation, PPI Tuesday and CPI Wednesday. According to our equity strategy team, stocks are most influenced by headline inflation. Fixed income investors certainly tend to focus on core. If this continues, the coming week’s numbers should be good news for the former and bad news for the latter, as plunging energy prices should sharply restrain headline inflation readings even as we expect to see more bad news on the core. Somehow it’s already time to start looking ahead to the upcoming employment and ISM reports — this week’s initial claims data will cover the survey week for the October employment report, and the two key early initial manufacturing surveys will be released, Empire State Monday and Philly Fed Thursday. We’ll also get some notable housing market news to better judge whether the recession in that sector is slowing, with the National Association of Homebuilders survey out Tuesday and housing starts Wednesday. Other releases due out include industrial production Tuesday and leading indicators Thursday:

* We look for the overall producer price index to plunge 0.7% in September but the core to rise 0.2%. An estimated 20% plunge in quotes for wholesale gasoline should lead to a sizeable decline in the headline PPI this month. Meanwhile, the core is expected to get a mild boost from an expected partial bounce-back in motor vehicle prices, which have been a significant wildcard in recent months. Finally, the results at earlier stages of production should reflect the recent moderation in industrial commodity prices.

* We forecast a 0.1% rise in September industrial production. The labor market report showed a significant fall-off in hours worked within the factory sector during September. So, we look for the manufacturing component of IP to post its first outright decline since May, with notable softness in sectors such as textiles, wood products and chemicals. Elevation in both the oil drilling and utility components should help push headline IP into positive territory. Indeed, utility output appears especially due for some catch-up, given the surprising decline seen in August, when average temperatures across much of the nation were a good deal higher than normal.

* We expect the headline consumer price index to fall 0.2% in September but the core to rise 0.3%. A plunge in gasoline prices should help drive headline CPI into negative territory in September. Meanwhile, the core is expected to be boosted by ongoing gains in the OER and residential rent categories, as surveys continue to point to declining vacancy rates for rental properties. Note that these two categories account for nearly 40% of the core CPI. Other key categories — such as motor vehicles and apparel — are expected to be little changed this month. A potential wildcard in this month’s report is the hotel component, which has demonstrated considerable volatility in September of recent years. We are assuming a flat outcome for hotel rates but are concerned that this apparent sampling quirk could conceivably add or subtract as much as 0.1 percentage points on the core CPI (note that any such swing would likely be unwound in coming months). Finally, if our forecast for the core CPI is realized, the year/year rate would jump from +2.8% to +3.0%.

* We forecast September housing starts of 1.65 million units annualized. In response to a rise in the inventory of unsold new homes, housing starts have undergone a significant correction in recent months. We look for some further slippage (-1%) in September but believe that we may be getting close to the point where activity will begin to stabilize. Indeed, underlying economic and demographic fundamentals suggest that activity should level off in the neighborhood of 1.50-1.55 million units within the next few months. Finally, we continue to attach little significance to the permit data since we believe that they tend to now move contemporaneously with starts, and thus are no longer a leading indicator.

* Following declines in four out of the past five months, we look for a solid 0.4% rebound in the index of leading economic indicators for September, with positive contributions from the consumer confidence, money supply and stock market components more than offsetting a pullback in the factory work week.

Important Disclosure Information at the end of this Forum

Euroland
3.0% GDP Growth?
Oct 16, 2006

Eric Chaney (London)

GDP growth revised upward in 3Q and the full year

The flow of news from euro area economies continues to be positive.  Industrial production data for August were much stronger than expected in Germany and Italy.  Also, a sharp drop in headline inflation in September, to 1.7% from 2.3%, should consolidate the ongoing consumer recovery.  Consequently, we are revising our third quarter GDP growth estimate from 0.5%Q to 0.7%Q (or 2.8% annualised) and our full year forecast to 2.7%, versus 2.5% previously.  All in all, recent data and the experience of GDP revisions in past cycles are suggesting that GDP growth this year could well reach 3%, once the statistical dust settles which, in Europe, may take several years.  Three per cent would be more than twice as fast as the rate recorded over the last four years and far above even the most optimistic forecasts made last year, when 2006 was still a blank sheet of paper.  Business surveys, the voice of the real GDP makers, i.e., companies, have consistently indicated that GDP growth was far above long-term trend (2.05% in the last ten years) and, tenth by tenth, economic data are confirming their insight.  I see three important consequences to this surprising performance.

Strong growth despite some macro headwinds

First, the macro environment is not as favourable as it was in 1999-2000, the last years of significantly above-trend GDP growth, 2.9% in 1999 and 4.0% in 2000.  At that time, the euro exchange rate was falling, the ECB had cut rates for fear of deflation risks following the Asian crisis, and global trade was sharply accelerating.  This year, the euro is strong and has appreciated by 3.4% in the first nine months of the year, the ECB has raised the refi rate by 125bp and global trade, although buoyant, has not significantly accelerated since last year.  My conclusion: this domestic demand-driven recovery has a supply-side dimension, probably revealing a structural acceleration in productivity and more flexible labour markets, in the sense that the decline in the unemployment rate has not fuelled domestic inflation.

Budget deficit down to 2.0% of GDP?

Second, the marvellous improvement in budget balances euro area governments are boasting about has practically nothing to do with discretionary policy actions and almost all to do with highly cyclical tax receipts, in particular corporate taxes.  The pan-Euroland budget deficit could be as low as 2.0% of GDP (excluding a one-off reimbursement of VAT receipts in Italy), from 2.5% of GDP last year.  However, governments should not take for sustainable this improvement: budget deficits had also dropped amazingly in 1999 and 2000 when, with a little help from UMTS receipts, the aggregate balance sheet was at equilibrium.  Three years later, the deficit had reached 2.8% of GDP, with German and French deficits above 4%.  The good news is that, so far, governments have not spent the fiscal manna and that the 2007 budgets are, on balance, moving further toward fiscal consolidation.  However, past experience has shown that the temptation to spend cyclical extra tax receipts is strong, so the implementation of 2007 budgets will have to be watched carefully.

Will strong growth yield higher interest rates?

Third, stronger growth calls for higher interest rates, other things being equal, at first sight at least.  In reality, things might not be as simple as they look.  In reality, as inflation declines, real interest rates are already rising.  In this regard, I find it important that core inflation, against all expectations, has not picked up at all this year.  The details of the September HICP might even show that it is indeed declining.  Also, uncertainties regarding the 2007 outlook are high.  From a domestic standpoint, the reaction of recovering economies to indirect tax hikes and overall tighter fiscal policies is a major source of uncertainty.  Also, the reaction to higher short-term interest rates with pretty stable long-term interest rates is unknown.  And I am not even mentioning the slowdown of the US economy and, perhaps, slower exports to oil producing countries.  However, it is probably fair to say that stronger past GDP growth is not exactly water under the bridge for central bankers, since the level of real interest rates should be in sync with the real growth rate of the economy.  ECB hawks have certainly not missed that point.

Important Disclosure Information at the end of this Forum

Japan
Does the Slower Lending Imply a Turning Point?
Oct 16, 2006

Takehiro Sato (Tokyo)

What’snew:Following strong momentum since the latter half of 2005, bank lending growth has slowed since the summer, mainly among the major banks. Some market participants probably read this trend negatively, as evidence that the economy is nearing a turning point. However, we disagree with this view.

Conclusion:Our banking analyst once suggested that major banks’ lending growth may slow because of a decline in lending to smaller companies, now that their repayments of public capital free them from their business revitalization plans. If so, then we think the real message is nothing other than normalization in the lending market, which we consider a welcome development. In addition, the lending growth slowdown may be temporary for the next few months.

Market implications:The lending growth slowdown may dampen the sentiment of stock investors, but if it stems from temporary, pre-emptive financial strategies, we would take it as a good opportunity to buy on weakness.

Risks:We think a lack of vigilance would be risky. Even if the slowdown in loan growth does not have negative implications, margins could still be under pressure from excessive competition amid a slack recovery in fund demand.

Lending slowdown not necessarily bad news

Following strong momentum since the latter half of 2005, bank lending growth has slowed since the summer, mainly among the major banks. Some market participants probably read this trend negatively, as evidence that the economy is on the verge of a turning point. However, we disagree with this view. Japanese banks are repaying public capital, normalizing their lending to SMEs, and improving their returns on assets. We see it as the start of a positive process different from the financing squeeze during past financial slumps.

Major banks’ lending has slowed noticeably since August

BoJ data show that September bank lending rose 1.6% (versus 1.9% in August) before write-downs, securitizations and other special factors, and increased 2.3% adjusted for these factors (versus 2.7% in August). The YoY change stayed positive but slowed again, mainly because of the major banks. The trend was generally in line with the Japanese Bankers’ Association’s lending data for the same month, which came out before the BoJ data did and showed growth of 2.1% (versus 2.8% in August) before adjustments and 2.9% (versus 3.7% in August) after adjustments.

Whereas the BoJ data are based on average monthly balances, the JBA data are based on end-of-month balances and tend to be more volatile, as they include loans to financial institutions and loans to the central government. However, we think there must be special reasons for the considerable divergence between the data based on average monthly balances and end-of-month balances.

Our banking analyst once suggested that major banks’ lending growth may slow because of a decline in lending to SMEs, now that their repayments of public capital free them from their business revitalization plans. The slowdown may also stem from the impact of these factors on slightly longer-term loans and banks’ efforts to improve their returns on assets to improve their appeal to the stock market.

If the lending growth slowdown is related to banks’ repayments of public funds, then we think the real message is nothing other than normalization in the lending market, which we consider a welcome development. In addition, the lending growth slowdown may be temporary, for the next few months, until repayments of public funds are basically over.

Real significance of lending growth slowdown, slump in money supply growth

We think the lending growth slowdown is partly related to the recent slump in money supply growth. In September, growth in M2+CD rebounded slightly to 0.6% YoY (versus 0.4% in August) because of a rebound in quasi-money (time deposits) growth to basically unchanged YoY, despite M1 (cash and demand deposits) slowing substantially for a fifth straight month. Hence, monthly YoY changes in lending and money supply do not have a readily apparent cause-effect relationship. Also, even though growth in JGBs/financing bills (probably government bonds for individuals) and investment trusts was modest, broadly defined liquidity rose 2.0%, on par with the August growth, slightly weak relative to the rebound in M2+CD.

Other than the slowdown in lending growth, possible factors for the weak growth in money supply are a decline in demand for deposits as a savings vehicle and a shift to investment trusts and other risk assets, now that the financial system has stabilized; a contraction in net fiscal expenditures as a result of an improvement in tax revenue; and the use of loans for the repayment of CDs, commercial papers, local government bonds and other existing liabilities (a shift from direct to indirect financing).

In other words, in a typical economic recovery, private-sector fund demand growth bolsters the money supply through more positive lending stances on the part of financial institutions, but the three special factors we just noted may be holding back growth in the money supply. We thus see no need to take the slump in money supply growth negatively. Rather, we think it is encouraging that the economy is doing well even as net fiscal expenditures are declining.

Market implications

The lending growth slowdown may dampen the sentiment of stock investors, but bolster the bond market (i.e., help push yields down) by bringing back the arbitrage relationship between loan rates and JGB yields. Also, we expect the yield curve to flatten considerably as the BoJ normalizes its monetary policy in a measured way, and the yen to continue to weaken because of US-Japan interest rate differentials.

However, if the lending growth slowdown stems from temporary, pre-emptive financial strategies, we do not think it should necessarily be taken negatively, even if it leads to a further slump in money supply growth in the short term; rather, we would take it as a good opportunity to buy on weakness in the stock market. In this regard, we still expect a Goldilocks combination in which asset markets should remain favorable.

Risks

Nevertheless, we think a lack of vigilance would be risky. Even if the decline in loan volume does not have negative implications, margins could still be under pressure from excessive competition amid a delayed recovery in fund demand. With loan rates weak, banks’ increase in ordinary deposit rates to 0.10%, following the BoJ’s end of ZIRP, could hold back an improvement in loan-deposit rate spreads.

Important Disclosure Information at the end of this Forum

Disclosure Statement

The information and opinions in this report were prepared or are disseminated by Morgan Stanley & Co. Incorporated and/or Morgan Stanley & Co. International Limited and/or Morgan Stanley Japan Securities Co., Ltd. and/or Morgan Stanley Dean Witter Asia Limited and/or Morgan Stanley Dean Witter Asia (Singapore) Pte. (Registration number 199206298Z) and/or Morgan Stanley Asia (Singapore) Securities Pte Ltd (Registration number 200008434H) and/or Morgan Stanley & Co. International Limited, Taipei Branch and/or Morgan Stanley & Co International Limited, Seoul Branch, and/or Morgan Stanley Dean Witter Australia Limited (A.B.N. 67 003 734 576, holder of Australian financial services licence No. 233742, which accepts responsibility for its contents), and/or JM Morgan Stanley Securities Private Limited and their affiliates (collectively, "Morgan Stanley").

Global Research Conflict Management Policy

This research observes our conflict management policy, available at www.morganstanley.com/institutional/research/conflictpolicies.

Important Disclosures

This report does not provide individually tailored investment advice. It has been prepared without regard to the circumstances and objectives of those who receive it. Morgan Stanley recommends that investors independently evaluate particular investments and strategies, and encourages them to seek a financial adviser's advice. The appropriateness of an investment or strategy will depend on an investor's circumstances and objectives. This report is not an offer to buy or sell any security or to participate in any trading strategy. The value of and income from your investments may vary because of changes in interest rates or foreign exchange rates, securities prices or market indexes, operational or financial conditions of companies or other factors. Past performance is not necessarily a guide to future performance. Estimates of future performance are based on assumptions that may not be realized.

With the exception of information regarding Morgan Stanley, reports prepared by Morgan Stanley research personnel are based on public information. Morgan Stanley makes every effort to use reliable, comprehensive information, but we do not represent that it is accurate or complete. We have no obligation to tell you when opinions or information in this report change apart from when we intend to discontinue research coverage of a company. Facts and views in this report have not been reviewed by, and may not reflect information known to, professionals in other Morgan Stanley business areas, including investment banking personnel.

To our readers in Taiwan: This publication is distributed by Morgan Stanley & Co. International Limited, Taipei Branch; it may not be distributed to or quoted or used by the public media without the express written consent of Morgan Stanley. To our readers in Hong Kong: Information is distributed in Hong Kong by and on behalf of, and is attributable to, Morgan Stanley Dean Witter Asia Limited as part of its regulated activities in Hong Kong; if you have any queries concerning it, contact our Hong Kong sales representatives.

This publication is disseminated in Japan by Morgan Stanley Japan Securities Co., Ltd.; in Canada by Morgan Stanley Canada Limited, which has approved of, and has agreed to take responsibility for, the contents of this publication in Canada; in Germany by Morgan Stanley Bank AG, Frankfurt am Main, regulated by Bundesanstalt fuer Finanzdienstleistungsaufsicht (BaFin); in Spain by Morgan Stanley, S.V., S.A., a Morgan Stanley group company, which is supervised by the Spanish Securities Markets Commission (CNMV) and states that this document has been written and distributed in accordance with the rules of conduct applicable to financial research as established under Spanish regulations; in the United States by Morgan Stanley & Co. Incorporated and Morgan Stanley DW Inc., which accept responsibility for its contents. Morgan Stanley & Co. International Limited, authorized and regulated by Financial Services Authority, disseminates in the UK research that it has prepared, and approves solely for the purposes of section 21 of the Financial Services and Markets Act 2000, research which has been prepared by any of its affiliates. Private U.K. investors should obtain the advice of their Morgan Stanley & Co. International Limited representative about the investments concerned. In Australia, this report, and any access to it, is intended only for "wholesale clients" within the meaning of the Australian Corporations Act.

Trademarks and service marks herein are their owners' property. Third-party data providers make no warranties or representations of the accuracy, completeness, or timeliness of their data and shall not have liability for any damages relating to such data. The Global Industry Classification Standard (GICS) was developed by and is the exclusive property of MSCI and S&P. Morgan Stanley bases projections, opinions, forecasts and trading strategies regarding the MSCI Country Index Series solely on public information. MSCI has not reviewed, approved or endorsed these projections, opinions, forecasts and trading strategies. Morgan Stanley has no influence on or control over MSCI's index compilation decisions. This report or portions of it may not be reprinted, sold or redistributed without the written consent of Morgan Stanley. Morgan Stanley research is disseminated and available primarily electronically, and, in some cases, in printed form. Additional information on recommended securities is available on request.