Labor versus Capital
Oct 23, 2006
Stephen S. Roach (New York)
What do the world’s three largest economies have in common? The answer underscores one of the key tensions of globalization -- unrelenting pressure on labor income. The corollary of that phenomenon is equally revealing -- ever-rising returns to the owners of capital. For a global economy in the midst of its strongest four-year boom since the early 1970s, this tug-of-war between labor and capital is an increasingly serious source of disequilibrium. It has important economic, social, and political implications -- all of which could complicate the coming global rebalancing.
My recent trip to Japan was the clincher. As I found in Germany during a series of extensive visits last month, and as has been evident in the United States throughout the current upturn, Japanese labor income remains under extraordinary downward pressure. There is no way this is a coincidence. In all three economies, unemployment has been declining in recent years -- a 27% drop in the US jobless rate since mid-2003, a 21% decline in Japan since early 2003, and a 15% fall in the German unemployment rate since mid-2004. Yet in none of the three economies has a cyclical tightening in labor markets resulted in a meaningful increase in real wages and/or the labor share of national income. By our calculations, fully 57 months into the current cyclical upturn, US private sector compensation is still tracking nearly $400 billion (in real terms) below the average trajectory of the past four business cycles. After a glimmer of revival in early 2005, stagnation is once again evident in Japanese real wages (see my 20 October dispatch, “Japan’s Missing Link”). Nor are there any signs of a meaningful upturn in German real wages; to the contrary, inflation-adjusted compensation per worker in the overall business sector has actually declined in four of the past five years. The case of Europe merits special comment. We harbor the illusion that European workers are different -- that sheltered by a deeply entrenched social contract, they enjoy great success in getting more than their fair share of the pie. That impression is no longer accurate. As Elga Bartsch points out in a fascinating new piece of research, after having spiked up dramatically in the aftermath of German reunification, pan-European real compensation per employee has been basically unchanged since 2001 (see her 20 October dispatch, “Whither Euro Area Wages?”). Nor does she see this changing as an increasingly tight European labor market now approaches its “speed limit.” The structural forces are simply far too powerful -- namely, globalization, a shift to part-time and temporary employment, and the diminished power of European labor unions. The coming wage round in Germany will undoubtedly test this view, but Elga does not look for a major breakout. Far from marching to its own beat, the European worker is in the same shape as those elsewhere in the industrial world -- suffering from the unrelenting pressures of relatively stagnant real wages. At work are the increasingly powerful forces of globalization -- namely, the combination of intensified cross-border competition and a wrenching global labor arbitrage that has given rise to an extraordinary productivity push in the high-wage industrial world. The good news is that the productivity payback is at hand. The United States has recorded a decade of 2.8% productivity growth -- doubling the sluggish 1.4% gains recorded from 1974 to 1995. Japanese productivity growth has averaged 2.1% over the past three years -- nearly double the 1.2% trend from 1995 to 2002. Even German productivity has been in the rise -- expanding at a 1.7% annual rate over the past five quarters -- more than double the anemic 0.7% trend over the 1998 to 2004 period (see my 2 October dispatch, “Global Comeback: First Japan, Now Germany”). The bad news is that these breakthroughs on the productivity front have not resulted in any meaningful improvement in labor’s share of the pie. Therein lies the puzzle: Economics teaches us that real wages ultimately track productivity growth -- that workers are rewarded in accordance with their marginal product. Yet that has not been the case in the high-wage economies of the industrial world in recent years. By our estimates, the real compensation share of national income for the so-called “G-7 plus” (the US, Japan, the 12-country euro-zone, the UK, and Canada) fell from 56% in 2001 to what appears to be a record low of 53.7% in 2006. (Note: Due to a lack of harmonized euro-zone data prior to 1996, the compensation share cannot be extended before that period; however, based on BIS calculations, the slightly narrower construct of the wage share of G-10 national income is currently lower than at any point since 1975). Of course, it is important to distinguish between the transitory results of the business cycle and the structural interplay between underlying trends in productivity and real wages. It may be that productivity strategies are dominate by cost cutting; with labor the largest slice of business production expenses, such tactics lead to constant pressure on the compensation share of national income. It may also be that the improvements in labor market conditions are so recent -- especially in Japan and Germany -- that the real wage lags simply haven’t had time to kick in. The US experience draws that latter hope into serious question. Fully 10 years into a spectacular productivity revival, real wages remain nearly stagnant and the labor share of national income continues to move lower. If the flexible American worker can’t do it, why should we presume that others in the industrial world would be any more fortunate? This takes us to what could well be the biggest challenge in this era of globalization -- the ability of the high-wage developed world to convert productivity gains into increases in the labor share of national income. In a recent paper, Richard Freeman of Harvard, long one of the world’s most prominent labor economists, underscores the very tough uphill battle that high-wage workers in the rich countries face in this era of globalization (see his June 2006 paper, “Labor Market Imbalances: Shortages, or Surpluses, or Fish Stories?”). By his calculation, the ascendancy of China, India, and the former Soviet Union has added about 1.5 billion new workers to the global economy -- essentially equaling the amount elsewhere in the world. With global trade and production increasingly shifting into the low-wage developing and transitional economies, what I have called the “global labor arbitrage” puts inexorable pressure on real wages in the high-wage industrial world. Some would argue that the worst of the arbitrage is over -- as wage inflation now takes off in China and India. Don’t count on it. Our estimates suggest that even after five years of double-digit wage inflation in China, hourly compensation for Chinese manufacturing workers remains at only 3% of levels prevailing in the major industrial economies. While labor gets squeezed, the owners of capital have enjoyed far more flexibility in this climate. Facing extraordinary competitive pressures, corporations have redoubled their efforts on the productivity front. And, as noted above, those efforts have indeed borne fruit -- for over a decade in the US and more recently in Japan in Germany. The fruits of those efforts show up in the form of surging corporate profitability and increased share prices -- with commensurate gains accruing to those workers/ households that are fortunate enough to hold shares. America, with its growing incidence of share ownership, has led the change in that regard. But this has hardly been a panacea for most US workers. Federal Reserve survey data show that 63% of families in the upper decile of the wealth distribution owned stocks in 2004 -- nearly four times the average 19% ownership share in the remaining 90% of the wealth distribution; moreover, median equity holdings amounted to $110,000 per household in the same upper decile --fully 13 times average holdings of $8,350 in the remainder of the wealth distribution (see “Recent Changes in US Family Finances: Evidence from the 2001 and 2004 Survey of Consumer Finances” published in the Federal Reserve Bulletin 2006). Don’t get me wrong -- this is not intended to be a replay of my ill-fated “worker backlash” call of the early 1990s, when I mistakenly believed that labor would exercise its power and demand a larger slice of the pie. Today, courtesy of a doubling of the world’s work force and an increasingly potent global labor arbitrage, high-wage workers in the industrial world are all but powerless to act. But their elected representatives are not. Witness the recent surge of protectionist sentiment -- especially in the United States but also in Europe. Nor do I suspect this political backlash to globalization will fade in the aftermath of the upcoming mid-term election in the United States -- especially, as seems likely, if the Democrats garner sizable gains in the Congress. Pressures on high-wage workers in the industrial world are likely to endure for years to come -- irrespective, or perhaps because of, the push for higher productivity growth. As a result, I suspect the angst of labor will remain high on the political agenda for the foreseeable future. Contrary, to orthodox “win-win” theory, globalization is a highly asymmetrical phenomenon. Initially, it creates far more producers than consumers. It also results in extraordinary imbalances between nations with current account deficits and surpluses. And it has led to a widening disparity of the returns between labor and capital. Does this mean that globalization is inherently unsustainable? Probably not. But it does mean that the most destabilizing phase of this mega-trend could well be close at hand. As seen through surging corporate profitability, the returns to capital have never been greater. Meanwhile the shares of labor income have never been lower. As day follows night, the pendulum will swing the other way -- and so will the balance between real wages and business profitability. It’s just a question of when -- and under what circumstances.
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Good News in the Bad News?
Oct 23, 2006
Vladimir Pillonca (London)
Both S&P and Fitch downgraded Italy’s sovereign debt by a notch. S&P downgraded Italy's debt to A+ from AA- while Fitch re-rated Italy to AA- from AA. Both agencies revised the outlook from negative to stable. Good news in the bad news. The bad news is self-evident — but there is also some good news hidden in this downgrade: the government has now more ammunition to push on with structural reforms — with a renewed sense of urgency. Negotiation both with trade unions and within the coalition itself could turn out to be more productive than usual (see also Eric Chaney’s recent Enough Italy Bashing). The economy is finally growing … so what’s the problem? Despite the good news on Italy’s business cycle and sharply rising tax receipts, these downgrades didn’t surprise us. The reaction in the government bond markets was also muted, suggesting that this risk was largely being discounted. The positive news, especially on the business cycle front, reflects unusually favourable circumstances: GDP growth is way above Italy’s potential growth rate. The problem is one of quality — not quantity. It’s not a matter of size: the scale of the net fiscal adjustment is respectable (€R15.2 billion or 1% of GDP) and the Budget will likely do the noteworthy job of pushing the budget deficit to or below 3% of GDP in 2007. Besides, this year the budget deficit may well turn out to be lower than expected, given the extremely favourable cyclical circumstances. That may sound promising — but the fundamental concern is not next year’s budget deficit — but the longer-term sustainability of Italy’s stock of debt. Desperately seeking a (sustainable) trajectory. To position Italy’s stock of debt on a sustainable downward trajectory, more needs to be done on the structural front. The primary surplus — on a declining path since 2000 — has to be raised significantly from its recent levels. Only a sustained increase in the positive gap between government revenues and expenditures can help to lower Italy’s large stock of debt. Higher interest rates will make the servicing of the debt more expensive, compounding the difficulties. Fiscal sustainability — missing four points. The reasons for concern are straightforward: the bulk of the financing for the 2007 fiscal package comes by increasing tax revenue rather than by cutting government expenditure in a permanent fashion. Specifically, this budget does little to cut spending in four critical areas: 1) pensions, 2) healthcare, 3) public employment and 4) local government. Spending on these items will need to be reduced permanently to ensure that a sustainable balance between government revenues and expenditures is achieved. Rebalancing can’t just be done on one side. This rebalancing between government revenues and expenditures cannot be largely confined to increasing revenues. Instead it should be achieved by acting incisively on expenditures. This is critical to put Italy’s debt-to-GDP ratio on a sustainable downward trajectory. Failing that, every year more revenue-raising initiatives will have to be devised, leading to further increases in tax pressure — for those who pay taxes. Anti-tax evasion measures can help — but it won’t suffice. Revenues simply cannot do this rebalancing alone, in our view. A key structural problem. Italy’s low rate of potential growth suggests that we should be cautious in expecting the recent pace of growth to be maintained for very much longer, especially in the absence of major supply-side reforms. On our estimates, Italy’s potential growth rate is not much higher than 1%Y (see Evolving Outlook, Risks and Speed Limits, August 29). That means that our best guess of future GDP growth in the next few years is unlikely to be very much higher than 1%, all else equal. This is a major drag to fiscal sustainability and longer-term corporate profit growth. While we think there have finally been some positive developments on this front (notably the Bersani Decree), a lot more needs to be done. The bad news is self-evident — but there is also some good news hidden in this downgrade. The government now has more ammunition to push on with structural reforms, and the negotiation both with the trade unions and within the coalition itself could turn out to be more productive than usual. Further, the fiscal package will bring the deficit down towards Maastricht compliant levels next year, which should help Italy to regain some fiscal credibility. More fundamentally, though, Italy cannot afford to act on the revenue side of the equation alone. Tackling government expenditure is the only way to systematically and credibly reduce Italy’s weighty stock of debt.
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Review and Preview
Oct 23, 2006
Ted Wieseman (New York) and David Greenlaw (New York)
A busy economic calendar, with important releases on the two key issues confronting the market at this point — housing and inflation — as well as key early data bearing on the upcoming employment and ISM reports, seemed as if it might make for an eventful week for the bond market. But that certainly did not even come close to happening, as the Treasury market barely budged for five straight days amid mostly lackluster trading volumes, ultimately ending the week with marginal long end-led gains. As we head towards the FOMC meeting in the coming week, however, pricing of the Fed in the futures market, if definitely not quantitatively at least qualitatively, had a much more interesting week. With a surprising surge in housing starts adding to a recent run of housing-related data suggesting that the worst of the housing market recession is probably behind us, and core CPI inflation continuing to gradually drift higher, the market’s previously firmly held view that a collapsing housing market would drag the broader economy down with it, belie the Fed’s inflation concerns, and prompt a quick switch towards rate cutting continued to go down in flames. As a result, over the course of the week the futures market actually moved to price in a risk, if only a very small one, of another Fed rate hike early next year, though the bearish medium-term view proved more entrenched, as slightly more easing beyond that point was priced in. Benchmark Treasury yields ended a week of minimal volatility — the largest one-day move of any benchmark issue was a 2.7bp rally by the long bond Wednesday — 0-3bp lower, with the curve a bit flatter. The 2-year and 3-year yields were unchanged at 4.87% and 4.80%, the 5-year and 10-year yields dipped 2bp each to 4.75% and 4.78%, and the 30-year yield fell 3bp to 4.90%. Fed pricing in the futures market saw similarly small moves, but with more interesting results. In particular, after having mostly priced out the possibility of a near-term rate cut the prior week — a sharp reversal from the extremes hit on October 4 when a 1Q rate cut was almost fully priced in — the fed funds futures market moved to actually price in a very small risk of one more rate hike by the January 30-31 FOMC meeting, as the February contract lost 1.5bp to 5.265%. Beyond January, however, slightly more rate cutting was priced in. The Dec 06 to Dec 07 eurodollar futures spread flattened 1.5bp to -39bp, with the former off half a basis point to 5.39% and the latter rallying 1bp to 5.00%. The low-rate Mar 08 contract also gained 1bp to 4.985%. Though there wasn’t much market impact, incoming data the past week on the two key issues confronting the market and policymakers at this point, potential downside risks to the economy from the housing market and potential continued upside risks to inflation, suggested less reason for worry on the former and more on the latter. Coming after the significantly better-than-expected home sales results for August and modest recent rebound in mortgage applications for new purchases after a sharp decline through August, a surprising surge in housing starts and a slight rise in the homebuilders’ survey — though to a still abysmal level — in the latest week provided further indications that while the housing market recession still likely has a good way to go, the worst of the downturn probably happened in the third quarter. Housing starts posted a surprising 5.9% jump in September to a 1.772 million unit annual rate, a three-month high. Both single-family (+4.3% to 1.426 million) and multi-family (+12.7% to 346,000) starts posted significant increases. Given the steady recent decline in apartment vacancy rates, we expect multi-family starts to remain an area of relative strength in the housing market, but the gain in the key single-family category was unexpected. Regionally, upside was led by the South (+14.0%), by far the largest region for new home construction. Activity in the West (-2.2%), where the housing market seems clearly to have the most fundamental problems, given record low affordability, continued to move lower. Meanwhile, the National Association of Homebuilders’ housing market index rose a point in October to 31. On a 50-breakeven scale, this was still an atrocious outcome, but it did break a run of eight straight declines. According to the NAHB, “The market correction appears to be approaching the bottom in terms of sales volume”, which it attributed to lower rates, falling energy prices, rising consumer confidence and “substantial sales incentives”. Incorporating the upside in housing starts, we now forecast that real residential investment declined at a 16% annual rate in the third quarter, up from our prior -18% estimate. And while we believe that declining housing activity will continue to be a drag on GDP growth through the end of next year, given the more positive tone of the recent data, we are increasingly confident in our forecast that the worst of the housing market recession occurred in 3Q and the drag on growth will moderate from here. See Is the Housing Recession Over? by Dick Berner for a full discussion. Meanwhile, core inflation continues to drift higher. The headline consumer price index fell 0.5% in September, dropping the annual rate to a two-and-a-half-year low of +2.1%, as energy prices plunged 7.2% on a near-record (exceeded only in the immediate aftermath of the post-Katrina spike) 13.5% collapse in gasoline. Gasoline prices will likely be down in double digits again in October. Meanwhile, for a second straight month the core rose 0.24%, lifting the year/year rate a tenth to +2.9%, a high in more than a decade. Moderate results from owners’ equivalent rent (+0.3%), education (+0.2%, a five-year low), airfares (-2.3%), and used cars (-1.0%) provided enough offset to upside in apparel (+0.6%) and personal care (+0.7%, a record in the seven years of data) to allow the core to barely round down to +0.2% again. On the positive side for inflation, at least in the near term, the Fed’s preferred measure, the core PCE price index, will likely show some moderation in September in contrast to the CPI. This price gauge was up 0.24% in September 2005, and the August year/year rate at +2.45% just barely rounded up to +2.5%. Translating the core CPI outcome to core PCE, the latter will likely rise close to a clean 0.2%, which would cause the annual rate to moderate a tenth to +2.4%. Base effects will likely help keep core PCE inflation restrained again in October (the monthly rise in October 2005 was +0.26%), providing some short-term comfort to the Fed, but unless there is a significant shift in the underlying inflation dynamics, which we do not expect, upside will likely resume in November. We expect core PCE inflation will peak near +2.7% in February. With the late release of the September employment report, it was already time to start looking ahead to key early October reports the past week, as the early regional manufacturing surveys and initial jobless claims coinciding with the survey week helped set initial expectations for the upcoming ISM and employment reports. The headline sentiment measures for the Empire and Philly reports were massively divergent, but, much more important in our view, both showed improvement on an underlying basis, particularly the latter, which proved to be a downside outlier last month relative to other regions and the national ISM. An ISM-comparable weighted average of the key activity measures rebased to a 50-breakeven scale showed the Empire State survey rising to 56.3 in October from 55.7 in September. The Philly Fed on this basis rebounded to 53.6 from 50.2. In light of these results, we look for the October ISM to improve to 54.0 from 52.9. Meanwhile, the jobless claims figures continued to portray a much more healthy labor market than implied by the disappointing 51,000 gain in September non-farm payrolls. Initial claims in the week of October 14 — the survey week for the October employment report — matched an 18-week low, and the four-week average hit a four-month low. Continuing claims in the prior week remained just modestly above the cycle low hit in May. We look for an improved 125,000 gain in October payrolls, which is probably at or quite possibly above the pace of job growth a labor market with a 4.6% unemployment rate can sustain without raising significant red flags. Focus in the early part of the coming week will be on the Fed and a flood of supply. The two-day FOMC meeting on Tuesday and Wednesday could potentially be quite important behind the scenes as Fed officials devote an extra day to discussing communications issues. Eventually this could have significant market implications, but we probably won’t know about them for a while. As far as what we will know in the form of Wednesday’s official policy statement, this meeting’s outcome appears likely to be largely a non-event, like September. Obviously any change in rates is out of the question, and we expect no significant change to the Fed’s key forward-looking language, retaining a near-term tightening bias in the face of upside inflation risks — “the Committee judges that some inflation risks remain. The extent and timing of any additional firming that may be needed to address these risks will depend on the evolution of the outlook for both inflation and economic growth, as implied by incoming information”. The only notable changes we expect to the statement are the normal updates to the description of the economic backdrop since the last meeting. While incoming data since the September meeting have pointed to a sharper slowdown in growth in 3Q than previously seemed likely, prospects for a reacceleration in 4Q have also risen. As a result, we see some room for a more upbeat forward-looking outlook on the economy than last time. In particular, the continued collapse in energy prices, which in September was only referenced as a potential positive for core inflation (“inflation pressures seem likely to moderate over time, reflecting reduced impetus from energy prices, contained inflation expectations, and the cumulative effects of monetary policy actions and other factors restraining aggregate demand”), could now also be referred to as a potential positive for near-term growth after the sharp recent rebound in consumer confidence and the robust underlying consumer spending results for September, both of which seemed to be importantly driven by the plunge in gasoline prices. On the supply front, US$41 billion in new Treasury issues will be auctioned (more than the upcoming November refunding), a US$7 billion reopening of the 5-year TIPS Monday, US$20 billion 2-year Tuesday, and US$14 billion 5-year Thursday. After focus on the Fed and supply in the first part of the coming week, a number of key data releases will be released in the later part of the week. After the significantly better-than-expected results for August, the home sales reports will help further gauge the degree to which the housing market recession might be moderating. We expect the first look at 3Q GDP growth to have a sub-par 1-handle, but on an underlying basis to be much stronger, with key final domestic demand growth expected to run near +3 1/4%, boding well for a reacceleration in overall growth in 4Q. Key releases due out include existing home sales Wednesday, durable goods and new home sales Thursday, and GDP and Michigan consumer confidence Friday: * We expect September existing home sales to dip to 6.25 million units annualized. The NAR’s index of pending home sales has been quite volatile of late, posting an 8-point drop in July followed by a 4-point recovery in August. Sorting through the noise, we believe that the pace of resales is likely to be little changed in September. Our estimate implies a bit less than a 1% decline. * We look for a 0.6% rise in September durable goods orders. A sharp jump in the volatile aircraft category is expected to provide a significant boost to the headline reading this month. This should more than offset an expected pullback in the motor vehicle sector. And with the ISM survey pointing to steady underlying momentum in the pace of order growth, we look for the key core category — non-defense capital goods excluding aircraft — to continue to edge higher. * New home sales posted a surprising rebound last month but are expected to resume a downward trajectory. We look for about a 2% drop in September to a 1.03 million unit annual rate. Note that the new home sales data continue to be viewed suspiciously by industry experts due to the perceived high volume of order cancellations that are not captured in this report. * We forecast third quarter GDP growth of +1.9%. Although domestic demand appears to have been well supported by solid advances in consumption (+3.2%) and business fixed investment (+14%), another significant decline in residential construction (-16%) along with a sizeable drag from net exports and a negative contribution from the inventory component should help to restrain growth in 3Q. Indeed, we look for a sub-2% GDP reading for only the second time in the past 14 quarters. However, we continue to anticipate a rebound — to about +3.5% in 4Q. Finally, the core PCE price index is expected to be up 2.3% in 3Q — a bit less than in 2Q but still above the Fed’s comfort zone.
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First Post-Election Rate Hike
Oct 23, 2006
Thomas Gade (London)
In Sweden, the Executive Board of the Riksbank will meet again this Thursday to decide on monetary policy. We expect the Riksbank to pull the trigger on another 25bp increase in the repo rate. This will bring the repo rate to 2.75% — still very accommodative. Markets are less convinced and are pricing in around a 75% chance of another rate hike this Thursday. Our quantitative repo-meter model tends to agree with the markets and is providing only vague signals for another rate hike. The monetary policy decision is the first since the historic change in government and the release of the public budget proposal for 2007. The public budget contained very limited direct stimulus to the economy. However, hidden in the budget composition, we see positive growth initiatives stimulating both labour supply and consumption demand. On the back of the budget release, we have raised our 2007 GDP growth forecast from 2.9% to 3.3%. We believe that the budget is positive for bonds as well as for consumer-related companies and the SEK relative to Europe. No drama following the elections. The monetary policy decision will be the first following the historic change in government from centre-left to centre-right on September 17. The signals out of the Riksbank have so far confirmed the expectation that it will continue to gradually normalise monetary policy. We therefore also continue to expect another 25bp rate increase this Thursday. In the election run-up, the Riksbank stressed a number of times that it would react to political knowns only. Now, the Riksbank has seen both the election outcome and the 2007 budget proposal which was released earlier last week. Should there be a change in the pace of monetary policy, which we don’t see as likely, the press release as well as the new inflation report following next week’s monetary policy decision would be the place where the Riksbank could signal and make the arguments for such a change. Similarly, the Riksbank is likely to continue its gradual pace of withdrawal of monetary accommodation while awaiting the significant round of wage negotiations taking place over the course of 2007. Growth hidden in 2007 public budget proposal
The new centre-right government in Sweden released its 2007 budget proposal earlier last week. The budget proposal contained most of the initiatives proposed during the election campaign. Although the budget proposal contains only a limited discretionary stimulus to the economy, we see indirect growth stimulus stemming from the individual elements of the budget. In the long run, employment should be boosted by 1.5-2.0% through lower income taxes. The wealth tax will be halved and the property tax capped and frozen this year and the next. Privatisation revenues of SEK 50 billion are planned per year over the next three-year period. Therefore, we have revised up our 2007 GDP growth forecast from 2.9% to 3.3%. At the same time, we lower our inflation forecast slightly, due to discretionary one-off tax changes (see Sweden Economics: Growth Hidden in 2007 Budget Composition, October 17, 2006). The budget initiatives should significantly boost employment and consumption and should be positive for consumer-related companies. The halving of the wealth tax and privatisation revenues should support the SEK. Ten-year government bond spreads versus Bunds are expected to become positive and widen, but mainly as a result of continued monetary tightening in Sweden. The privatisation process could be a wild card affecting spreads, we think. The public budget also highlighted some of the pitfalls in inflation targeting as it contained a number of discretionary actions which will cause one-off effects on inflation over the course of next year as well as into 2008. The one-off effects are mainly related to a large dental reform, a tobacco tax hike as well as an increase in traffic insurance tax (see Sweden Economics: Growth Hidden in 2007 Budget Composition). On our calculations, these one-off effects could lower inflation by as much as half-a-point in 2007. Unless these one-off effects influence inflation expectations significantly, the Riksbank is likely to view them as one-offs, we think. Repo-meter providing vague signals
Our quantitative repo-meter model is providing vague signals of a rate hike in the months ahead. The repo-meter models are probability models, which capture the probability of a monetary policy rate increase and decrease respectively through the changes on business sentiment, consumer confidence, inflation as well as the exchange rate (see Sweden Economics: Reviewing the Repo-Meter and the Riksbank, January 13, 2006). The model continues to show a positive probability for further rate hikes mainly as a result of upbeat business sentiment and consumer confidence. Meanwhile, the recent pull-back in inflation as well as the currency strengthening is preventing the model from providing any clear-cut signals. Instead, our model would take the side of financial markets. Similar to our model, financial markets are not fully convinced of another rate hike in October and are pricing in around a 75% chance of a 25bp rate hike this Thursday. On our projections, we continue to see the Riksbank tightening monetary policy into 2007. This is contrary to the euro area, where we continue to see the ECB pausing from year-end as the most likely scenario.
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This Week in South Africa
Oct 23, 2006
Michael Kafe, CFA (Johannesburg)
Key this week will be the long-awaited SARB Policy Conference, CPIX, PPI data and the Medium Term Budget Policy Statement. Monday 23 October 2006 SARB Conference: Macroeconomic Policy Challenges for South Africa This two-day conference begins on Monday October 23. Of relevance to financial markets will be a Monday morning session on Monetary Policy Issues that will be chaired by Dr. Monde Mnyande, Executive General Manager responsible for Research at the SARB. There will also be two separate afternoon sessions on (a)South African Current Account in the Context of SA Macroeconomic Policy Challenges; and (b)The Impact of Oil Price Shocks on the South African Economy.
Finally, a Gala Dinner will be hosted by His Excellency, Governor Tito Titus Mboweni, in the evening.
On Tuesday October 24, there is a late morning session on Financial Markets, International Trade and Capital Flows that will be chaired by Mr. Daniel Mminele, Executive General Manager responsible for Financial Markets. Wednesday 25 October 2006 (i) September CPIX We look for a September CPIX print of 4.9% y/y. This will be driven largely by food, oil and domestic worker costs. Oil prices are not a huge issue. We expect the 36c/l decline in petrol prices to take the running cost component of the transport sub-index down by at least 3% m/m. Also worth noting is the increase in public transport prices that will likely be captured in this quarter’s survey, as well as changes in motor insurance premia. Public transport costs usually rise significantly in the fourth quarter survey (i.e., in December). However, given that public transport tariffs were hiked in the third quarter (i.e., in July) this year as oil prices rose, there is risk that the usual ‘December effect’ could be brought forward to September this year. Food prices will be tricky (as always): Our food price model points to a possible increase in food prices as a result of a rise in the implied dollar cost of diesel and a jump the 6m wheat futures index in February. However the wheat futures index fell significantly in March and April, and given that the timing of pass-through from futures prices to underlying is anything between 6-9 months, it is possible that food prices may not have risen by as much as suggested by the February futures price jump. Hence, although the model points to a 0.8% m/m increase, which is close to double the monthly average increase in the past six months, we look for no more than a 0.6% increase. After this reading, we would look for a deceleration in food prices in coming months as the October-December harvesting season helps take some pressure off food inflation, and as relative stability in the rand and oil prices helps place a lid on grain futures prices. Domestic worker costs account for some 3.6% of the index, and are surveyed twice a year (usually in February and September). In the past, the measured inflation rate here was maintained until the next survey. Since February 2006, however, Statistics South Africa indicated that it would apply the measured inflation rate during the survey month only, and keep the index reading unchanged until the next survey. In February 2006, domestic worker costs fell 1.6%. We have our reservations about this number, given that we all know that wages in that particular sector are typically downwardly rigid. What’s worse, in the preceding five months, domestic worker costs fell a full percentage point. Thus, on a cumulative basis, domestic worker costs as measured by Stats SA fell by a total of 2.6 percentage points between September 2005 and February 2006! Clearly, with the rise in living costs this year, we think that it is reasonable to expect a catch-up in this month’s reading. As a result, we have pencilled in a rather high 4% m/m increase for the September survey. (ii) Medium Term Budget Policy Statement (MTBPS) We do not expect any major surprises here. Key will be how the National Treasury juggles government funding numbers in the face of slower-than-anticipated growth for the second half of the fiscal year. In the February 2006 Budget, the fiscal deficit for this fiscal year was estimated at R26.4bn or 1.5% of GDP. This was based on estimated revenues of R446.4bn and expenditure of R472.7bn. Net financing was expected to come in at R25.7bn. These numbers were based on a growth forecast of 4.9% for 2006, with a current account deficit of 4.4% of GDP. In the October 2006 MTBPS this week, we expect the National Treasury to revise its growth number down to some 4.4%, and raise its current account forecast by at least a percentage point. (For now, Morgan Stanley still sticks to its long-held forecast of 4% GDP growth for this year, but we expect the National Treasury to come up with a higher number, given that it is a natural growth optimist.) At the moment, indications are that government revenue is already some R17bn ahead of budget, thanks in large measure to higher-than-expected corporate tax and VAT collections, as economic conditions remained buoyant during the first half of the fiscal year (March to September). The strong increase in imports of consumer goods also led to an increase in import tax revenues – mainly custom duties. Government expenditure, on the other hand, remains behind budget, thanks to capacity constraints. For the fiscal year to August, only 40.1% of budget has been spent. This compares with 40.6% of budget by the same time last year. Assuming expenditure growth catches up during the second half of the year, and 2H06 revenue receipts slow down in line with budgeted estimates as growth slows, thanks to the recent move to tighter money, we estimate that the fiscal deficit for this year could fall from the original estimate of R26.4bn to no more than R10bn (0.6% of GDP). This number could be significantly less if the rand remains weak and commodity prices remain at their current levels, enabling the government to rake in even more corporate taxes. But the National Treasury is likely to deliver a more conservative revised deficit estimate of some R13bn or 0.75% of GDP in the MTBPS. Also, despite the much better-than-expected revenue collection, we think that the Treasury is unlikely to make very significant changes to this year’s funding profile just yet for two reasons: First, this fiscal year has the highest level of bond redemptions (some R35bn) in South Africa’s history – all of which falls due in the final quarter of the year. Because the timing of redemptions is heavily back-loaded, the Treasury will most likely want to tread cautiously. Second, with the country’s balance of payments situation having deteriorated a lot more than expected at the beginning of the year, the Treasury may want to keep its options open as far as supporting the SARB’s reserve accumulation efforts are concerned. As we have shown in the past few weeks, reserve accumulation in South Africa is still positive, but has fallen from R34bn in 2005 to R11.5bn in the first quarter of this year, and no more than R4bn in the second quarter. Finally, the Budget may contain some more details on the synthetic fuel industry tax proposals that were mooted in February, but we do not expect a final ruling just yet, given that submissions were made only recently. Thursday 26 October, 2006 September PPI Here, we look for a 9.2% print that promises to be highly contingent on the timing of the measurement of imported oil prices. Typically, oil price movements are captured from two separate but related sources, namely diesel and petrol prices. Changes in diesel prices are usually captured instantaneously in the products of petroleum and coal’ sub-index, while changes in imported petrol prices are captured in the ‘other minerals’ section of the ‘mining and quarrying’ sub-index, typically with a lag of 0-3 months. So far this year, the measurement of imported oil prices has been rather erratic. But a closer look at the detail would suggest that, lately, extra effort is made to catch up at the end of each quarter. June 2006 is the most glaring example. Since June, however, oil prices have risen by a cumulative 9% between July and August, while Statistics SA has only reported a 4.6% cumulative increase. In fact, the index reading was flat for August – a month where oil prices rose to their peak! Against this background, we think there is a high probability that we see the August price increases come through this month. This should offset the 36c/l drop in regulated oil prices during the month of September, and delay the impact of lower oil prices for another month or so. The pass-through from the 25c/l drop in diesel prices will however captured instantaneously. Food prices will also likely take the September producer price index higher: Although the 6m wheat futures price was broadly flat in August (there is usually a 0-3-month lag between movements in the 6m wheat futures index and producer food prices), the rise in the implied dollar cost of diesel would nevertheless have kept up the pressure on food. Also, the fact that the wheat futures prices reported their highest monthly increase in September makes us even more wary. But, even so, we are of the opinion that year-on-year agricultural food inflation likely peaked at 23% last month, and should start decelerating from here as technical base effects from last year start to kick in. Manufactured food prices will however likely continue to rise for another 3-6 months before peaking. Finally, we look for a 28% seasonal decline in electricity prices. The price of electricity is usually hiked in mid-winter (June) and brought down again in early spring (September). After rising by 44% in June this year, we expect electricity prices to fall by 28% this month. This is broadly in line with the decreases reported in the last three years.
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Price Pressures Rise
Oct 23, 2006
Gerald Minack (Sydney)
More evidence of spreading inflationary pressure increases the prospect of an RBA tightening at the next Board meeting. The only important data release before the meeting is the September quarter CPI (due Wednesday). It now seems that it will require very benign CPI to hold the RBA back from another rate increase. (The consensus forecast is for a 0.7% rise in both headline and core CPI for the quarter.) Today’s producer price data point to broadening inflationary pressure. For manufacturing, the upstream price indicators benefited from lower energy costs. But downstream (output) inflation remains relatively high — for domestically produced goods, 4.8% over the year to the September quarter. More alarming is the rise in business service costs. The prices charged by the business and property sector increased by 5.6% over the year, up from 4.9% over the year to the June quarter — a new cycle high. Likewise, the prices charged by the transport and storage sector barely moderated, despite the fall in energy costs. The prices charged by the residential construction sector eased, but costs are not responding. Builders’ material costs now exceed their selling prices for the first time in three years. Upstream consumer price data are mixed. The price of consumer imports moderated at the margin, while domestically produced consumer goods increased by 4.9% over the year. There are two points to note about all this. First, price pressures are broadening. Most sectors are seeing relatively elevated price increases. Second, there are an increasing number of sectors where input costs are now rising faster than output prices. Of course, for most sectors the most important cost is labour, but there, too, the news is not good: productivity growth has apparently slowed dramatically, implying that unit labour costs are rising. Price indicators are backward-looking, while the RBA is forward-looking. But the RBA is also mindful of appearances. With important growth indicators remaining robust — notably employment and borrowing — these elevated price readings add pressure for another rate increase. It now seems that it would take a remarkably benign CPI to forestall a move at the November board meeting.
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