The Real Stake of Turkey-EU Negotiations
December 11, 2006
By Serhan Cevik and Eric Chaney | London, London
Turkey’s accession negotiations with the EU are an ‘anchor’ of modernization. History holds the key to understanding where we stand today and identifying possible trajectories for the future. This is why we need to put Turkey’s relations with the European Union into a historical context, before analyzing its convergence path. The process of ‘Europeanization’ started centuries ago during the Ottoman Empire, with the realization of scientific and institutional progress in the west. But it really accelerated to a revolutionary pace in the early decades of the modern republic under the reign of Ataturk, overhauling archaic institutions and bringing economic rejuvenation to the agrarian society. Unfortunately, despite such significant progress, a dreadful sense of inertia descended over the country and political frictions slowed institutional modernization. Consequently, although Turkey applied for the associate membership status in the European Economic Community in 1959, the EU waited until 1999 to confirm the candidacy status and until 2005 to start accession negotiations. Nevertheless, Turkey’s difficult relations with the EU have always played a fundamental role in its institutional and economic development.
The challenging journey towards EU membership will change Turkey as well as Europe. Bringing political and economic institutions into line with European standards will transform Turkey’s economy and social standing, but it would be naïve to expect accession talks to be straightforward, without any challenges. The experience of the last 12 months is an obvious case in point. First, despite the encouraging steps forward in recent years, Turkey still has a long list of political and socio-economic requirements to complete. Second, Europe’s enlargement fatigue and the unresolved Cyprus conflict are likely to keep obstructing Turkey’s accession process, even if Turkey meets all the conditions without any delay. Indeed, Turkey’s membership aspirations have always been an important feature in the ‘widening versus deepening’ debate in Europe, but the prevailing rhetoric suggests a deeper resistance to further integration and enlargement. In our view, these underlying shifts in Europe’s political climate are likely to place new stumbling blocks (such as the argument on the EU’s absorption capacity) in front of Turkey’s accession process. That said, we still believe that Turkey’s journey towards ‘Europeanization’ will continue to transform the country’s economy and institutions. Turkeyremains the least popular candidate for EU membership. Although Turkey is converging towards Europe in every sense, there is a growing anxiety over economic and social costs of the Turkish membership. Surveys show Turkey as the least popular candidate, with barely one-third of EU citizens supporting its membership bid. It is true that Turkey’s per capita income is just about 30% of the EU-25 average, but that alone cannot explain the lack of conviction of several EU countries about Turkey’s membership aspirations. There are probably deep-rooted cultural factors behind such an unfavorable judgment that may indeed prevent full integration at the end. Nevertheless, we still want to focus on the economics of convergence in this report. A snapshot picture of current economic conditions presents a challenging case, but we know very well that static evaluations could be misleading. Therefore, we need a forward-looking approach, not just an extrapolation of Turkey’s erratic history. Only by estimating the country’s economic conditions at the time of accession, can we come up with a reasonable assessment of potential costs and benefits of its full integration with the EU. Turkey’s per capita income is low, but shows a remarkable potential for convergence. One of the major concerns is the income inequality between Turkey and the EU and regional income disparities within Turkey. Turkey’s per capita GDP in purchasing power standards was just 29.8% of the EU-25 average in 2005, even below Bulgaria (31.9%) and Romania (32.9%). Further, although the latest figure represents a 16% increase from the country’s relative income level of 25.7% in 2001, it is still below the average of 30.5% in the 1990s. As a result, Europeans perceive Turkey’s young and growing population as a threat that could lead to a wave of immigration. However, we believe that such figures alone are not enough to reach a gloomy conclusion. As a matter of fact, an encouraging process of convergence is already underway, and the Turkish economy should continue catching up with the EU over the medium term. Even in the near future, we are likely to see further improvements that would raise Turkey’s per capita income to 34.2% of the EU-25 average (or about 40% if we take into account the conversion of national accounts to the European standard) by the end of 2008. Archaic institutions and macroeconomic volatility slowed Turkey’s income growth. Though our main objective in this report is to identify long-term convergence scenarios, we first need to focus on where Turkey is coming from. In our view, the country’s past underperformance was a result of structural weaknesses and sub-optimal policymaking. In other words, the fundamental problem was institutional constraints that fostered distortionary policies and worsened economic vulnerabilities. As a result, growth volatility, measured by the standard deviation of the growth rate of real per capita GDP, doubled from an average of 2.5 in the 1980s to 5.1 in the 1990s and then surged to 8.4 with the 2001 crisis. But that systemic shock also turned into an inflection point for politics and economic policies. With an unprecedented political consolidation, the first single-party government in over a decade has adopted prudent policies and introduced an array of reforms. Not surprisingly, we have witnessed a dramatic drop in economic and financial volatility. For example, income volatility declined from the peak of 8.4 in 2003 to 0.8 this year – the lowest reading since 1970. Thanks to structural improvements – ranging from fiscal consolidation to bank restructurings – the moderation of the business cycle has in turn set the stage for secular disinflation and boosted output growth to an annualized rate of 7.5% in the last five years. The EU accession process helps to reduce institutional inertia and raise income growth. Since institutional factors are behind the mystery of economic growth, the prospect of EU accession that facilitates institutional modernization would help to speed up income convergence on a sustainable basis. Just like other accession candidates, Turkey should also benefit from such an institutional paradigm shift and thereby accelerate its productivity-driven growth. Indeed, the process is already taking place, as greater openness and structural adjustments keep bringing productivity gains across the economy. For example, output per hour worked increased at an annual rate of 8.7% in the post-crisis period, becoming the most important factor driving output growth. Nonetheless, the level of labor productivity still stands at 45% of the EU-25 average. Hence, we believe that productivity growth must remain on its elevated trend to lead a more meaningful convergence in per capita income towards the EU average. Productivity growth is a crucial ingredient of potential output, but we also need to consider demographics, human capital endowment and investment growth in assessing Turkey’s growth potential. Turkey’s young and growing population is a demographic gift, not a threat. Many fear Turkey’s growing population, with an average age of 26.5, but we see it as a demographic gift that could help the country achieve faster convergence. After all, working-age population is the basis for employment and income growth. Turkey’s problem has always been the low level of employment limiting the speed of convergence. While the working-age population as a share of the total stands at 71.2% (compared with 64% in Europe), the number of employed is just 45% of the working-age population (63.8% in Europe). The employment rate is partly a function of the level of labor force participation, which unfortunately stands at 49.3%, compared with 72% in Europe. However, if Turkey improves the state of the labor market and brings its employment rate to the European level, the number of employed could increase by almost 50%, or by 11.6 million workers. Put differently, Turkey can potentially create new jobs that would be around half of the entire employment in the ten new members of the EU. Given the significant difference between per capita GDP and per worker GDP, that would imply a level of per capita income that is already at about 50% of the EU-25 average, even with today’s figures. In other words, Turkey’s demographic characteristics, which may look like a threat now, are actually an indication of its great potential to accelerate the pace of income convergence. Turkey’s potential growth rate is almost three times that of the EU-25. Macroeconomic normalization and structural changes have acted like a ‘technology shock’, raising the rate of productivity growth to a higher plateau. And given the favorable demographic trends, we estimate Turkey’s potential growth rate at around 7.5% – three times the EU-25’s potential. Of course, having great potential is no guarantee for catching up with the rest of Europe at an accelerated pace. Maintaining the actual growth rate close to the potential growth rate, without triggering inflation pressures, is a challenging task that requires prudent macro policies and, more importantly, a wide-ranging set of structural reforms to remove microeconomic bottlenecks. As discussed above, one of the important building blocks for such a scenario is improving the economy’s labor absorption capacity. Greater flexibility in the labor market, together with the rationalization of the tax regime and bureaucracy, would certainly help to accelerate job creation and reduce inefficiencies in traditional sectors of the economy. For example, gross value added per worker in the agriculture sector is less than one-third of those figures for services and manufacturing sectors. In other words, sectoral productivity differentials (reflecting structural problems) also explain regional income disparities and the low level of per capita income relative to the EU average. Therefore, by improving labor market conditions – reducing informality and the share of agricultural employment and increasing participation and employment ratios – Turkey can enhance its potential growth rate and keep its actual growth rate close to its potential. Turkeyneeds to increase investment in human and physical capital. Turkey may have the potential to boost employment growth, but that is not an automatic process even with more flexible labor market regulations. Educational attainments are crucial, especially in today’s global economy. Even though we have seen a steady improvement over the years that will no doubt make the next generation of workers better equipped, Turkey’s human capital endowment remains low compared with other countries. For example, the share of the adult population with upper secondary education is 25% in Turkey, as opposed to the OECD average of 56%. This is partly a result of a ‘gender gap’ in educational attainments that also leads to an unusually low female participation in the labor force. Therefore, Turkey needs a comprehensive strategy to improve human capital endowment across the board. That is of course necessary but not sufficient to achieve higher productivity and income growth. After all, labor productivity depends on the capital-to-labor ratio and total factor productivity, not just the quality of human capital. Gross fixed investment growth has accelerated in recent years, but is still not enough. Fiscal consolidation and restructuring in the banking sector have already led to a better allocation of capital, increasing business investment spending at an annual rate of 30% from 14.5% of GDP in 2001 to 24% this year. However, even such an impressive degree of capital accumulation is not enough to keep the economy growing at a rate close to its potential. Sadly, domestic savings are inadequate to finance the country’s investment requirements. This is why it needs a sustained increase in foreign direct investment, which had remained at an annual average of US$720 million (or 0.4% of GDP) and accounted for a mere 2% of capital spending between 1985 and 2003. But that was not surprising, given macroeconomic volatility and structural limitations keeping foreign firms away from the Turkish market. The good news is that macroeconomic normalization and institutional improvements in the investment climate have already led to a breakthrough in FDI flows – surging to US$9.8 billion (or 2.7% of GDP) in 2005 and around US$20 billion (or 5.2%) this year. Obviously, the EU accession process plays an important role in attracting FDI and therefore accelerating productivity growth. It has happened in numerous other countries, and Turkey should enjoy a similar injection of low-cost capital with positive externalities. Coupled with higher educational attainments (especially in science and technology), the FDI-driven accumulation of new technologies and know-how would support the rise in total factor productivity growth, which already increased from 0.5% a year in the 1990s to 4.8% in the last four years. Turkeycan achieve an acceptable degree of income convergence by 2015. Estimating the path of income convergence is an empirically challenging task, but our simple model based on growth rates and population dynamics provides useful insights and reasonable accuracy. Full income convergence is not necessary at this stage, or even at the time of accession. Hence, we instead focus on two alternative scenarios – uninterrupted accession process towards full membership or prolonged ‘Europeanization’ with no membership status. In our accession scenario, Turkey’s trend GDP growth would reach 7.5% a year, as opposed to 2.5% in Europe, thanks to the rising share of the qualified workforce and capital inflows. That would bring per capita income from 29.8% of the EU-25 average in 2005 to 48.5% (even excluding the likely revision in national accounts) by 2015. In our sub-optimal scenario, negotiations would fail, but ‘Europeanization’ would continue, albeit at a slower rate and with higher political risks. Trend GDP growth would be only 4.5% and leave Turkey lagging behind China and India. All in all, we still believe that the likelihood of an absolute breakdown of Turkey’s relations with Europe is negligible and the accession process, though more challenging than for other candidates, will help to accelerate the speed of income convergence. Turkeyneeds to deepen the reform agenda to maximize the return from the EU anchor. Turkey’s modernization efforts have far-reaching roots, and even if the accession process fails, Turkey would not change its orientation toward the ‘west’. Of course, a smooth transition is the best possible outcome, accelerating institutional transformation and strengthening economic performance. However, regardless of the course of accession talks, we believe that Turkey must deepen its reform agenda beyond macro adjustments to break the vicious cycle of the status quo to establish a more competitive business climate, and to provide better opportunities for its young and growing population. After all, the country’s impressive performance in the last five years is mainly a reflection of macroeconomic normalization. Moving forward, however, the benefits of being normal will gradually disappear and income convergence is likely to become even more dependent on economic reforms and greater political openness.
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Short and Long-term Issues for Monetary Policy
December 11, 2006
By Thomas Gade | London
This week the Riksbank will again decide on monetary policy. In line with our own expectations and fully priced in by markets, a decision to raise the repo rate by 25bp looks almost certain. The Riksbank is likely to signal a continued gradual withdrawal of monetary stimulus, as monetary policy remains vastly accommodative. This is in contrast to the Euro area and the US, where the ECB is now close to neutrality while the Fed may even be above neutrality, according to our estimates. As inflation has continued to surprise on the downside, we will look out for possible reservations with respect to the future path of monetary policy, should inflation remain subdued. Inflation has continued to surprise on the downside recently. Inflation was 1.0% YoY in October on the Riksbank’s favorite UND1X measure, some three-tenths below the official Riksbank forecast. Even with the expected rise in November, inflation would still be tracking well below the latest official Riksbank forecast. Thus, it is possible that two of the six-member Executive Board may again express some reservations about the future pace of monetary withdrawal (see Sweden Economics: Unanimous, Yet More Uncertain, November 15, 2006). We will only know the details of the discussions through the minutes released early next year, but their reservations could be expressed in the press release accompanying the monetary policy decision. Although we are not changing our forecast, we cannot rule out the possibility of a short-term drop in front-end interest rate expectations. In recent months, the krona has continued to rally, subduing inflation. Meanwhile, the Swedish economy continued to expand at a strong 1.0% QoQ (4.1% SAAR) in 3Q, and preliminary expectations indicators suggest a slight slowdown only in 4Q. A concern for the Riksbank, the expansion in bank lending to households is only showing vague signs of a slowdown, despite the sharper drop in M3 money supply. A central focus for the Riksbank will be monitoring the wage demands in the large rounds of wage negotiations during 2007. Close to 65% of current employees will have their wage contract up for renegotiation through 2007. We currently expect 4% nominal wage growth on average over the three years traditionally governed by the wage contracts. Preliminary demands have been slightly below expectations, but a good estimate of the overall outcome is not likely to be reached before March (see Sweden Economics: The 2007 Wage Negotiations — Expectations and Implications, November 21, 2006). Monetary policy in Sweden was recently evaluated in a report by Francesco Giavazzi and Frederic S. Mishkin. The report makes a number of recommendations to the Riksbank in terms of the conduct and governance of monetary policy. First, the report makes an interesting case for using a price level target instead of an inflation target. The Riksbank in Sweden currently adopts a flexible inflation-targeting regime. A trending price level target would in principle function as an inflation target. However, a price level target is history-dependent. As a deviation in inflation from the inflation target would change the path of the price level, a trending price level target would allow the central bank to revert overshoots and undershoots and ensure a reduced uncertainty as to where the price level would be over long horizons. As such, this should stabilise output fluctuations and enhance the efficiency of monetary policy. The stabilisation works through inflation expectations. Facing an undershoot of inflation, the economic agents would expect future inflation to overshoot in the future. Therefore, the real interest rate should drop and thus enhance the effect of the nominal movements implemented by the central bank. Although not directly rejecting a trending price level target, Riksbank Governor Stefan Ingves has thus far stated that more research is required on this issue before the Riksbank would consider adopting such a concept. Second, the report applauds the current debate in the Riksbank of whether it should move towards publishing its own interest rate forecast and the uncertainty bands. This should provide a clearer picture of the path of future short-term interest rates the Riksbank considers appropriate to reach the target, as well as the uncertainty surrounding the future monetary policy path. Currently, only the Reserve Bank of New Zealand and Norges Bank publish their assessment of the most likely interest rate path. Evidence from Norges Bank shows that the central bank’s central projection of short-term rates and short-term interest rates implied by markets often are very well aligned. Nevertheless, the deviation between those projections and the actual short-term interest rate can be quite substantial. Although markets often tend to focus primarily on the central projection, the latter point underscores the benefits of explicitly publishing uncertainty bands. While the debate is still ongoing at the Riksbank, we would expect it to switch from using market-implied interest rate forecasts to publishing its own interest rate forecasts within the next few years. Although many of the recommendations made by Professors Giavazzi and Mishkin are not likely to have a short-term impact on monetary policy in Sweden, they strike us as interesting from a more global perspective. Professor Mishkin currently serves as a member of the Board of Governors on the US Federal Reserve Board. Therefore, the report is likely to reflect his view on the conduct and governance of monetary policy, hinting at possible implications for the development of monetary policy in the US.
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Global Transitions
December 11, 2006
By Stephen S. Roach | New York
After four years of the strongest growth since the early 1970s, the global economy is entering an important transition. The character of that transition is the subject of endless debate. Financial markets are currently priced for a Goldilocks-like soft landing -- a benign slowdown that tempers inflation and interest rate pressures. The risk, in my view, is that global growth could fall well short of consensus expectations -- with important implications for unsuspecting markets. I suspect that our current baseline forecast offers only a hint of the coming transition in the global economy. While our projected 4.3% increase in world GDP for 2007 remains well above the 45-year growth trend of 3.7%, it falls significantly short of the 5.0% increase we currently estimate for 2006. The anticipated downshift is broad-based, with the US and Europe leading the way in the developed world and a slowing in Asia ex Japan -- especially China and India -- standing out in the developing world (see accompanying table). Our downwardly-revised US forecast reflects the repercussions of a post-housing-bubble shakeout, whereas the slowdown in Europe is expected to be driven by fiscal consolidation in Germany and Italy, along with the lagged impacts of ECB monetary tightening and a stronger euro. In an increasingly interdependent world, it also makes sense to mark down our growth forecasts in Asia, largely because it will be next to impossible for the region’s export-dependent economies -- especially China -- to avoid the impacts of a slowing of end-market demand in the US and Europe. Downshifts in the US and China should not be taken lightly. By our reckoning, these two economies have collectively accounted for over 60% of the cumulative growth in world GDP over the past five years -- including direct effects (43%) and the indirect effects traceable to trade linkages (at least another 20%). A key question for the global outlook, in my view, is not whether new sources of global growth have emerged on the scene -- the so-called decoupling thesis -- but whether we have gone far enough in marking down our forecasts for the US and China. Our US team now concedes that America has lapsed into a temporary “growth recession” -- econo-speak for a growth rate that is sluggish enough to allow the unemployment rate to start rising again (see the 11 December dispatch by Richard Berner and David Greenlaw, “It’s a ‘Growth Recession,’ Not a Lasting Downturn”). They are now looking for three quarters of just 2% annualized growth in real GDP over the 3Q06 to 1Q07 interval -- a downward revision of 0.6 percentage point from their previous forecast. This scenario has soft-landing written all over it -- a surgical strike on the housing market that leaves the rest of the US economy relatively unscathed. The growth recession is expected to be relatively short-lived, giving way to a projected 3.0% annualized rebound in real GDP in the final three quarters of 2007. In cutting their near-term growth forecast, Dick and Dave concede that the risks remain on the downside. I couldn’t agree more. The difference between us is that I would assign a higher probability to those risks than they do. I fear that the soft-landing crowd has been too quick to pounce on the first signs of softening as confirmation of the endgame to the current downturn. Experience teaches us to be wary of the lags in jumping to premature conclusions about the scope and duration of cyclical adjustments. Take the residential construction sector, for example. Employment in the residential building and specialty trade contractors industries, combined, has now declined by 110,000 from the February 2006 peak -- reversing only 15% of the cumulative run-up that occurred over the preceding five years. With housing starts already down 35% from their peak, it seems perfectly reasonable for employment in this sector to fall a good deal further -- a headcount reduction that would constrain overall labor income generation and put heightened pressure on personal consumption. It’s not just the nascent recession in homebuilding. Also at risk are the related businesses like furniture, appliances, mortgage finance, and real estate brokers. And, of course, there is the likely unwinding of the consumer wealth effect. Only asset-driven wealth effects can explain how a decade of frothy consumption growth (3.7% in real terms) has exceeded after-tax real income growth (3.2%) by an average of 0.5 percentage point per year. With the last bubble now bursting, I suspect that the wealth effect is about to turn negative for overly-indebted, saving-short US households -- dragging consumption growth below the pace of income generation as rational households abandon asset-based saving strategies and return to more of an income-based approach. As consumption slows, demand-driven capital spending should be quick to follow -- precisely the inference that can be taken from a weak capital goods report in October. The lesson of post-bubble shakeouts is important here: When a booming sector goes bust -- dot-com six years ago, housing today -- there are no built-in firewalls that contain the ripple effects. The US soft-landing scenario does not adequately allow for these risks, in my view. Moreover, I am highly suspicious of the idea that the rest of the world is likely to be insulated from a US growth shortfall. China, the fourth-largest economy in the world, devotes an outsize 35% of its GDP to exports -- and the US is its biggest external market. In Japan, the second-largest economy, exports are 17% of GDP, and the US and China are its two largest customers. For Canada, the 8th-largest economy in the world, exports to the US account for fully 27% of its GDP. In Mexico, the world’s 13th-largest economy, US exports make up 24% of its GDP. And these are just the direct effects. Supply-chain linkages throughout the world -- especially to Asian suppliers of the Chinese assembly line such as Korea, Taiwan, and Japan -- will compound the impacts of a demand shortfall in China’s largest export market, the US. It would be one thing if the non-US world could draw incremental support from improving internal demand -- especially private consumption. But consumption shares are still falling in China, and a recent downward revision underscored a similar and very disappointing development in Japan. Moreover, European consumption is currently adding no more than one percentage point to pan-regional growth. With Asia and Europe lacking any vigor in their autonomous consumption dynamic, global decoupling seems all the more a stretch. That raises yet another important question mark for the global soft-landing scenario. The China factor bears special mention -- not just because of the export linkages noted above but also because of some important developments on the internal demand front. The Chinese seem increasingly determined to cool off an overheated investment sector -- hardly surprising with fixed investment now nearing an unheard of 50% of GDP. A failure to bring an increasingly irrational capital allocation process under tighter control is a recipe for capacity overhangs and deflation. The Chinese are mindful of these very risks and are hard at work in shifting their growth focus. Reflecting the combined impacts of administrative controls and monetary tightening, there has been a discernible slowing in the growth of both industrial output and investment in the final months of 2006. I expect more of that to come in early 2007 -- sufficient to take Chinese real GDP growth down from the blistering 11.3% comparison of mid-2006 into the more sustainable 8-9% range by year-end 2007. Meanwhile, the Chinese are hard at work in laying the groundwork for a pro-consumption tilt to the growth dynamic -- consistent with the better balance that a higher-quality growth experience ultimately requires. For China, this could well mark a critical transition in its remarkable economic development -- with important implications for Asia, the broader global economy, and for what has been an increasingly China-centric dynamic at work on the demand side of major commodity markets. The year ahead is not just about a looming transition in the global business cycle. It could also mark an important transition in the globalization debate. I suspect that the focus is likely to shift away from the brilliant successes of China and India toward an increasingly politicized pro-labor pushback from the rich countries of the developed world. The income shares of the major industrial economies are all at extremes -- record high returns to capital and record lows for labor shares. Courtesy of an increasingly powerful IT-enabled globalization that is now affecting both tradable manufacturing and once non-tradable services, job growth and real wages in the high-cost developed world remain under unusual pressure. That’s great for corporate profits but very tough for real wages. A pro-labor shift in the political power base of the industrial economies -- already evident in the US, Germany, France, Italy, Spain, Japan, and possibly Australia -- could lead to a reversal of these trends. It opens up the possibility that the pendulum of economic power might well begin to swing from capital back to labor. Such a development, in conjunction with our forecast of a significant slowing in global GDP growth, implies a weaker-than-expected top line for global businesses. That could have profound consequences for the earnings cycle that continues to underpin ever-frothy world financial markets. Moreover, to the extent any pro-labor shift has protectionist overtones, it could also prove to be a stern test for globalization, itself. In looking to 2007, my main message is to be wary of extrapolation. After a powerful four-year boom, an important transition lies ahead for the world -- both on economic as well as on political terms. The consensus appears to be unprepared for the full extent of the transition that could well occur -- banking on the benign outcome of a soft landing in the US to be offset by accelerating growth elsewhere in a decoupled world. The official baseline forecast of the IMF is quite consistent with such a sanguine prognosis. It calls for a 4.9% increase in world GDP next year -- virtually identical to the 4.8% average gains over the 2003-06 period. The Morgan Stanley forecast of 4.3% global growth is already well below that consensus. As post-housing bubble adjustments begin to play out in the US, the lags of an interdependent and still unbalanced global economy are only just beginning to kick in. And a new group of politicians is only just beginning to take the reins of power. All this underscores the possibility that we may not have gone far enough in factoring in the downside risks to global growth in 2007. Transitions are never easy -- especially when juxtaposed against the complacency spawned by four fat years.
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Review and Preview
December 11, 2006
By Ted Wieseman and David Greenlaw | New York, New York
Another employment report, another market rout. Treasuries fell sharply the past week after decent losses through Thursday that followed surprising upside in the non-manufacturing ISM report and more hawkish-than-expected remarks from ECB President Trichet were significantly added to by a third straight employment report plunge Friday. This month’s jobs report was solid — a decent gain in November payrolls that was in line with our expectation but a bit stronger than consensus and modest upward revisions to prior months but with some partly offsetting moderation in other details like the unemployment rate, earnings and hours. But it was certainly not as strong as the prior two reports that crushed the bond market, which both featured huge upward revisions to past job growth and in October also saw significant upside in hours and earnings and a drop in the unemployment rate. But coming after the dismal run of data the prior week, which led us to slash our 4Q GDP forecast to +1.6% from +2.8% and abandon our prior forecast for one more Fed rate hike in 2007 (we now see the Fed on hold through late 2007), the report provided some recently rare upbeat news on the economy. And coming just a few days ahead of the FOMC meeting it was released against the backdrop of a market still priced for a vastly more dovish Fed path than Fed officials have indicated they believe is likely. This forced a major repricing of the Fed in the futures market, which is now moving towards pricing out a rate cut as early as March after seeing it as highly likely at the end of the prior week. Given the solid results from the employment report and the Fed’s repeated and clearly expressed continuing fears of upside risks to inflation, we expect Tuesday’s policy statement to retain the tightening bias that has been in place since policy went on hold after the June meeting, while recognizing the recent stretch of sub-par growth and the potential positive impacts of this on the inflation outlook. Benchmark Treasury yields rose 12-16bp over the past week as a 6-10bp front-end led plunge on Friday added to 6bp, curve-neutral losses posted through Thursday. Entirely as a result of Friday’s action, the curve flattened modestly on the week, with 2s-10s moving 3bp lower and 2s-30s 4bp lower (reversing only a third of the big steepening moves seen the prior week), as the 2-year yield rose 16bp to 4.675%, the 10-year yield 13bp to 4.55%, and the long bond yield 12bp to 4.66%. The 5-year yield rose 14bp to 4.53% and the 3-year 15bp to 4.57%. The bulk of the market’s move was again in real rates rather than inflation expectations. TIPS inflation breakevens were little changed as the 5-year TIPS yield rose 12bp to 2.27% and the 10-year TIPS yield rose 11bp to 2.20%. The very dovish Fed path that was priced into futures markets coming into the week was significantly scaled back. In the near term, the February fed funds contract was off 4bp to 5.23% and the April contract 10.5bp to 5.18%. So odds of a rate cut at the January FOMC meeting were reduced from about 25% to 10% and the chance of a cut by the March meeting to around 30% from 70%. And the biggest loser in the eurodollar futures market was the June 07 contract, which plunged 23bp to 5.055%, essentially taking one full rate cut out of the first part of next year. The reds (Dec 07 to Sep 08) lost 21bp on average, with the low-rate June and Sep 08 contracts selling off 20.5bp and 20bp, respectively, to 4.655%, shifting back towards favoring a 4.50% trough to the expected rate cutting cycle from 4.25%. Non-farm payrolls rose 132,000 in November, very close to our forecast but a bit better than consensus, and there were net upward revisions to October (+79,000) and September (+203,000, after having been originally reported at +51,000!) of 42,000. In November, further significant job losses in construction (-29,000) and manufacturing (-15,000) were offset by strength in various service sectors, including healthcare (+32,000), restaurants (+34,000), retail (+20,000), business services (+43,000) and government (+18,000). Other details of the report were a bit softer. The average workweek was flat at 33.9 hours, resulting in just a 0.1% rise in aggregate hours worked. Average hourly earnings growth moderated to +0.2%, though on a year-on-year basis accelerated back to the cycle high +4.1%. Meanwhile, the unemployment rate rose a tenth to 4.5%, though this was entirely a result of a surge in the labor force. Household survey-based employment continued to surge, rising 277,000. Adjusted for definitional differences to make it comparable to the payroll survey, the gain in the household survey employment measure was even stronger at +321,000. Recall that much stronger growth in this measure of employment relative to the initial payroll count correctly predicted the huge upward benchmark revision announced a couple months ago. Since the March benchmark month, this gap has continued — payroll growth has averaged 139,000 a month, while the concept-adjusted household survey gain has averaged 289,000. The employment report was the key market focus the past week in an otherwise quiet data calendar. Two releases earlier in the week had mixed implications. The expected sharp downward adjustment to unit labor costs growth eased inflation concerns a bit, while surprising strength in the non-manufacturing ISM further highlighted the two-tier nature of the current economic backdrop — major weakness in homebuilding and auto production, with significant hits to the manufacturing sectors serving those sectors, but much more robust activity elsewhere. Non-farm business labor productivity growth was revised up to +0.2% in 3Q from 0.0%, as the upward adjustment to output (+2.3% versus +1.6%) implied by the GDP report was largely offset by higher growth in hours worked (+2.1% versus +1.6%). On a year-on-year basis, productivity growth was up 1.4%, a low since 1997. The main news in this report was the huge downward adjustment to unit labor costs implied by the big cut to 2Q wages and salaries in the GDP revision. Second quarter unit labor cost growth was slashed to -2.4% from +5.4% and 3Q was revised down to +2.3% from +3.8%. On a year-on-year basis, this resulted in unit labor cost growth in 3Q being dropped to +2.9% from +5.3%, the originally reported latter reading having matched the highest gain since 1982. The non-manufacturing ISM headline business conditions index rose to 58.9 in November from 57.1 in October, the high since May. The orders (57.1 versus 56.5) and employment (51.6 versus 51.0) gauges posted modest gains. Eleven of 18 sectors reported growth in November (led by wholesale trade, information, management of companies and support services and agriculture), three reported no change and four contraction (education, hotels and restaurants, construction and government). The prices paid index (55.6 versus 51.9) showed the same surprising upside as the manufacturing version. Commodities reported up in price included various energy items, paper products and steel, plus some items not normally thought of as commodities like airfares, hotel rates and construction costs. The short supply list was also odd and highlighted the quirkiness of this report with its attempt to shoehorn a host of disparate industries (despite the persistence of many reporters in wrongly calling it a ‘services’ report, which it is not) into a survey structure more appropriate for manufacturing companies. The job market is tight. The FOMC meets Tuesday, and clearly an unchanged 5.25% funds target is all but a certainty. We also expect that there will again not be a significant substantive change in the key language in the official policy statement. In particular, we look for the tightening bias — “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” — to be retained. We do, however, expect that the statement will recognize the recent downshift in economic growth, which seems to have intensified a bit in 4Q, and suggest that inflation pressures may be gradually abating. This would set the stage for potentially dropping the tightening bias at an upcoming meeting if there were to be a continuation of the signs of moderating inflation pressures seen in the October CPI report in future inflation data, though we do not expect to see such confirmation just yet. Following the sharp downward revision to our 4Q GDP forecast to +1.6% from +2.8%, some indications that the period of sub-par growth could extend a bit further into 2007 than we previously expected, and the slightly better recent inflation data (at least for core CPI if not so much for core PCE), we adjusted our Fed call the past week and no longer look for a final rate hike next spring. We now expect the Fed to be on hold at 5.25% until late next year, when we anticipate a gradual move in core PCE inflation back towards the 1-2% comfort zone to allow a start to a modest easing in policy that we expect to extend into 2008 and bring the funds target from its current slightly restrictive stance to a more neutral setting. See Changing the Fed Call by Richard Berner and David Greenlaw, for full details. In addition to the FOMC meeting, the upcoming week has a number of key economic data releases as well as some supply in the form of an US$8 billion reopening of the 10-year note on Wednesday. Main data focus will be on retail sales Wednesday and CPI Friday. The trade report Tuesday could have a significant impact on fourth quarter GDP forecasts. The Empire State manufacturing survey Friday might provide some indications of whether the recent manufacturing slowdown is easing, though this survey, which on an ISM-comparable weighted average basis over the long run has been the single best predictor of the ISM among the regional surveys, has recently been much running much stronger than the national report (whereas the usually woeful predictive power of the Chicago PMI has actually had a good run recently) and therefore will probably be discounted by investors until it starts to match up better. Other data due out include the Treasury budget Tuesday and industrial production Friday: * We look for the trade deficit to hold steady in October at US$64.3 billion, with exports falling nearly 1% and imports down 0.6%. On the export side, industry figures suggest that aircraft exports remained strong but down somewhat from the near-record September pace, shipments figures point to softness in other capital goods, weak auto assemblies point to weak results there, and industrial materials will likely be restrained by a reversal of the bizarre 65% spike in petroleum volumes last month. On the import side, another sharp pullback in petroleum products should be the main contributor, while autos will also likely also be down again. Port data suggest little change in other goods. * We expect the federal government to report a budget deficit of US$75 billion for November, nearly US$10 billion narrower than in the corresponding month a year ago. Much of the improvement reflects a fall-off in outlays by the Department of Homeland Security, which had experienced a spike in spending in the immediate aftermath of Hurricane Katrina. For the fiscal year as a whole, we continue to see the budget deficit tracking only slightly wider than the $248 billion of red ink recorded in FY 2006. * We look for a 0.1% rise in overall retail sales in November and a 0.4% gain ex autos. The chain store results were on the soft side and auto sales disappointed. Also, we expect to see continued deterioration in housing-related categories such as furniture and building materials. However, an anticipated jump in the consumer electronics sector along with a modest reversal of the recent price-related declines in the gas station component should provide some support. At this point, we see real consumption spending running at +2.9% in Q4. * We forecast a 0.2% rise in the consumer price index in November, both overall and excluding food and energy. A flattening out of energy prices following the sharp declines seen in recent months should lead to a headline result that is more in line with the underlying inflation trend. Meanwhile, we see the core rebounding to a +0.24% gain — implying some upside risk to our rounded estimate. In particular, we expect some elevation in the key shelter component based partly on another expected 0.4% result for OER. Also, based on private sector surveys we look for a rebound in hotel rates. On a year/year basis, the core is expected to tick up to +2.8%. * We look for a 0.2% rise in November industrial production. The labor market data implied a slight decline in manufacturing output outside of the motor vehicle industry, with particular softness in sectors such as chemicals, printing, furniture, and wood products. However, automaker assembly schedules point to a modest rebound in that industry on the heels of some significant slippage in prior months. And electricity output appears to have posted a slight gain despite relatively mild temperatures across much of the nation during the month. So we look for an uptick in overall industrial production and a flat reading for the utilization rate.
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Turning Over a New Leaf
December 11, 2006
By Takehiro Sato | Tokyo
Lowering GDP forecast following revision of past data We are lowering our forecast for real GDP growth in 2006 and 2007, following the second preliminary figures for July-September GDP and a significant retroactive revision of data for January-March 2006 and before in the government’s Annual Report of National Accounts for F3/06. A slightly more cautious view of overseas economies is another factor we considered. The main reason for our F3/07 revision is the lower base effect stemming from the retroactive changes to earlier data and the unimpressive showing by domestic private demand in the July-September quarter. The reliability of GDP statistics will be further called into question by the major revisions to past data, but we think the only thing that has changed is the scale for measuring economic activity, not past fundamentals. Our downward revision for F3/08, on the other hand, owes to a more guarded outlook for overseas economies and is related chiefly to a review of the net export contribution. We still look for Japan’s economy to gradually pull out of deflation, led by domestic demand (especially capex), and the outlook for a pick-up in the economy and prices in F3/09 is now clearer than before. Our revised real GDP forecasts, reflecting the changes above, are +2.0% for F3/07 (+2.1% for C2006), +2.2% for F3/08 (+2.2% for C2007), and then for an improvement to +2.7% in F3/09 (+2.5% for C2008). Our GDP deflator forecast has been revised up to -0.7% (from -0.9%) for F3/07, but lowered to +0.5% (from +0.7%) for F3/08 due to the impact of a moderated assumption for landed oil prices and anemic CPI. For F3/09, we now forecast +1.0% (+0.9% previously). The timing for nominal growth to overtake real growth is the April-June quarter of 2007, as under our earlier forecast. We have lowered our nominal GDP forecasts for F3/07 to +1.3% (C2006 +1.3%) and F3/08 to +2.8% (C2007 +2.5%), but expect a strong fillip in F3/09 at +3.7% (C2008 +3.4%). We expect the core CPI to remain stable at an extremely low level of +0.1% in F2007 (and C2007), as productivity climbs with the labor distribution ratio keeping low, but to finally show some pep in F3/09 at +0.5% (+0.3% in C2008). Main scenario for Japan’s economy The economy hit an air pocket after expanding until the January-March 2006 quarter. Nominal GDP in July-September maintained a second successive quarter of zero growth. Consumption was especially sickly, hit by poor weather in the summer and a reverse wealth effect as small and mid-cap stocks fell sharply and wages were slow to pick up, contracting in July-September. With the weather impact dropping out, however, consumption demand has improved to an extent since the autumn. Inventory levels of IT goods have been the subject of some concern, but underlying demand is solid despite some impact from model changes for mobile phones, deferred PC purchasing ahead of the new operating system, and shipments delays for some new game consoles. We probably do not need to be too concerned about recent limpness in domestic private demand. While there are similarities between now and the situation in 2000 around the end of the IT bubble and in the soft patch since the summer of 2004, there are also plenty of respects in which conditions are better now: there has been a structural change in the labor market, where supply and demand are now tight, a pick-up in prices and the asset markets which show the temperature of the economy, and there is now a more robust financial system. Japan’s economy is increasingly resistant to risk, and we think the dangers of a severe recession being triggered by an external shock are now limited. Turning to the outlook, corporate earnings have been brisk, as capital’s share of income remains high, and capex has been firm, but labor’s share of income has been weak, capping the growth in workers’ incomes. As a result, we think that personal consumption will grow no more than about 2% annualized, and the contrast between the strong corporate sector and the listless household sector will not be easily eradicated. However, since capex demand is solid, the economy can continue to expand moderately above its potential growth rate, led by the corporate sector, and productivity growth is likely to remain surprisingly strong. Decoupling of Japan and US economies The outlook for the US housing market still seems murky even after a correction, and fears remain that weakness there will spill over into other areas of the economy. However, employment and income data, which fuel consumption, continue to show moderate growth, and we think the impact of a flagging housing market can be mitigated by higher incomes and lower gasoline prices. In fact, a rise in labor’s share of income in the US is already becoming evident as the corporate share of income shows signs of peaking. In other words, during the last five years the US economy has been propped up by capital investment and the housing wealth effect while the corporate income share has been rising. Going forward, with the corporate share of income dropping and a housing wealth effect no longer in prospect, it will likely be left to increased employment and wages to support consumption. Lower gasoline prices should also help offset the effect of a reverse wealth effect from falling house prices. On the monetary policy front, there should be amply scope to cut rates as inflation cools, and this too should limit the downside risks for the US economy. The global economy is also less US-centric than before, and will not be so vulnerable even if the US is unfortunate enough to experience a steep recession. Our current forecasts, in assuming that domestic demand will keep Japan on a growth track, imply a decoupling of the US and Japanese economies. Wage stagnation is a structural problem The dampening effect of wages at a time when labor supply and demand is tight has been one of the surprises for the Japanese economy. Real wages have already been below year-earlier levels for the last six months. The reasons are unexpectedly deep-rooted — the ratio of temporary and part-time staff is rising, and the demographic trend as senior employees reach retirement is also a factor. It appears likely that wage increases will remain restrained, relative to the supply/demand pressure in the labor market. A comparison with the US suggests that wages should begin to move up during F3/08, on an optimistic view, as employment pressure finally triggers higher wages. In this case, nominal wages would be likely to remain more or less flat throughout the period covered by our forecasts. Employee income itself should keep rising slowly as the number of workers increases, but we are maintaining a guarded stance on personal consumption during F3/08. Prices could go beyond being very stable and start to contract A failure of wages to rise notably in the near term would also signal that labor productivity is still growing strongly. This productivity improvement and the capital investment supporting it should restrain future price increases, but we need to emphasize that we expect prices to hold stable, and are not expecting a drop back into deflation. In this respect, the BoJ tends to overestimate the impact of productivity deterioration (rise in unit labor cost) on prices, or at least to underestimate the extent to which an unobtrusive productivity revolution has strengthened Japan’s economy. From a bottom-up perspective, the declines in broadly defined public utility service prices, such as mobile phone charges, as a result of deregulation, were a talking point at one time, and this is not going to go away. These declines stem from efforts to reform the public and private sectors over several years, and as productivity improvement in the quasi-public sector becomes real they should be sustainable. If the ‘core of core’ of the CPI does not pick up as smoothly as we forecast, the pressure from YoY price declines for oil products from the April-June 2007 quarter creates a non-negligible risk that the core CPI inflation rate could turn negative again YoY. As explained above, real consumer purchasing power is being enhanced, and such a development would not necessarily be deflationary, but it would put the BoJ in a tough spot. Based on the oil price and forex rate forecasts of our global economics teams, we expect the GDP deflator to turn positive in the April-June 2007 quarter, as the domestic demand deflator improves but the import deflator declines. This would signal that the gap between real growth and nominal growth has been eliminated after 13 years. The domestic demand deflator has already turned positive in the latest July-September quarter. The end of deflation is old news for the markets, but the government is likely to officially confirm this in the summer of 2007, prior to the Upper House election. Corporate earnings poised for double-digit growth in F2008 In macro terms, improvement in the GDP deflator means an increase in nominal income per unit of production. The problem is the distribution between households and corporations. Under our outlook above for little increase in unit labor cost but sustainable improvement in unit profits, upside for the GDP deflator should continue to feed into an overshoot for corporate earnings relative to forecasts. Top-down company forecasts for F3/07 (MoF corporate statistics based for firms with capital of more than ¥1 billion) are mostly locked in for October-December already, and call for 10% YoY growth — still a double-digit increase, even with our downward revision of nominal GDP growth. Higher sales are to drive steady growth in F3/08 operating profit, but higher capex is increasing the depreciation expense, so firms are looking for profit growth to be quite moderate relative to sales, but that still implies five straight years of record corporate earnings. With nominal growth in the economy likely to accelerate in F2008, we think that further double-digit profit growth is probable in that year. Policy and market implications For fiscal policy, we expect a hike in the consumption tax to be pushed back until F3/11-3/12 regardless of the result of the Upper House elections in summer 2007. Assuming that a general election takes place in summer 2009, it would be unrealistic politically to expect a tax increase in F3/10, and the new Cabinet has made clear its stance of prioritizing economic growth. So, we have not included the effects of a higher consumption tax in our forecasts this time. For monetary policy, frequent ground-paving comments by senior BoJ figures have made the next rate hike simply a matter of timing, in our view. However, if the BoJ goes for another rate hike when the economy and prices are weak, opinion will be divided as to whether this is genuinely forward-looking. If the market is unconvinced, a flattening of the yield curve would be its reaction to a rate hike that has been in some measure forced on the market. The risk of the core CPI inflation rate turning negative once again in the April-June 2007 quarter cannot be ignored either. The BoJ does not seem to be giving much weight to sluggish price data, but if these turn negative, its responsibility would be questioned should it press for further hikes. This creates the risk that a third rate hike may slip back beyond our earlier expectation of the July-September quarter of 2007. On the other hand, Japan’s monetary condition (MCI) is likely to remain ultra-accommodative for a long time, with the effective yen rate staying weak, creating highly favorable conditions for the asset markets.
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It’s a “Growth Recession,” Not a Lasting Downturn
December 11, 2006
By Richard Berner and David Greenlaw | New York, New York
Forecast at a Glance | 2006E | 2007E | 2008E | Real GDP | 3.3% | 2.4% | 3.0% | Inflation (CPI) | 3.3 | 1.6 | 1.9 | Unit Labor Costs | 3.3 | 3.2 | 2.7 | After-Tax “Economic” Profits | 22.2 | 3.8 | 4.7 | After-Tax “Book” Profits | 19.3 | 2.1 | 2.4 |
Source: Morgan Stanley Research E = Morgan Stanley Research Estimates We’ve sharply cut our near-term expectations for US growth, with the advance in GDP averaging 2% annualized for the three quarters ending in the first quarter of 2007, or about 0.6 percentage point below our estimate of just a month ago. More important, while our estimate of roughly 1½% for the fourth quarter of 2006 is the low-water mark for growth in our baseline outlook, the pickup we now envision likely will be slow, and a return to the trend of 3% probably awaits the summer of 2007. This “growth recession” — a period of growth appreciably below potential — likely will last long enough to reduce somewhat the lingering upside risks to inflation. As we previewed last week, the combination of slower growth and reduced inflation risks, if it occurs, will thus allow the Fed to stay on hold for much of 2007, and to ease gradually as inflation moves lower late next year and into 2008 (see “Changing the Fed Call,” Global Economic Forum, December 4, 2006). Now that our calls are close to consensus, what are the risks for the economy and for financial markets? Most important, we do not see this period of sluggish growth as the prelude to a more lasting downturn in economic activity. And thematically, like the consensus, we envision rising personal saving, peaking inflation, and a steeper yield curve in the year ahead. But in our view these themes may play out in ways the consensus doesn’t envision, and that may make all the difference for the outlook. Here’s why. For the economy, we see risks evenly balanced around our new, more subdued baseline. We continue to envision a ‘two-tier’ economy, with housing and Detroit now in recession, and the forces sustaining growth in the rest of the economy skirting the fallout from those industry downturns (see “The Two-Tier Economy,” Global Economic Forum, November 6, 2006). As those twin recessions fade, in fact, we expect that the pace of overall economic growth will quicken. Importantly, however, we’re not “compartmentalists.” Instead, our two-tier call rests on four key premises. First, while we believe that the housing recession is far from over, we think that the intensity of the downturn will peak by spring 2007. Our new baseline does envision a more intense housing recession in the near term than we thought a month ago. We estimate that the decline in housing activity will cut a full percentage point from GDP both in the current quarter and in the first quarter of next year as builders are moving even more aggressively to cut supply. But the pace of declining housing demand seems to be slowing, and that combination seems likely to reduce the odds of declines in home prices appropriately measured on a nationwide basis (see “False Dawn for Housing? Global Economic Forum, December 8, 2006). And we continue to think that the housing wealth-consumer spending link is weaker than many believe. As a result, the spillover from housing wealth to consumer spending seems unlikely to derail the consumer. A second key premise is that the economy’s income-generating capacity has improved sustainably, and by enough to allow consumers to rebuild personal saving in the face of decelerating housing wealth while maintaining moderate gains in spending. Solid job gains, firmer labor markets and thus wage gains, and a decline to 2% headline inflation have lifted real wage income growth to a solid 4½% annual rate over the year ended in October. November’s employment canvass implies more of the same: Nonfarm payrolls rose by 132,000, not far from the 150,000 (1.3% annualized) average in the first ten months of 2006, especially considering the strong, upward pattern of revisions seen since the summer. Demand for labor inputs is stronger still, running at a 2% rate, as the workweek has risen throughout the year after adjustment for changes in the industry composition of employment. And while sharp downward revisions to GDP-based compensation per hour data call into question the pattern of wage growth, we believe that the acceleration in private hourly earnings to 4.1% in the year ended in November reasonably represents the current pace. While personal saving hasn’t yet turned back into positive territory, the fourth-quarter combination of 6.2% annualized growth in real disposable income and 2.9% in spending suggests that it will do so soon. The third key notion is that while global growth may be slowing, growth in domestic demand abroad is still stronger than in the United States, and thus net exports seem likely to contribute to US growth (for the global outlook, see Steve Roach’s accompanying dispatch, “Global Transitions”). We don’t buy into the decoupling story — that overseas growth is immune to US weakness. But growth in domestic demand in our two major trading partners, Canada and Mexico, remained at 4.1% and 5%-plus through the third quarter, and in the Eurozone, it eclipsed the 2½% US pace for the first time since the 2001 recession. And of course, in much of Asia and Latin America, such demand has long outpaced that in the US. US exports must grow twice as fast as imports to narrow the gap in real net exports, and we’re betting that the growing gap between US growth and that abroad, combined with the incipient decline in the dollar, will bring that about. Finally, we think that notwithstanding a monetary policy that has become mildly restrictive, US financial conditions are still supportive of growth. If anything, the rise in stock prices, the decline in interest rates, the tightening of credit spreads, and the decline in the dollar have recently made financial conditions still easier. Credit-sensitive demand should benefit: With pent-up demand for capital spending still positive, we expect that the deceleration in equipment and software outlays to a 3.5% annualized pace in the last three quarters of 2006 will give way to a faster pace in 2007. Against that backdrop, we see slightly less inflation risk than a month ago, because four quarters of growth averaging 2.2% will begin to reverse the narrowing of economic slack that characterized the first four years of the expansion. The gap between actual and potential growth will widen somewhat, the unemployment rate will rise towards 5% (in part as labor force growth outpaces employment), and future operating rates in industry will rise only slowly. Nonetheless, in our view, inflation has yet to peak and likely will turn down gradually. That’s because inflation expectations remain slightly elevated, the relationship between economic slack and inflation is not a strong one, and the dollar is now declining. Measured by the core personal consumption price index (PCEPI), inflation has leveled off at 2.4%, but in the past three months has moved higher. Measured by the University of Michigan’s 5-10 year median, longer-term inflation expectations edged above 3% in December. The so-called Phillips curve may well be flatter than in the past, meaning that just as a substantial reduction in slack only pushed inflation up moderately in this expansion, a little increase in slack won’t go very far to reduce it. And while the dollar has only declined by about 2% on a broad, trade-weighted basis in the past eight weeks, the direction could offset disinflationary forces, especially with import prices of consumer goods excluding automotive products up 1% in the year ended in October. Like the consensus, we believe that the yield curve will disinvert or resteepen from current levels, but how that happens is critical. Many think that a turn toward ease will be the dominant factor, so that short-term rates decline by more than long-term rates, in classic cyclical fashion. In contrast, we think cyclical comparisons probably won’t help analyze the current yield curve setting. We think that the Fed will anchor short-term rates, and long-term rates may rise somewhat from current levels. Following November’s employment report, market participants dramatically scaled back the chance of Fed ease by the March FOMC meeting to 30% from 70% just a week ago. Those odds will probably shrink further in coming months. To be sure, Fed officials following this week’s FOMC meeting will surely acknowledge the recent stretch of sub-par growth and its potential disinflationary benefits. But subpar growth has yet to reverse the decline in the unemployment rate, and core inflation, especially measured by the PCE price index, hasn’t come down significantly. Thus, policymakers’ belief that inflation is still too high likely will persuade them to retain their tightening bias. Longer-term yields may rise gradually beyond 4¾% as the odds of a downturn and Fed ease fade, as rising term premiums elevate the level of real long-term yields, and as a weaker dollar may erode the appeal of carry trades. There are several downside economic risks: The housing recession could deepen, capex is a question mark, and credit quality may begin to erode, triggering tighter lending standards. And weaker growth means more downside risks to corporate earnings. But upside economic risks and their consequences for markets should not be ignored: The housing downturn could end more quickly, the capital-spending pause may have been a false alarm, and although global growth may be slowing, US firms may be getting a bigger market share. For markets that have thrived on low volatility, these crosscurrents may begin to reverse that trend.
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