United States
Fed Ease Unlikely Until 2008
February 05, 2007

By Richard Berner | New York

Forecast at a Glance

		2006E	2007E	2008E
Real GDP		3.3%	2.8%	3.0%
Inflation (CPI)		3.2	1.6	1.9
Unit Labor Costs		3.2	2.5	2.6
After-Tax “Economic” Profits		20.8	3.0	5.3
After-Tax “Book” Profits		18.0	0.6	2.8

Source: Morgan Stanley Research  E = Morgan Stanley Research Estimates

 

We are updating our Fed call: We now think that the Fed will leave short rates unchanged for all of 2007, instead of easing late in the year as we have long assumed.  Likewise, in our view the odds of a policy tightening are now the same as those of an ease.  The reasons: While “core” inflation has receded from its September peak, and we haven’t changed our baseline inflation outlook, we think future inflation risks are slightly higher and more uncertain than a month ago.  In contrast, despite the current ‘two-tier’ nature of the economic expansion, solid growth now seems more sustainable and consistent with the current stance of monetary policy. 

That we judge inflation risks slightly higher than a month ago might seem strange.  After all, core inflation (measured by the CPI excluding food and energy) has declined to 2.6% from September’s 2.9% year-over-year rate.  Tougher comparisons, a slower-growing economy, and the lagged effects of a tighter monetary policy on inflation expectations likely mean that inflation has peaked.  Too, lower energy prices probably mean less “pass-through” of energy costs to airfares and other energy-using goods and services.  We now assume that, courtesy of a gradual easing in tight refined product and crude markets, the recent declines in product and crude oil prices will persist, trading in a $50-60/bbl range (see “Oil Update: Fast Forward” Global Economic Forum, January 26, 2007).

In addition, a further deceleration in core inflation is possible given the recent indications of some cooling in the pace of increase in shelter costs.  Shelter accounts for more than 40% of core inflation.  And after accelerating sharply over the first half of 2006 to a 4.7% annual rate (6-month change basis), in the second half of last year the so-called owners’ equivalent rent (OER) measure that is included in the core inflation gauges decelerated to 4%.  Likely that’s because some of the inventory of unsold new homes is making its way onto the rental market, boosting vacancy rates for rental properties again.  Rising rental vacancies tend to cap shelter cost increases, reflecting the heavy influence of the rental market on the OER component.  If core inflation continued to drift lower, it is conceivable that the Fed could ease — even if the economy is growing near trend.

However, several other forces are working in the opposite direction and could well boost inflation again.  Inflation expectations are slightly elevated, labor and product markets are tight, cost pressures continue to build, and consumer import prices have accelerated over the past year.  Median 5-10 year inflation expectations measured by the University of Michigan’s consumer canvass stood at 3% in January — a bit below recent peaks but a bit above their levels in 2004-05.  And distant-forward (5-year, 5-year) inflation compensation has moved up by 10 bp in the past two weeks, breaking the 6-month downtrend.  While the jobless rate ticked up to 4.6% and average hourly earnings cooled to a 4% rate in January, those moves may not last.  And the acceleration in non-auto consumer import prices to a 1.2% rate in December probably has yet to show up in consumer inflation gauges. 

Moreover, the slowing in productivity growth, likely magnified by just-released significant upward revisions to payroll employment and nonfarm hours worked, raises questions of whether trend productivity and thus potential output are lower than previously thought.  As San Francisco Fed President Yellen indicated recently, both would elevate inflation concerns at the Fed.  We estimate that productivity slowed to just 1.6% over the course of 2006, following a downward-revised 2.2% in 2005; both are below the sustainable trend. 

As we see it, trend productivity growth is roughly 2½%, which is good news for long-run inflation prospects.  But a below-trend, cyclical productivity undershoot is underway as job growth finally catches up with the economy — an undershoot that balances off the significantly above-trend gains in productivity in the early stages of the current expansion (see “The Coming Productivity Undershoot,” Global Economic Forum, March 20, 2006).  Corporate America’s hiring discipline, aimed at correcting the hiring excesses of the 1990s, yielded a 3.1% average annual gain in productivity in the first three years of this expansion — or 0.6% above the trend.  In our view, the current undershoot is showing up in the productivity performance of years 4-6, averaging 1.9% — or 0.6% below the trend.  Indeed, we forecast a return to the 2½% trend rate in 2008.

Nonetheless, these developments create uncertainty about inflation fundamentals.  If the trends lifting inflation intensify, we could ultimately see a pickup in core inflation.  To be sure, the outcome of this tug of war — between tight markets and rising costs on one hand and the deceleration in shelter costs and the downward pull of monetary policy on inflation expectations on the other — is unclear.  Most important, it’s likely to take some time to resolve these crosscurrents one way or the other. Absent an unforeseen shock to the economy, therefore, it appears the Fed will be on hold for at least the next few quarters.

What about the growth prognosis?  It’s certainly tempting to forecast stronger growth, given that the ‘two-tier’ economy may be morphing into something stronger.  The deep housing recession may be ending, the automotive downturn centered in Detroit seems to have bottomed in October, and other factors that we thought would offset those weak spots seem to be supporting growth (see “Is the ‘Growth Recession’ Ending?” Global Economic Forum, January 8, 2007).  Income gains and consumer spending have been solid, hearty global growth lifted net exports to a massive fourth-quarter gain, and government outlays have contributed to growth. 

But while we agree with the FOMC that, as they noted following their meeting last week, “some tentative signs of stabilization have appeared in the housing market,” some of those signs may owe to unseasonably warm weather in the past few months.  Thus we do not think that the housing recession is over, and expect a “payback” in growth to about 2½% in the first half of 2007 (see “Paybacks Ahead?” Global Economic Forum, January 29, 2007).  Moreover, it appears that the spillover from the housing and automotive downturns on manufacturing production extended into the early months of 2007.  Finally, some downside risks surrounding the capital-spending outlook linger, following a fourth-quarter contraction — the first outright decline in four years.  Consequently, we haven’t meaningfully changed our 2007 baseline outlook, with growth at 2.9% on a Q4/Q4 basis, just 0.1% higher than a month ago. 

Nonetheless, in contrast with the increased uncertainty surrounding the inflation forecast, five factors suggest that solid growth now is more sustainable and consistent with the current stance of monetary policy.  First, the strength in net exports hints that US companies are gaining market share in a buoyant global growth environment.  To be sure, a surge in aircraft deliveries accounted for nearly a third of the fourth-quarter gain in exports, but aircraft backlogs likely will stretch well into 2008.  Second, while production cutbacks extended into at least the first quarter, they are making inventories look lean again.  Third, while supply-induced energy price spikes are still possible, growing non-OPEC supply and higher refinery yields mean that energy quotes should not rise significantly beyond current levels even as winter returns, offering a tonic to US and global growth. 

Fourth, the recent upward revisions to payrolls give us more comfort that the economy’s job- and income-generating capacity has improved in the past three years — the mirror image of the productivity undershoot.  As previewed in October, statisticians revised up the nonfarm payroll tally by 0.6% between March 2005 and March 2006.  The recasting of the data likely was the product of a reconsideration of the way that net new business formation affects the translation of the payroll canvass into economy-wide estimates.  As a result, the new data also show additional job gains amounting to 0.2% annualized, or 20,000 monthly, between March and December.   Thus, while job growth has slowed from its peak a year ago along with the economy, the underlying pace is a bit firmer — and still sufficient to sustain gains in income and keep labor markets tight. 

Nor are we overly concerned about the softness in January payrolls and dip in the workweek.  A portion of the 29,0000 decline in factory jobs (net of returning strikers) appears to be the product of Detroit’s employee buyouts, rather than further cyclical weakness.  And ironically for those of us unduly influenced by warm weather in the Northeast, early-January storms elsewhere in the country may have depressed nationwide payrolls and hours.  Our favorite proxy for weather-related influences on the data — the "not at work due to bad weather" component of the household survey — came in a little more than 100,000 above the January average since 2000. 

Finally, financial conditions still seem to be supportive of growth.  Rising stock prices, tight credit spreads, ample credit availability, the dollar’s decline over the past year and still low long-term rates have combined to offset a slightly restrictive level of the Federal funds rate.  Indeed, today’s low level of term premiums, which has helped to keep the yield curve inverted, may make financial conditions easier and the current level of the Federal funds rate less restrictive than it appears. 

Thus, we still think that 10-year note yields will trade in a range, but a slight rise in term premiums still seems likely in coming months as investors wrestle with uncertainties over the outlook.  Lingering inflation risks, solid growth, and a renewed chance of Fed tightening mean that 10-year yields could rise above 5% and the yield curve will re-steepen beyond two years.  This modest yield backup is unlikely to threaten risky assets, however, because it most likely will be in real terms, reflecting sustainable growth.

Despite our growing confidence in the sustainability of growth, we must acknowledge downside risks: A sizable jump in bond term premiums could make financial conditions more restrictive.  A significant backup in rates could weaken housing activity and potentially trigger business caution, stifle job growth and further depress housing prices.  A month ago, Fed Vice-Chairman Kohn voiced similar uncertainties: “We also do not know whether the possible stabilization that seems to be taking hold would be immune to a rise in longer-term interest rates should term premiums increase or the federal funds rate fail to follow the downward path currently built into market expectations.”  But it’s also important not to overlook upside risks to growth.  For example, a rebound in capital spending would broaden the sources of economic resilience.  Together with inflation uncertainty, that could put Fed tightening back in play.

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United States
Review and Preview
February 05, 2007

By Ted Wieseman | New York

Treasuries posted modest gains over the past week and the curve flattened marginally, with yields pulling back somewhat from their highs since August hit at Monday’s close. The upside was certainly quite muted considering the mostly supportive key economic data released through the week — a drop in the ISM below the 50-breakeven level, a surprisingly low 0.1% gain in core PCE inflation, and the first soft employment report in some time. Indeed, significant early gains made Thursday on the inflation and ISM results that marked the week’s best levels were more than reversed over the course of the day, and the net response among the benchmark issues to the employment report by Friday’s close was a meager 0.4-1.7bp rally. Most of the week’s upside actually seemed to be driven by month-end-related buying that came in a rush after the FOMC meeting Wednesday, and easing of the mortgage-related swaps paying that had significantly weighed on the market the prior week also helped. Against the weaker ISM and employment results and benign inflation numbers, fourth quarter GDP growth accelerated out of the mid-year soft patch at a better-than-expected +3.5% annual rate, but relative to our estimates, all of the upside was in a smaller subtraction from inventories, leading us to reduce our 1Q estimate to +2.9% from +3.5%. No surprises emerged from the FOMC meeting, with rates left unchanged, the tightening bias reiterated word for word, and the statement updated merely to reflect recent data showing stronger growth and some moderation in inflation. The market responded by pricing in a marginally more hawkish near-term Fed path in the futures markets, but, in response to the data and some short covering, a more dovish outlook on a longer-term view. We think the Fed is likely to be on hold for some time and that the eventual next move could go either way depending on how the economy develops over the course of the year. The economic calendar is very quiet in the coming week, with the main focus in the Treasury market likely to be on the refunding auctions. The Treasury cut the 3-year size more than expected, resulting in a smaller-than-anticipated US$38 billion refunding package, and also announced, earlier than we expected, that complete elimination of the 3-year after May is under consideration.

On the week, benchmark Treasury yields declined 4-5bp, with little change in the curve aside from a slight underperformance by the front end. The 2-year yield fell 4bp to 4.94%, while the 3-year, 5-year, 10-year, and 30-year yields all declined 5bp, to 4.87%, 4.82%, 4.83%, and 4.93%, respectively. This left yields only 5-6bp better than the more than five-month closing highs hit Monday, a pretty pathetic showing given the overall supportive economic news, which broke what had been a nearly two-month run of almost uninterrupted upside surprises in most of the key data (better-than-expected inflation readings being the conspicuous exceptions). The front bunch of fed funds futures contracts all ended unchanged on the week — March, April and May all at 5.25% and June at 5.255% — but slight losses were seen a bit further out, with the July and August contracts each off a half bp to 5.245% and 5.23%, respectively. Later in 2007 and into 2008 and 2009, however, a somewhat more dovish path was priced into eurodollar futures, with the Sep 07 contract rallying 3bp, Dec 07 6.5bp, and the 2008 and 2009 contracts 7.5-8.5bp. The Mar 07 to Mar 08 spread flattened 7.5bp to -29bp, with the former flat at 5.365% and the latter gaining 7.5bp to 5.075%. The low rate Dec 08 and Mar 09 contracts gained 8bp each to 5.005%.

After surprisingly strong results the prior four months clobbered the Treasury market, a generally soft report for January provided a slight lift. Non-farm payrolls rose 111,000 in January, a significantly smaller gain than upwardly revised readings in December (+206,000), and November (+196,000). The slowdown largely reflected another significant decline in manufacturing, led by big job losses in the auto sector, and the smallest rise in business services since September. The biggest gain in construction jobs since last March provided a partial positive offset.

It’s possible that the upside in construction, which was all outside of residential sectors, reflected the unusually warm weather in the early part of the month, but, oddly enough, the number of respondents in the household survey saying they were not at work during the survey week because of bad weather was actually quite elevated relative to recent prior Januaries for some reason. Other details of the report were weak.

The unemployment rate rose a tenth to 4.6% as employment in the household survey (adjusted for revised population controls in January) declined 122,000. The average workweek fell a tenth to 33.8 hours, which combined with the small rise in payrolls resulted in a 0.1% decline in aggregate hours worked. Average hourly earnings rose 0.2%, matching the smallest monthly gain since late 2005, though the year/year pace was still a solid +4.0%, up a percentage point over the past year.

This report was certainly a disappointment, but, in our view, it did not really alter the underlying picture of a relatively tight labor market showing some modest acceleration in wage pressures. Moreover, while income growth and factory output appear to have stagnated in January, bad weather and other temporary factors — such as a downtick in vehicle assemblies — appear to have played a role. We expect to see some improvement in the employment picture in coming months.

The seasonally adjusted benchmark revision to the March 2006 payroll level was +752,000, slightly below the +810,000 early estimate BLS provided in October. This resulted in average monthly payroll growth in the 12 months through March being upped 63,000 to a robust +237,000, the strongest average over such a period so far in the expansion.

Adjustments to the birth/death model and the regular monthly revisions to November and December resulted in payrolls being lifted an additional 181,000, or 20,000 a month, for the April to December period. The revised average gain in payrolls in the year through March 2006 is now almost identical to the +239,000 a month average in the household survey’s employment measure adjusted for definitional differences with the establishment survey. In the ten months since March 2006, payrolls have now risen an average 160,000, while concept-adjusted household employment growth has averaged 260,000, a possible sign that another significant upward revision could be made next year to the March 2007 benchmark month.

The weakness in factory payrolls and hours worked seen in the employment report was flagged a day earlier by a weak ISM survey. The headline manufacturing ISM composite diffusion index fell to 49.3 in January from 51.4 in December, the lowest reading since mid-2003. While the key orders (50.3 versus 51.9) and production (49.6 versus 52.4) gauges saw meaningful declines, the employment index (49.5 versus 49.4) was little changed. Nearly half of the decline in the overall index was caused by a 9-point plunge in the inventories index to 39.9, the lowest reading since February 2002 and largest one-month drop since 1984. Heavy inventory liquidation this month points to potential upside in activity going forward, so the inclusion of this index in the composite is somewhat counter-intuitive. The prices paid gauge rose to 53.0 from 47.5.

Various metals and corn were reported up in price.

Real GDP rose at a 3.5% annual rate in the fourth quarter, accelerating from two quarters averaging +2.3%. Final sales gained 4.2%, with a slowdown in inventory accumulation, concentrated in autos, subtracting 0.7 percentage points from growth. We had expected a significantly larger inventory drag, so this result led us to reduce our 1Q estimate by half a point to +2.9%. Much of the upside in final sales came from a 1.6pp boost from net exports, as exports gained 10.0% and imports declined 3.2%. Final domestic demand rose a relatively sluggish 2.4%, with a strong rise in consumption (+4.4%) and solid gain in government spending (+3.7%) partly offset by another plunge in residential investment (-19.2%) and a small decline in business investment (-0.4%). The drop in residential investment subtracted 1.2pp from growth and motor vehicle output subtracted another 1.3pp (more than reversing the odd 0.8pp add BEA recorded in 3Q that seemed to contradict industry assembly figures), so GDP excluding housing and autos surged 6%. The upside in growth was accompanied by some moderation in inflation. On a quarterly average basis, the core PCE price index only slowed marginally to +2.1% from +2.2%, but the recent trend has been better. With the core PCE price index up a less-than-expected 0.1% in December, this key inflation gauge has risen at only a 1.7% annual rate in the past three months, the smallest gain over such a period since mid-2005. On a year/year basis, however, it was unchanged at +2.2%, down a bit from the high of +2.4% seen from August to October, but still above the top of the Fed’s 1-2% ‘comfort zone’.

No surprises emerged from the FOMC meeting. The funds target was held unchanged at 5.25% and the tightening bias was repeated word for word — “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 to the statement were adjustments to the description of the recent economic backdrop that reflected incoming data since the December 12 meeting, which have pointed to both stronger growth — “Recent indicators have suggested somewhat firmer economic growth, and some tentative signs of stabilization have appeared in the housing market” — and some easing in core inflation — “Readings on core inflation have improved modestly in recent months.” At this point, the Fed seems clearly to be on hold at 5.25% for the foreseeable future. When the next rate move eventually comes, from our perspective it’s pretty close to a toss up at this point whether it will be a rate cut or a rate hike. If the acceleration to above-trend growth in 4Q moderates going forward and core inflation continues to gradually ease back towards the Fed’s comfort zone, there will eventually be room to take rates a bit lower to a more neutral stance from the current slightly restrictive setting. On the other hand, if the recent pick-up in growth is sustained and prevents resource pressures from easing and core inflation either reaccelerates or just appears to be stuck at current unacceptably high levels, then further tightening down the road would be the likely response.

After the very busy past week, the upcoming week’s calendar is quiet.

Main focus in the Treasury market will be on the refunding auctions — 3-year Tuesday, 10-year Wednesday and 30-year Thursday. With a bigger-than-expected cut in the 3-year size, the refunding package will be a smaller-than-expected US$38 billion — US$16 billion 3s (US$3 billion lower than last time), US$13 billion 10s (unchanged), and US$9 billion 30s (US$6 billion smaller than the last new 30-year, but as we expected with the move this quarter from semi-annual to quarterly issuance). At the refunding announcement, the Treasury also said that elimination of the 3-year was under consideration. We had thought that the 3-year was likely doomed at some point if the recent positive budget trends continued but were surprised that the Treasury made the announcement so soon that this was being considered. The debt managers said that a 3-year would definitely be auctioned in May, but that a decision on its future beyond then would be provided at the May refunding announcement. Pending the results of tax season, our baseline assumption is that the 3-year will be eliminated after May.

The economic data calendar is very quiet in the coming week. Chain store sales results will be announced Thursday and will help set expectations for the upcoming January retail sales report along with the better-than-expected motor vehicle sales results released the past week. The most notable other data release is the productivity report Wednesday. We forecast a 2.2% gain in 4Q non-farm business labor productivity and a 2.1% rise in unit labor costs. The measure of output that is relevant for the calculation of productivity rose 4.2% in 4Q — an even sharper advance than the headline GDP reading of +3.5%. Together with an assumed 2% gain in hours worked, this implies a rise in productivity that is actually a bit better than the sustainable trend. Meanwhile, unit labor costs appear to have risen at a pace close to the core inflation rate.

Factoring in anticipated revisions, productivity is expected to also show +2.2% growth on a year/year basis, with unit labor costs running at +2.7%.

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European and EMEA Economics
Influenced by Gravity
February 05, 2007

By Thomas Gade | London

A baseline for foreign direct investment

We have estimated a baseline level of bilateral FDI between EU-15 countries and the Central and Eastern European Countries (CEEC) as well as China, India and Turkey. Our macro analysis shows scope for increased FDI in Turkey, Slovakia, Russia and India from EU-15 countries. Central and Eastern European Countries are still competitive, but FDI from EU-15 countries could flow further eastward in the future. As a result of ongoing FDI inflows, a number of potential medium-term financial implications can be outlined. First, bond yield spreads between the CEECs and EU-15 will likely narrow further. Second, ongoing FDI inflows should support a real exchange rate strengthening vis-à-vis the EU-15. Third, FDI inflows should support local equity markets.

Future flows guided by gravity factors

We have estimated a macroeconomic gravity model to determine the equilibrium level of bilateral foreign direct investments from EU-15 countries into the CEEC as well as China, India and Turkey. Our model determines a baseline for the bilateral FDI level based on fundamental macro factors, and we have ranked the individual countries according to their deviation from this baseline. The deviation from the model baseline allows us to construct different scenarios for FDI flows through 2010, where we allow for a possible catch-up effect.

Using reasonable assumptions for GDP growth rates and GDP per capita growth rates while keeping exchange rates constant, we have created two possible scenarios for potential FDI flows until 2010. We have assumed that either a quarter or alternatively half of all negative deviations between actual FDI and the model baseline is corrected every period for economies where actual FDI is below that predicted by the model baseline. For positive deviations, we have assumed no pull-back of capital and therefore no correction. The correction mechanism will speed up flows to underinvested countries, but is not necessarily a dominating factor as countries above the baseline will continue to attract significant FDI flows under the assumption that growth rates over the next three-year period will be similar to the average growth rate in the previous 5-10 years.

Central and Eastern European Countries are still competitive, but FDI from EU-15 countries could flow further eastward in the future.

Financial support to local financial markets …

Bond yield spreads are likely to narrow as FDI flows would lower the path of public debt and lead to less issuance of public debt if FDI flows are part of a privatization process. Therefore, FDI inflows will likely lower the cost of capital, suppressing the normal positive yield spreads between developed markets and emerging markets. In terms of FX, increased FDI inflows should support the currencies of the destination countries vis-à-vis the source countries. In the longer term, the real exchange rate may strengthen further as a result of the Balassa-Samuelson effect, which could gradually hamper the competitive position of the host countries. A lower cost of capital should in general support equity markets. The change in income dynamics could in particular be a positive factor for consumer companies in the CEEC in comparison to the EU-15.

… leading to a protectionist backlash in ‘Old’ Europe?

Foreign direct investment from the EU-15 to the CEEC is often associated with offshoring. This creates productivity gains in both the EU-15 and the CEEC as well as boosting employment growth in the CEEC. Meanwhile, we find only limited evidence of job losses in the EU-15 countries, at least in the long term. Instead, wage growth compression and a shift in the distribution of income from labor to capital seems to be a more likely result of increased offshoring and labor sharing in the global economy. At our annual MacroVision conference in New York in January, Morgan Stanley’s Global Macro Team and clients debated the issue of the increasing income share of capital at the national level (see MacroVision 2007, February 1, 2007). Given the divergence between labor income and capital income, a backlash of protectionism was outlined as one of the key risks in the global macroeconomic environment. A backlash of increased protectionism must therefore be outlined as one factor potentially hampering future FDI flows. However, the link between offshoring and job loss or wage compression may not be as direct as commonly perceived, but may also be linked to rigidity in European labor markets, in our view. A political change leading to increased protectionism may still be a probable future event, but such a change could well be founded on wrong arguments.

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Israel
Balancing Act
February 05, 2007

By Serhan Cevik | London

Israelis facing a curious challenge about how to bring inflation up to the target range. Consumer price inflation moved from 1.2% at the end of 2004 to 3.8% last April and then declined to -0.1% by the end of the year. This unusual degree of volatility is a result of changes in energy quotes and, more importantly, the pass-through from exchange rate movements to domestic prices. Against the dollar, the shekel depreciated as much as 8.5% in the first quarter of 2006 — pushing inflation higher — but then appreciated 8.9% by the end of the year, leading the year-on-year inflation rate into deflationary territory (see Technical Deflation, November 20, 2006). This is why the Bank of Israel has suddenly reversed its policy stance and cut short-term interest rates by 125bp in the past four months. In other words, against deflationary pressures generated by the shekel’s appreciation, the central bank is lowering interest rates in order to weaken the exchange rate and thereby bring inflation within its target range of 1-3% a year. Even though the strategy has so far weakened the shekel — marginally — from an average of 4.20 in December to 4.23 in recent weeks, it could also result in higher currency and inflation volatility.

Inflation excluding the pass-through effect is already right in the middle of the target range. The CPI posted a 1.7% cumulative drop since last August, lowering the headline inflation rate by 0.1% by the end of the year. However, that was simply a reflection of the shekel’s strength pushing dollar-linked prices lower. Indeed, if we exclude the pass-through effect influencing about 30% of the basket, the year-on-year increase in the CPI stood at 2% — slightly higher than a year ago and right in the middle of the central bank’s inflation target range. In the near future, we do not expect any significant changes in inflation dynamics, as the significant correction in oil prices and the shekel’s relative strength remain overwhelming factors. Nevertheless, the diminishing influence of currency appreciation will start allowing real economic variables to become more dominant over the future path of inflation.  

With benign global conditions and lower interest rates, real GDP is growing at an above-trend pace. The Israeli economy has already recovered from the guerilla war in Lebanon back to its above-trend growth trajectory. The state-of-the-economy index, for example, increased by 3%, on a seasonally adjusted basis, from last summer’s low and recorded a 7.1% year-on-year surge at the end of last year. With benign global conditions and lower interest rates, there is now an upside risk to our real GDP growth estimate of 4.5% this year. Indeed, the latest figures show that the corporate sector has become even more optimistic and consumers are already started to spend more. Although labor productivity growth is still robust in most of the sectors, unemployment is steadily declining towards its natural rate and changes in the output gap are becoming more and more inflationary, in our view. According to the Bank of Israel’s calculations, the narrowing of the output gap already contributed 0.4% to the change in the CPI last year, despite a marked slowdown in private consumption in the third quarter. This is why we think that the central bank is likely to stay on hold and watch out for developments on the demand side of the economy.

The extent of monetary easing has made the cushion smaller against the risk of volatility. The shekel’s strength is a result of fundamental improvements like faster growth, fiscal correction, growing current account surplus and record-high foreign capital inflows (see Net Gains, January 10, 2007). Nevertheless, while we are not alarmed by the fact that nominal short-term interest rates are now a full percentage point lower than those in America, it would be naïve to ignore the influence of interest rate differentials on portfolio allocations. So far, economic developments and the monetary policy stance in the US have been fairly supportive for the shekel, which remains undervalued against a trade-weighted basket of currencies. Furthermore, fiscal consolidation and lower debt issuance support domestic bond prices, even after 10-year spreads tightened by about 120bp to 60bp of late. Though still appreciating Israel’s long-term potential, we also think that the extent of monetary easing has made the cushion smaller against the risk of a volatility burst.

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China
An Update on Monetary Conditions
February 05, 2007

By Denise Yam, CFA | Hong Kong

Interbank rates still soft: Following the 50bp hike in reserve requirements in January, increased issuance of central bank bonds (Rmb760 billion since the beginning of the year versus Rmb3.65 trillion in 2006) and additional repo transactions, interbank interest rates in China have found a bottom, but have remained soft, suggesting sustained ample liquidity.  Although 7-day SHIBOR bottomed at 1.37% on January 16, and had climbed to 2.1% by early last week, ample liquidity appears to have capped the ascent, in our view.

Stock market performance dominates authorities’ concerns: We believe that the Chinese authorities are concerned that excess liquidity and lower market rates mean a lower funding cost for net borrowers in the interbank market, which includes securities companies, contributing to their concern over stock market volatility.   The rebound in interest rates, together with several policy measures and verbal comments by officials, led to a 12% correction in the Shanghai A-share index from its peak (January 24).  These measures and comments include: (1) enforcement of the Land Appreciation Tax (LAT), (2) suspension of new mutual fund sales, (3) SASAC and CSRC’s plan to monitor SOE’s activities in the stock market, (4) talks of possible capital gains tax on stocks, (5) tightening on bank lending for stock investment, and (6) cautionary comments by Cheng Siwei (NPC vice-chairman) to stock investors.

Regular bond issues now include 3-year notes:  The PBoC clarified on January 29 that regular bond issues will continue to take place every Tuesday and Thursday, with planned issue sizes announced on the prior working day.  Nevertheless, regular issues of 3-year notes, which were discontinued in May 2005, have resumed in the last two weeks (on Thursdays).  The longer-maturity notes serve to lock up banking system liquidity for longer, and their reintroduction signals the PBoC’s bias towards further tightening.

Liquidity management to dominate monetary policy space in the short term:  In our view, as investment in China remains driven by liquidity rather than returns, monetary policy is more effective when it addresses the quantity rather than the price of available capital.  We expect the PBoC to continue to focus on liquidity management through adjusting reserve requirements (two more 50bp hikes this year) and bond issues to soak up liquidity in the interbank market in the immediate term.  We believe that the PBoC is still targeting to lift interbank rates back to the 2.5-3% range in the short term.

Deposit/lending rates to move higher over medium term nevertheless:  We still expect deposit/lending rates to head higher towards a more neutral level consistent with the pace of economic growth so as to enhance the efficiency in capital and resource allocation over the medium term.  We forecast hikes of an average of 54bp a year in deposit/lending rates in the next two years.  The timing of these hikes would be difficult to predict, but our central case will be for a 27bp rate hike in each of the half years.

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Turkey
No Rain, No Gain
February 05, 2007

By Serhan Cevik | London

The sharp increase in temperatures is already having economic consequences. Global warming is no longer a fictitious risk, as some used to argue even as recently as a few years ago. The global surface temperature already increased from an average of 13.9 degrees centigrade in the first half of the 20th century to the peak of 15˚C last year (see Warming Up, January 25, 2007). Leaving the factors behind global warming to climatologists who are now predicting average temperatures to rise as much as 6.4˚C by the end of the century, we want to focus on immediate economic consequences of higher volatility in climatic conditions. Like the rest of the world, Turkey has experienced a sudden surge in surface temperatures and a marked drop in precipitation in the last couple of years. According to the country’s office of meteorological services, average rainfall in the fourth quarter of last year declined by 8.5% compared with the same period in 2005 and by 11.1% compared with the long-term seasonal mean. Moreover, the drop in precipitation worsened even more in December, coming 57.6% and 73.1% below the 2005 reading and the long-term average, respectively. With such climatic shifts, it is therefore not surprising to see lower agricultural production and sharply higher (unprocessed) food prices.

The rise in inflation last month was an unequivocal result of higher food prices. The consumer price index posted a 1% increase in January, raising the annual inflation rate from 9.7% at the end of last year to 9.9%. Though disappointing, the worse-than-expected outcome was a result of the 4.4% jump in food prices, which account for 28% of the CPI basket and increased almost four times more than the January average in the last three years. Global warming or not, this is a significant supply shock to inflation dynamics, in our view. And within the food category, the culprit was once again unprocessed food prices, which recorded a staggering 8.8% rise in January — roughly five times more than the average of 1.8% in the previous three years. As disturbing as it is, the increase in food prices is nothing new. Similar to many other countries, Turkey has suffered from inflation stemming from the deviation of unprocessed food prices from seasonal patterns in recent years. After increasing by 1.7% in the first half of 2005, the unprocessed food component rose by as much as 21.8% last summer (see The Mysterious Vegetarian Demand Bubble, June 19, 2006). Unfortunately, the recent correction to an average of 12.4% in the last quarter of 2006 turned out to be temporary and we may now be witnessing a new wave of supply pressures, as the annual rate of increase in unprocessed food prices surged back to 20.7% in January. However, although food-price volatility will remain a risk, ‘core’ measures of inflation present an encouraging outlook.

The core CPI declined by 0.3%, lowering the annual inflation rate to 8.6% in January. The headline inflation rate may have increased because of higher food prices, but the CPI excluding unprocessed food prices was actually down 0.2% last month, lowering the year-on-year rate of increase to 8.3% from 9.2% in December and the peak of 10.5% last June. Likewise, the central bank’s favorite ‘core’ CPI measure (which excludes energy, unprocessed food, tobacco and gold prices) dropped by 0.3%, bringing the annual inflation rate from 8.9% at the end of 2006 to 8.5% in January. According to our calculations, the seasonally adjusted ‘core’ CPI showed a marked deceleration in the annualized rate of inflation over three months from the peak of 13.4% last summer to 7.8% in December and 3.9% last month. Turkey is still facing a challenging normalization phase after bearing multiple and simultaneous supply shocks, but we believe that the fall in oil prices and tighter domestic monetary conditions should bring inflation down to around 8% in June and then accelerate the pace of disinflation in the second half of the year.

The central bank will maintain the current stance until inflation moves within the uncertainty band. In our opinion, as inflation moves within the central bank’s uncertainty band later this year, the Monetary Policy Committee will become more comfortable with the medium-term outlook and start gradually easing the policy stance. Albeit still expecting a 150bp reduction in short-term interest rates by the end of this year, exogenous factors like climatic oscillations or the behavior of commodity prices will continue to be the main source of inflation volatility.

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