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UK
Monetary Policy Outlook — No Change in Sight February 15, 2007 By David Miles and Melanie Baker and Vladimir Pilonca | London, London, London The Bank of England’s quarterly Inflation Report is the clearest statement of the collective judgment of the Monetary Policy Committee (MPC) on the outlook for the economy and for monetary policy. The message from the February report — published earlier this week — was very clear: at unchanged interest rates, the bank’s best guess is that inflation stays right on target. Risks of inflation being above or below the target — again at unchanged rates — are evenly balanced. It would seem to follow naturally that if the monetary policy committee behaved in a risk-neutral way, so that it was content to adopt a stance that on average meant that the target for inflation was hit, then our best guess should be for no change in rates. Yet the weight of market opinion is still that rates are more likely to be cut than held at 4.5%. To our mind, this has led to yields on short-dated gilts all being driven down to levels that are hard to reconcile with the message in the Inflation Report. The Bank of England’s February Inflation Report and press conference was consistent with our view that further rate cuts in coming months are not the most likely path for monetary policy. Our central expectation is that interest rates remain at 4.50% through most of 2007 (and we tentatively anticipate a rate rise in 4Q07). If the economy moves in line with the MPC central projection (of course, the chances of this happening exactly are very small), then there would be no need to cut rates again: inflation would be very close to the target rate of 2% for the whole of the next three years. In this latest report, the MPC revised its central inflation and growth forecasts. The central inflation projection (based on ‘market expectations’ for broadly unchanged interest rates) shows inflation close to the 2% target for the whole of the forecast horizon. The bank’s central profile is now flatter than in November’s report, which showed inflation dipping below the target and then rising two years out. The bank describes risks to its inflation profile as substantial, but balanced. It continues to ascribe a large degree of uncertainty to its central projection. On GDP growth, the bank now sees the balance of risks to its central projection as a little to the downside. Our central forecasts are not very different from the bank’s. With GDP growth likely close to potential growth this year and with unit wage inflation above the 2.0% CPI target rate, however, our central case remains that a rate rise will look likely by the end of the year. The bank’s new inflation forecast is much flatter than the one in the November Report. This is not a profile which suggests that it is feeling complacent on risks to inflation, rather that the path remains quite uncertain but the risks are evenly balanced. The bank sees the main risks as being the outlook for growth, the margin of spare capacity (energy prices may have shrunk potential supply) and the evolution and effect of energy prices. On the latter, the bank points out that while there is a direct impact on inflation from higher energy prices, the indirect impact can be positive or negative. Pricing pressures can build along the supply chain as input prices rise or companies possibly squeeze other parts of their cost base, e.g., wages. The bank’s central projections for inflation, assuming unchanged rates, look somewhat similar to our own, although our central profile is a little more volatile. On growth, the bank remains, if anything, a little more optimistic than us, although our estimate of potential growth is likely to be a little lower. Nevertheless, if the economy evolves in line with either set of central forecasts, a rate cut does not seem to be the most likely outcome. Many commentators continue to stress that what might appear to be weak consumer spending figures suggest that a rate cut in the
Japan
More than a V-shaped Recovery February 15, 2007 By Takehiro Sato | Tokyo V-shaped recovery in consumer spending GDP headline growth surpassed our reading and returned to a growth track, led by domestic private demand. A turnaround in consumer spending, along with stronger-than-expected capex and housing investment, boosted growth in the economy during the quarter, with domestic demand posting more than a V-shaped recovery. Although overseas demand growth slowed, it continued to make a positive contribution. Domestic demand rose 1.0% QoQ (versus -0.3% in Jul-Sep), while domestic final demand rose 1.1% (versus -0.5% in Jul-Sep). The economic slowdown that followed the peaking of the economy in October-December 2005 and ran through the July-September quarter levelled off and ended in the October-December quarter. The better-than-expected growth was due to retracement to the weakness of the previous quarter as well as to the downward revision in that quarter, so does not ease concerns about the sustainability of momentum ahead. In addition to the key structural factor of a tight labor market, the asset market, the best barometer of the economy, is also improving and the economy is steadily becoming better able to withstand a negative demand shock. Meanwhile, with overseas economies on the upswing, the weakening of the yen in real terms can be expected to provide support for exports. Accordingly, this actually increases the level of upside risk related to our already upbeat scenario. Personal consumption The dissipation of factors that held back consumer spending in the July-September quarter, including bad weather and a negative wealth effect induced by a decline in small/mid cap stock prices, cleared the way for a solid rebound. The downward revision in the previous quarter from -0.9% QoQ to -1.1% also pushed up growth in October-December. Looking at monthly trends in household consumption expenditure, however, October and November spending was strong, but unusually warm winter temperatures depressed spending on clothing and consumer electronics in December, causing a slowing in growth. So far in the current quarter, department store sales got off to a good start in early 2007, but then slowed in the middle of January. The Cabinet Office’s Economy Watchers Survey contains a few references to a slump in clothing sales due to a mild winter. Wage activity also looks somewhat dull for such a tight labor market. Real employee income rose +0.8% QoQ. Salaries of permanent employees rose at an annualized rate of over 1%, but since this was due mainly to growth in low-wage industries, overall salaries grew at a slower rate than hiring. The labor distribution rate was nearly 52%, continuing to remain stable as it has for two years now, suggesting that growth in employee compensation should be able to at least keep pace with growth in the economy as a whole. Although consumption is likely to slow from the January-March quarter as extraordinary factors wind down, we expect annual growth of 1-2% to hold. GDP deflator The GDP deflator remained in a negative YoY trajectory in October-December with a 0.5% decline, but rose in QoQ annualized terms with a 0.1% increase, marking the first marginally positive move since October-December 2004. The import deflator continued to post strong growth (+6.3% YoY), but the impact of high oil prices continued to wind down in YoY terms. Meanwhile, the domestic demand deflator returned to negative YoY growth after the July-September quarter, when it turned positive (+0.1 YoY) for the first time in some eight years since January-March 1998. Among domestic demand deflators, the public and residential investment deflators remained in an upward trajectory, while the capex deflator also bottomed. Above all, the decline in the personal consumption deflator is hurting overall. Looking ahead, we expect the GDP deflator to return, probably around the July-September 2007 quarter, to a positive YoY level due to an expected decline in growth in the import deflator due to softer prices, and the outlook for renewed gradual improvement in the domestic demand deflator. Policy implications Although the headline GDP numbers were strong, we still lack clear signals that consumption and prices are solidly trending upward. Due to limited growth in employee compensation, the unit labor cost turned negative QoQ, declining further on a YoY basis. However, since domestic private demand was stronger than a V-shaped recovery, we cannot totally rule out a rate hike in February. (It seems backward-looking to raise rates based on the GDP numbers, but would be easier to explain to politicians.) Based on genuine economic fundamentals, we are skeptical of the need for an early rate hike, and also for the BoJ, there is risk of inflation turning negative after a rate hike, which would put the BoJ in a corner. However, discarding economic fundamentals, and instead taking into account the behavioral psychology of Governor Fukui, we think the likelihood is still over 50%, if only marginally at 51%. Market implications Given the strong corporate earnings posted in Oct-Dec quarter, we expect to see the stock market start lifting off the floor toward the end of the current fiscal year. However, with the prolonging of monetary easing, firms with considerable land on their balance sheet should benefit in a trend that bears some resemblance to the 1987-88 bubble period. In this environment, high-quality stocks are at a disadvantage, which limits upward movement of the major indices. At the same time, the bond market is likely to remain tight, as expectations for an interest rate hike are expected to retreat after February, given the chances of prices turning negative YoY. If pressed for an excuse to raise rates, an excessive rise in asset prices and an excessive weakening of the yen would be two candidates, but for these factors to have an impact on long-term interest rates would require an unusually extreme case that is not very realistic. We expect the “Goldilocks combination” of a gradual appreciation in asset prices, low and stable interest rates, and a continued weakening of the yen in real terms, ironically, as the credibility of the BoJ declines.
UK
UK: Monetary Policy and Inflation: the Evolving Outlook February 15, 2007 By David Miles | London The latest Bank of England Inflation Report, released on February 14, and the press conference held by Governor Mervyn King continued to suggest to us that having a central (single most likely) case of the Bank of England remaining on hold throughout 2007, with risks of rate rises/falls roughly symmetric, is sensible. We thus leave our central forecast, that the Bank of England stays on hold at 5.25% throughout 2007, unchanged. The Inflation Report shows that the Monetary Policy Committee (MPC) now has a central inflation profile showing a fairly sharp fall to just below 2% by autumn with inflation near the 2% target on a two-year horizon. This outcome is true whether you look at the profile which incorporates ‘market expectations’ on interest rates (which have rates at 5.5 in 2Q07 and 5.6 in 3Q/4Q07, suggesting a 25bp rise in 2007) or the profile which assumes flat interest rates at 5.25%. With unchanged rates, the central MPC forecast is that inflation is marginally above 2% at end-2008 and at that point on a slightly upwards trajectory; but it is probably back at 2% by the end of 2009. The MPC suggests that risks to inflation are “weighted to the downside in the near term and to the upside in the medium term”. The scale of risks either side of the central forecast are now wider than they were assessed to be a few months ago. As a central case, in the near term, the MPC sees the unwinding of energy and import price inflation feeding into consumer prices and business costs; however, this is “partly offset by higher pay growth and some rebuilding of corporate profit margins”. Inflation is said to return to target in the medium term as a result of strong demand growth. Our near-term central forecast has been, and remains, very much in line with what the MPC showed this week — we also see inflation moving fairly rapidly back down towards the 2% target with risks to this central projection being symmetric. However, looking further ahead, we believe that the bank’s GDP central forecast is marginally stronger than likely, and so we are less convinced of the medium-term upwards bias to inflation risks. “Greater-than-usual uncertainty over the outlook” The MPC describes risks to its inflation forecast as being balanced; however, it does highlight significant uncertainty around the central profile. It describes “the near-term outlook for retail gas and electricity prices; the relative influence on wages and prices of demand and non-wage costs; the behaviour of inflation expectations; and the degree of spare capacity in the economy” as presenting various upside and downside risks to its near and medium-term projections. This substantial increase in the uncertainty is reflected in an increase in the width of the inflation fan charts (which show the probability of inflation falling in bands either side of the central forecast). In respect of the upside risks to wage growth in 1Q07, the bank’s regional agents, who conducted surveys in December and January, found that “a net balance of contacts expected to award a higher settlement this year than in 2006”. However, they deemed that the average expected settlement for 2007 stood at 3.4%, only 0.2pp above the 2006 average. So, as yet there are no clear signs that the risks of wage inflation rising in the wake of what is probably temporarily high consumer price inflation are crystallising. Our own central case for rates The range of opinions on the MPC, regarding the central forecast and the balance of risks, was highlighted throughout the Report. Here is how the Committee’s judgment at its most recent meeting was described in the Inflation Report: “The Committee noted at its February meeting that the central projection, under the assumption that the Bank Rate followed market yields, was for inflation to settle around the target in the medium term, though the near-term profile was unusually volatile…Given that outlook, and bearing in mind the balance of risks, the Committee judged that no change in the Bank Rate was necessary at that meeting to bring CPI inflation back to the target in the medium term”. So, in the light of the inflation profiles presented this week in the inflation report, the Committee concluded that no rate hike was necessary. This is consistent with our judgment that the single most likely outcome is that rates will remain unchanged. |