Digesting the Growth Shock: Some Positive Insights
February 21, 2007
By Vladimir Pillonca | London
Italy’s GDP jumped by 1.1% QoQ (4.5% annualised) — a full two standard deviations above its 2001-2005 average growth rate of 0.1% — and significantly above expectations. Important questions are how the economy will respond to this (positive) shock, and what to make of it. Quarter-on-quarter growth of 1.1% is almost four times what we believe Italian potential growth to be. In this sense, this outcome looks like an outlier, and growth could slow or even turn negative early this year. But the implications should mostly be positive, once we move beyond the first half of this year. If the Italian economy were to evolve in line with our central forecasts, later next year expectations of an upgrade on sovereign debt might start to gain traction.
The year might not start in a good way After the binge of the final quarter of last year, 2007 might not start in a good way — the jump in Italian GDP was so abnormally strong that an offsetting decline in the level of output in the first half of this year should not be ruled out. This would not be a tragedy, but merely a correction. Unfortunately, we will have to wait until March for the GDP breakdown, which will reveal which components have contributed the most to the leap. In the meantime, we will have to rely on other data to try and solve the puzzle of why growth has jumped so sharply in the final quarter. Industrial orders data show a strong pick-up in orders from abroad, which rose to 13.4% YoY in December (after jumping by 6% MoM in November alone), and fresh data on industrial revenues show similar patterns. Our suspicion is that, beyond generally strong global growth, advanced purchases from Germany ahead of the VAT hike may have boosted the contribution from exports to Italian GDP growth in 4Q. Besides, growth was surprisingly strong right across the euro area (see Eric Chaney’s Firing on Twelve Cylinders, February 16, 2007). Even though we think that the recent sharp acceleration in growth will probably be at least partly reversed in the first half of this year, overall Italy is still likely to grow by more than previously anticipated in 2007. To an extent, this is due to simple arithmetic: even flat QoQ growth throughout this year would result in GDP growth of 1.2% for 2007 as a whole — twice Italy’s average growth over the previous five years. More formal (statistical) analyses also reinforce the idea that this growth shock will have a positive impact on growth for this year as a whole. What to make of it We don’t think that Italian potential growth has suddenly doubled (let alone quadrupled), but recent data have been better than expected, and the recent pace of growth was almost unthinkable only last year, when the economy barely grew at all. Beyond the cyclical dimension, these positive economic outturns may already reflect some initial effects from recently introduced economic policies and reforms. The government’s liberalisation programme, for example, should help CPI inflation to remain below the 2% mark most of this year, after reaching its lowest level since 1999 in January, at 1.7%Y. This decline in the rate of inflation should boost real wages, benefiting consumers’ purchasing power at a time when fiscal pressure is rising across the economy. For this year, we revised up our Italian GDP forecast to 1.4% YoY, and this should be achieved relatively easily, given that 1.2% YoY alone is carried over growth from 2006. So, risks are probably skewed to the upside of our central forecast. The simulations we performed suggest that a positive shock on Italian GDP growth does not die out instantaneously, but takes up to six quarters to unwind, and the longer-term impact of a positive shock is positive, though not large. This has positive implications for the medium-term outlook. Besides, we already anticipated Italian growth to recover in the second half of this year, and accelerate further in 2008 (see Italy Economics: Flickers of Light at the End of the Tunnel, December 13, 2006, V Pillonca, for a detailed analysis). Overall, things seem to be looking up, though downside risks remain, not least from the impact of tighter fiscal policy, higher interest rates and the lagged effects of euro appreciation. Still early for a sovereign re-rating, but next year… The initiatives taken to meet the Maastricht Criteria on the Budget Deficit this year, after years of overshoots, are a noteworthy first step on the way to fiscal consolidation, though the government could have gone further on seeking structural solutions. Reforms have the potential to impact positively Italy’s longer-term macro prospects and to increase the attractiveness of investing there. The main risk is one that few good data releases throw policy-making and the reform effort back into first gear. We expect the budget deficit to undershoot the 3% threshold this year, after a significant deterioration in 2006, when it could even temporarily breach the 5% mark. We won’t get the full year public finance numbers for 2006 until this March, but this worsening is entirely due to adverse one-offs, and excluding these the outturn will likely turn out to be below the 3% mark even in 2006. While the budget deficit looks set to fall towards Maastricht-compliant levels this year and next, the stock of debt is set to remain very large relative to the size of the economy, and will likely decline only slowly, in the absence of policy change. For this reason, I think it is premature to expect upgrades from rating agencies in the near term; at this stage of the cycle, it is ambitious to tell what’s cyclical from what’s structural, both in terms of economic growth and public finances. But if the economy were to evolve in line with our central forecasts, later next year expectations of an upgrade on sovereign debt might start to gain traction.
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Congratulations to Mr. Fukui, but the Bad Taste Lingers
February 21, 2007
By Takehiro Sato | from London
Bad taste lingers After hesitating in January, the BoJ pushed through its policy rate hike to 0.5% by an 8-1 majority at the February 21 Policy Meeting. The Lombard rate was simultaneously lifted to 0.75%, normalizing the gap between the policy rate and the Lombard rate. The government did not exercise its right to demand a postponement of the decision. The lone dissenter, as expected, was Deputy Governor Iwata, who according to Governor Fukui did so because of an uncertain price outlook. This split in opinion between the BoJ Governor and Deputy Governor is the first of its kind under the revised Bank of Japan Law, and is groundbreaking, given Japanese culture. The BoJ’s style here is reminiscent more of the Bank of England than the Fed, which we welcome. Governor Fukui’s relative stature strengthens and the deputy governor’s authority recedes. The decision leaves a bad aftertaste, however, given the January postponement and lack of clarity still behind the February decision. At the previous Monetary Policy Meeting in January, the board members were united in their upbeat outlook on the economic track. This fact was formally acknowledged at BoJ press conferences following the January MPM. Despite this, the BoJ curiously passed on the rate hike then, creating a marked discrepancy between the BoJ’s communications and its real actions, which befuddled the market. By signing off on a rate hike now, however, the BoJ can just barely maintain a consistency between its economic outlook and monetary policy. The message of this statement basically fits with that to date in the Outlook Report, save for the near-term outlook on prices. Indeed, the BoJ hedged its bets by referring to oil prices (its February monthly report released on the same day included something similar). We’re still in the dark on the BoJ’s exact reasoning for this rate hike. The Board recognized a major rebound in GDP data from just a week ago. In a way, the BoJ has given the market the impression that it changed its policy based on a single and particular piece of economic data, which reeks of a backward-looking style to us. Ideally, a crafty central bank would want to avoid giving such an impression. Going forward, market participants will likely overly fixate on GDP data every time speculation on an interest rate hike escalates. Furthermore, as the negative CPI rate now seems firmly in sight, an objective analysis of fundamentals from a forward-looking standpoint would raise questions about the adequacy of this rate hike. Indeed, this type of decision-making could pose problems to the future of the BoJ’s relationship with politicians. Immediate monetary policy issues exhausted The rate hike has probably exhausted all potential monetary policy issues for some time. The BoJ is likely to have used up much of its energy for now, having enforced a rate hike in the nick of time, given the outlook for a negative CPI rate and pressures from the government and ruling party. We think that the next Outlook Report in April will most definitely include downward revisions to the price outlook. The monetary policy issue will only likely become a major item on the agenda again at the beginning of next year, when prices are expected to inch into positive territory. Indeed, our rough calculations are for possible 0% YoY growth in the nationwide core CPI figures for January and February (March 2 and 30). The March nationwide core CPI (announcement date not set yet) is primed for negative YoY territory, and could coincide with BoJ’s April Outlook Report release on April 27. How ironic it would be for the BoJ if prices turn negative on the same morning as the Outlook Report comes out. Another rate hike no doubt is out of the picture, which cinches the policy rate at 0.50% for the year. Our projection on the timing for another rate hike is from the April-June quarter of 2008, once downside crude oil factors dissipate, making prices more susceptible to climb. That said, the market seems likely again to speculate on another rate hike toward the August MPM, following the Upper House elections and the release of April-June GDP data. Risk of excessive interest rate decline So what are the market implications under this scenario? Bond market participants would need to be less conscious of a policy rate hike for the time being, but must guard against excessive declines in long-term rates. For the equity markets as well, expectations for a near-term rate hike clear, leaving room for more active asset plays. Changing economic sentiment in Japan and the US following the G7 meeting in Essen make the yen more autonomous in the forex market, and a narrower Japan-US interest rate gap with the BoJ’s hike should only enhance this autonomy in the near term. That said, the Japan-US interest rate gap remains at 4.75% even after the rate hike, making it unlikely for the dollar to keep falling. In fact, individual investors will probably buy the dollar on dips now that the outlook for an additional rate hike has receded. Thus, we expect the dollar to trade in a bound range as it is caught between domestic individual investors investing overseas and foreign investors investing in Japan. Risks A risk to the above scenario is the BoJ warming up to another rate hike, if a rise in crude oil prices keeps price declines brief. Our scenario assumes that crude oil prices stick in the US$50-60 range, but if this assumption falters, the possibility of stably negative prices would also crumble. Expecting crude oil factors alone to boost prices above zero seems rather unrealistic, however, as this would require a major surge in crude oil prices (e.g., 30-40%). In other words, we think that prices are highly likely to trend in the negative range.
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