Exchange Rates ‘Do Not Reflect Economic Fundamentals’
April 19, 2007
By Eric Chaney | London
The euro and the pound are becoming the strongest currencies in the world, like it or not, as the dollar and the yen continue to depreciate. As far as the euro is concerned, the trade-weighted index calculated by the ECB reached 107.4 on April 16, just a whisker away from the end-2004 peak (108.3). At that time, the appreciation of the euro had triggered verbal protests from euro area finance ministers and harsh comments about the ‘brutality’ of exchange rate moves by the ECB’s President Jean-Claude Trichet. Ironically, the official statement that followed the G7 meeting in Washington last weekend kept repeating: “We reaffirm that exchange rates should reflect economic fundamentals. Excess volatility and disorderly movements in exchange rates are undesirable for economic growth (…). In emerging economies with large and growing current account surpluses, especially China, it is desirable that their effective exchange rates move so that necessary adjustments will occur”. In the real world of financial markets, fundamentals matter only in the long term and deviations from fundamentals may last for long periods of time.
The euro is 12% overvalued in real terms Looking at a large set of valuation measures, I conclude that the euro is currently over-valued against the US dollar, the Japanese yen and, more importantly, in effective terms, that is against a basket of the most relevant currencies. Plotting the median fair values estimated by my colleagues Stephen Jen and Luca Bindelli (see Quarterly Valuation Update, January 2007) against the market rates reported on April 18 indicates that the euro is 20% over-valued against the US dollar, 34% against the Japanese yen and 16% against the Swiss franc. Only against the British pound is the euro slightly under-valued (3%). Since many other currencies matter, I have also looked at the real effective exchange rate (Reer) of the euro, that is, the average exchange rate against a basket of relevant currencies, adjusted for relative inflation trends. The European Central Bank is computing a monthly time series starting in 1990, a period long enough to offer the benefit of hindsight. Over this 16-year period, the real exchange rate of the euro has declined by 0.7% per year, a speed that standard statistical tests find significant. This makes sense, from an economic perspective: in the long run, productivity growth differentials are the main drivers of real exchange rates and it happens that, over this period, productivity growth was slower than the average productivity growth of EMU trading partners. Accordingly, the current real exchange rate of the euro should be compared to its trend, not to its long-term average. On my estimates, the euro is currently 12% above its long-term real trend. Note that it is also above its long term-average, although less significantly (5%). The conclusion I draw from these various valuations is that there is little doubt that the euro is significantly over-valued, 10% being a conservative estimate, in my view. Euro area demand is robust, but not insensitive to interest and exchange rates Two factors are pushing the euro above levels consistent with fundamentals, in my opinion: 1. Foreign exchange markets have fundamentally changed their views about the euro, not long ago considered as a structurally weak currency. In fact, markets seem to have moved from excessive pessimism (‘the euro area will never grow’) to excessive optimism about the sustainability of growth in Europe. 2. In contrast with the US Federal Reserve and the Bank of Japan, the European Central Bank has made it perfectly clear that the monetary tightening campaign has not ended. At the press conference that followed the Council meeting on April 13, Mr. Trichet said that “he would not say anything that would be aiming at changing expectations for the month of June”. Since the markets were betting on a rate hike, this was neat and clear. It is true that domestic demand is robust in most euro area countries, thanks to high corporate profitability and healthy job creation. However, higher real interest rates are likely to weaken domestic demand at some point, starting with interest rate-sensitive sectors such as housing and corporate investment. In addition, a stronger euro would erode the competitiveness of euro area-based companies on both external and internal markets (focusing only on exports is misleading) and thus would reduce incentives to invest domestically. For euro area policymakers, the catch is that they have already implicitly acknowledged that a weaker US dollar makes sense, in order to reduce the US current account deficit that they have identified as a threat for financial stability and, ultimately, global prosperity. However, since a weak US dollar implies a weak Japanese yen and a weak Chinese yuan, the euro and closely related currencies, such as the British pound or the Swiss franc, are getting excessively strong, by default. President Trichet noted with exquisite diplomacy that the “IMF should distinguish between market-driven exchange rates and policy-driven rates”. Not being constrained by diplomatic etiquette, I would express the same idea more directly: current exchange rates do not reflect economic fundamentals because of political actions interfering with market forces. Sitting next to a currency trader Let’s go a step further: walk onto a trading floor, sit next to a currency trader for a moment and listen to them. Their line of reasoning is likely to be something like: If (i) Asian policymakers do not alter their exchange rate policies, (ii) the financial markets continue to believe that the US economy will remain weak for longer than previously expected; and (iii) the ECB does not change its current hawkish stance, then the euro will continue to appreciate. Since (i) and (ii) are true and (iii) seems true for the time being, anticipating a stronger euro is a relatively safe one-way bet. The conclusion of this short visit to the trading floor is straightforward: the euro should continue to rise against the US dollar, the Japanese yen and the Chinese yuan, until something really new happens. Assuming that neither Asian exchange rate policies nor the bearish sentiment towards the US economy change in the near term, only the European Central Bank seems to be in a position to prevent an excessive rise of the euro. One might argue that the ECB is in charge with price stability, not exchange rate policy. This is perfectly correct, but there is an obvious link between these two areas: a stronger euro would reduce imported inflation and, though with longer time lags, dampen domestic demand growth, as a consequence of lower corporate profits. Hence, a forward-looking central bank focusing on its price stability mission cannot and should not ignore exchange rate trends. The next question is: What could the ECB do in order to stem the rise of the euro? At this stage, I see three options: 1. Postponing the refi rate hike that was practically pre-announced for the June meeting; 2. Hiking the refi rate to 4.0% in June and explaining that accommodation has been ‘largely’ removed, thus forcing markets to re-price the probability of further rate hikes. 3. Hiking the refi rate in June, keeping a tightening bias, and trying to talk down the euro, as Mr. Trichet did in late 2004. Option 1 is very unlikely, in my view. The beauty of providing the markets with guidelines about future monetary policy is that it helps stabilise expectations. However, the other side of the coin is that not following these guidelines might be costly in terms of credibility, the best single asset modern central banks have in their books. Option 3 could be the result of a compromise between hawks and doves within the Council, but I am afraid it would not work: currency traders and investors would give little weight to the ECB’s rhetoric, if it is not shared by other central banks. We are thus left with Option 2. Interestingly, Guy Quaden, head of the Belgium Central Bank and member of the ECB’s Council, said recently: “Our monetary policy is now significantly less accommodative than at the end of 2005”. While sounding obvious — the refi rate was raised five times since then — this remark nevertheless indicates that option 2 is a distinct possibility, though not yet a probability.
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The Outlook for Inflation and Monetary Policy in the UK
April 19, 2007
By David Miles | London
Consumer price inflation moved above the 3% mark in the year to March. This triggered the release of an open letter from the Governor of the Bank of England to the Chancellor of the Exchequer explaining why the inflation target (set at 2%) had been breached by more than 1%. This is the first time in the ten years since the Bank of England was made independent, and given an explicit inflation target, that such a letter has been written; remarkably, over the past ten years the annual rate of inflation has never been more than 1% away from the target. In the light of this unexpected development, market prices for gilts imply that rates are expected to rise soon, and probably two rate hikes of 25bp will be seen over the next few months. We continue to see the odds of rate moves as somewhat lower than is suggested by bond prices and also lower than surveys of economists suggest. Here we briefly explain why, and update our assessment of where inflation and interest rates are going in the light of the new inflation data and the response of the Bank of England to it. First, we should say that our assessment of the chances of a near-term rate rise have increased in the light of this week’s data. We had felt that there was close to a 50:50 chance of a rate rise at the April meeting of the monetary policy committee (and the minutes of that meeting released this week do indeed reveal that it was a close decision, with two of the nine members of the committee voting for a rate rise, and others clearly thinking there was a good case for a rate rise). On balance, the chances of a rate rise at the upcoming May meeting are higher than our assessment made before the April meeting; so we have come to see the single most likely outcome for the May meeting as a 25bp rate increase. But while we think that, on balance, a rate rise next month is the single most probable outcome, we are not convinced that further rate rises are very likely. Indeed, if consumer spending slows, as we expect it will, the strength of demand in the UK might well have fallen rather short of the Bank of England’s current expectation by the autumn and a rate rise in May could well be reversed by year-end. Whether that happens depends, of course, on how inflation and inflation pressures seem to be evolving. The likely evolution of inflation: What was notable about the letter that the Governor wrote to the Chancellor after the inflation figures was that it revealed that the Bank of England’s assessment remains that inflation will move down quite sharply over the next few months. We share that view. Cuts in some energy prices will start to affect the inflation numbers over the next few months. The impact of past rises in energy prices also fall out of the year-on-year comparisons. And some of the main factors that drove the inflation rate above 3% in March — rises in furniture and some food prices — may be reversed fairly quickly. What this means is that when we factor in the actual inflation date to March and then project inflation forward — allowing now for a 25bp rise in rates in May that may nonetheless prove temporary — we generate a profile that puts inflation back close to the 2% target level by August as the most likely outcome. There remain, of course, major uncertainties around that central forecast. It is those uncertainties that mean that any assessment of how monetary policy evolves can only be an assessment of relative probabilities and not a single ‘interest rate call’. The upside inflation risks, which impart the upward bias to risk around our central forecast for interest rates, remain that the current high actual inflation rate triggers a response from wage setters that creates a more sustained set of inflationary pressures than exist today. That remains a real risk. But the latest actual wage inflation numbers, which show that basic wages (excluding bonuses) continue to rise at a steady rate of around 3.6%, show that risk is not crystallising. What this means is that our assessment of the probabilities of where rates might go in the near term — over the next couple of months and over the next six months — are somewhat skewed to the upside of our central guess. Our single most likely scenario is that we get a 25bp rate rise in May, but that by year-end that rate rise may have been reversed as the actual inflation rate falls back close to target and demand pressures from consumer spending fall off significantly. Nonetheless, by year-end there is, we believe, a significant chance that rates may be 6% or more. Yet risks are fairly symmetric, so rates being at 5% also has significant probability, and indeed is an outcome we judge to be a bit more likely than rates being at 6%. What does all this mean for our assessment of where bond yields might be going? Since our judgement is that the market consensus is a little too pessimistic with regard to the chances of rate rises, we anticipate some mild decline in yields on shorter-dated bonds as the year progresses. But at the ten-year horizon, we continue to see yields, which are hovering around 5%, as being a little beneath a sustainable level.
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Secrets Unveiled
April 19, 2007
By Serhan Cevik | Istanbul
Normalization has helped to decouple the business cycle from financial volatility. You have to dig well into the data to find a long period of uninterrupted growth in Turkey where boom-bust cycles had become the norm over the decades. This is why the last 20 quarters present a unique decoupling of the business cycle and the emergence of a new growth trend, in our view. With an average real GDP growth rate of 7.3% a year, Turkey has become one of the fastest-growing commodity-importing countries in the world. Although, like the rest of the global economy, Turkey has also benefited from the abundance of liquidity and lower transition costs, it would be unfair to dismiss Turkey’s performance as a mere result of capital movements. As we have argued, fiscal consolidation and structural reforms are at the heart of macro normalization that has led to productivity improvements and the moderation of business-cycle volatility (see Stabilization as Innovation, May 9, 2005). Turkey has weathered a number of setbacks in the last five years, but let us focus on financial volatility. Given the country’s exposure to liquidity-driven capital flows, many observers predicted, after the burst of global volatility last year, the end of output expansion and even suggested the possibility of debt default. However, the Turkish economy turned out to be much more resilient than consensus expectations and remained on a robust, healthier growth path. Tighter monetary conditions have led to the moderation of domestic demand. After the volatility shock, we published a series of reports analyzing the behavior of private consumption (Secrets of Consumption Dynamics, September 4, 2006) and investment expenditures (Secrets of Investment Dynamics, November 22, 2006). Our findings were unambiguous and pointed to a shift in the composition of growth but no collapse in economic activity. Even though the end of fiscal dominance has paved the way for the development of new transmission channels (like a marked increase in bank lending to the private sector), the estimates showed the overwhelming influence of income growth and cautionary responses to currency volatility on domestic demand. As expected, following a period of satisfying pent-up demand, the private sector has reacted to tighter monetary conditions by adjusting the consumption of goods that are sensitive to interest rates and changes in credit conditions. For example, after growing at an annual rate of 7% in the 2002-05 period and 9.9% in the first half of 2006, private consumption showed a sharp deceleration to 1.3% in the second half of the year. Among all the components of consumer spending, durable goods exhibited the most notable correction, with the rate of growth moving from 14.2% in the first half of the year to -7.4% in the last six months. Similarly, the growth rate of private sector gross fixed investment spending slowed from an annual average of 30.5% in the 2003-05 period and 24.3% in the first half of 2006 to 10.5% in the second half. Although the degree of correction in investment expenditures is limited compared to the behavior of consumer spending — an encouraging development for long-run growth and inflation dynamics — it nevertheless confirms the moderation of domestic demand and the effect of political uncertainty. Exports now play an important role in the composition of economic growth. With domestic demand moving to a more balanced growth path, exports have taken an important role in the composition of economic activity. The contribution of net exports to real GDP growth moved from an average of -2.7% in the 2002-05 period and -2.8% in the first half of last year to 2.9% in the second half. And the preliminary figures show a 25% year-on-year nominal increase in exports in the first quarter of this year, which should translate into a strong contribution to real GDP growth. As a result, the production side is holding up quite well, posting a 10.8% increase in industrial output in the first two months, thanks to faster growth in export-oriented sectors. With such a shift in the composition of economic activity, we expect real GDP growth to be around 5.6% this year and, assuming a reasonable degree of political stability, to accelerate above 7% in 2008. But before highlighting the key drivers of our assessment, we should update our model and verify our earlier findings. Private domestic demand is sensitive to income growth and currency volatility. Since private consumption and investment expenditures represent the largest component of total spending in the economy, it makes sense to concentrate on private domestic demand and its influence over the business cycle. Our least squares model uses explanatory variables like disposable income, currency volatility, stock prices and real interest rates. The results show that income is a key driver of private domestic demand along with currency volatility and corporate earnings. Since there are no reliable data, we use stock prices as a proxy for corporate earnings. Stock prices — partially capturing the wealth effect — are a significant determinant of private domestic demand. Interpreting the log coefficients as elasticities, we find that a 1% increase in stock prices boosts demand by 0.4%, while the negative sign of currency volatility suggests lower domestic demand in times of higher volatility. Real interest rates appear not to have a significant impact on domestic demand, but this is because ex-post real interest rates influence not the total planned spending but only interest-sensitive ones, in our view. In short, our findings still show that disposable income is the most important determinant of domestic private demand, while an increase in corporate earnings gives a boost and higher currency volatility lowers domestic expenditures. Productivity growth is key for understanding the new growth trend. One of the most important factors behind our optimism about Turkey’s growth and disinflation prospects is productivity gains. Without a sustained rise in productivity, no economy can maintain higher growth. And this is what Turkey has achieved, as labor productivity increased by 7.5% a year in the last five years. But the trend shift is not just limited to labor productivity. More importantly, total factor productivity surged from an annual growth rate of 0.5% in the 1990s to about 5% in the post-crisis period. Put differently, the contribution of total factor productivity to GDP growth increased from 3.5% in the 1990s to almost 60% over the past five years (see The TFP Revolution, October 17, 2006). This is why we have argued that the economy is experiencing an upward shift of the supply frontier and the moderation of macro volatility. Is this sustainable? We think so, because the underlying reasons — like fiscal consolidation, structural reforms and greater integration with the global economy — will keep promoting economic rationalization and capital deepening. A more balanced growth path will support the disinflation process. In our view, Turkey will grow at a robust pace, albeit more balanced and slower this year. But this is good news for the central bank in its efforts to bring down inflation. Of course, monetary policy works with a lag, influencing economic activity within three quarters but inflation within 1.5 years. This is why we are yet to see the full effect of tighter monetary conditions. Moreover, cautionary pricing decisions (incorporating an additional ‘risk premium’ in the election year) have led to a disconnect between the moderation in domestic demand and disinflation. Nevertheless, the economy will gradually move back to its non-inflationary growth trajectory, as political uncertainties disappear from the horizon.
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Modest Slowdown Alert
April 19, 2007
By Takehiro Sato | from New York
Positive momentum in January-March but risk of modest slowdown in April-June The economy may have expanded nearly 3% as an annual rate in January-March, even after the strong rebound in October-December 2006, with a recovery in personal consumption and ongoing increases in capex. The base effects boost in F3/08 might modestly exceed our +1.2ppt estimate, considering relatively strong economic gains for two straight quarters from October-December 2006. This factor strengthens the probability of F3/08 real growth reaching our bullish projection of +2.4% versus the consensus view. However, it is unclear whether the economy will sustain upbeat growth on par with the past two quarters from April-June, and some observers expect flatter activity from April-June through the summer along the lines of 2004, given the recent emergence of a number of risks. Basically, we do not forecast a soft patch, though our scenario already discounts for a slowdown to an annual growth rate in the 1% range. That said, we think that the possible manifestation of slower economic growth in the summer, together with a widening price decline rate, could hurt market sentiment and affect monetary policy. We discuss these points below. (1) Personal consumption: Removal of the ‘tax cut’ effect from June Personal consumption data are fairly healthy from both the demand and the supply sides for January-March. On the demand side, data such as the Household Survey reported a modest 0.2% MoM rise in consumption spending (real, seasonally adjusted) even after January’s impressive 1.4% gain. We think that a sampling bias associated with this survey has kept consumption data ahead of actual momentum since January, posting robust numbers despite a strong rebound in October-December. Actually, our review of income data for the Household Survey shows an unusual upswing in some income brackets from January. Also, there is a possibility that an accumulation of lower-income households in the survey sample, along with bad weather and a negative wealth effect from a drop in small- and mid-cap stocks, resulted in weak spending data for July-September 2006. Yet, the current supply-side consumption data, such as department store sales and consumer goods shipments, are also firming, and our real synthetic consumption index (seasonally adjusted) that utilizes supply-side and demand-side data posted a healthy mid-1% QoQ average gain in January-February. We hence conclude that recent consumption advances cannot simply be dismissed as a sampling bias. However, there are uncertainties in the consumption outlook. The first concern is accelerated consumption of spring items as warm winter temperatures brought sales of spring clothing forward into January-March. Feedback in the Economic Watchers’ Survey reported sluggish demand for spring products in March with the return of colder weather. The backlash from accelerated sales might continue in April-June. The second concern is an effect on disposable income from a technical discrepancy in the timing of tax payments. The transfer of tax sources to regional governments from F3/08 has reduced the national income tax burden by ¥150 billion per month (¥1.8 trillion annualized), even after discounting the elimination of the special tax-reduction measure, temporarily lifting disposable income. Yet this means that disposable income should decline from June when taxpayers face higher residents taxes, comparable to the reduction of national taxes. We estimate a substantial ‘tax hike’ of ¥300 billion per month (¥3.6 trillion for the full year) in regional taxes, including removal of the special tax-reduction measure, from June. Households might limit spending from the summer in reaction to lower disposable income if they went ahead and spent extra disposable income from January. This would obviously not be an issue if wages and job growth exceeded the tax increase. However, monthly labor data report a stronger downward trend in wages from January. Benefits from economic expansion are not reaching the smaller businesses that account for almost 70% of total employees, in contrast to the recent flow of wage hike news from larger companies. Wage cutbacks for civil servants and other quasi-public employees are a serious challenge in regional areas. Monthly Labor Survey data reflect lower wages for public school teachers, doctors at public hospitals, and other quasi-public employees. This trend is stalling macro wage growth. Investors are counting on ‘baby-boomer consumption’ spurred by lump-sum retirement payments to seniors. Yet this income is likely to go first toward mortgage loan repayments, and we doubt it will be a major upside factor for macro consumption activity even if some industries do benefit. If these concerns are accurate, investors should be wary of consumption levels from June. (2) Industrial production: Slower automobile exports from April-June Industrial production strengthened moderately in October-December 2006 to +2.2% QoQ (after applying the annual revision for 2006), led by higher automobile output. However, we estimate a -1% QoQ dip in January-March 2007 as a backlash from robust activity in the previous quarter, chiefly due to a decline in automobile output. METI’s production forecast survey predicts +1.8% and +0.4% MoM growth rates in March and April (after applying the annual revision). The March result will strongly influence the April-June outcome, and we expect a restoration of production growth in April-June with help from a +0.6ppt boost in the base effect, assuming that output expands 0.5% MoM in March. Yet some risks factors are emerging that might unexpectedly weigh on output from April. The primary concern is slower growth for the US economy. Our US economics team has lowered its real growth rate projections to a +1.4% annual rate (versus +2.2% previously) for January-March and a +1.7% annual rate (versus +2.5%) for April-June, and has cut the 2007 growth estimate to +2.0% (versus +2.4%). The anticipated near-term slowdown to the 1% range takes into account weaker momentum in the jobs and income environment from two straight quarters of negative growth in capex since October-December 2006, as well as recent manufacturing inventory adjustments. Basically, we do not expect the sub-prime loan crisis, which has attracted substantial investor attention, to seriously undermine the US economy, and our existing scenario already discounts for nearly 20% annual contraction of residential investments in real terms. However, we are not overly optimistic since the sub-prime loan situation could prompt lenders to tighten their credit provision stance, and there is a possibility of housing market troubles affecting car loans and other related lending. In this context, our autos industry analyst Noriaki Hirataka also warns that automobile output expansion could ease from April-June, given the risk of inventory build-up for Japanese vehicles in North America with the exhaustion of last year’s compact car boom. In this regard, the recent BoJ Tankan survey actually reports a gradual rise in ‘excess’ inventory sentiment in the autos industry. Investors should monitor this situation closely, since a major setback in automobile output could combine with IT adjustments to weaken overall manufacturing activity, considering the role of automobiles as a leading export driver in 2006 and heavy consumption of electronic parts by the automotive industry. Although the consensus view emphasizes the possibility of IT adjustments based on the high inventory index for IT-related products, we think that industrial production data might overstate IT-related inventories, and we advise investors against taking these numbers at face value. In fact, excess IT inventories are not being blamed for the recent softness of semiconductor prices. The BoJ Tankan’s inventory DI supports this view. (3) Residential investment: Decline in housing starts since December Housing starts stayed around an annual rate of 1.3 million units throughout 2006, including an average of 1,313,000 units (+3.4% QoQ) in October-December, as the prospect of higher land prices and mortgage loan rates motivated buyers. Since then, housing starts volume has declined MoM for the past three months since December 2006. Yet this does not necessarily indicate weaker demand. The main drag is a pullback by condominium developers from new land site purchases and housing projects with the upturn in land prices in major urban areas. Some developers are also restricting the number of units for sale in anticipation of higher prices. Housing starts fell 9.9% YoY to an annual rate of about 1.2 million units in February due to these supply-side factors. This downward pressure might continue in March. We predict GDP residential investments by allocating floor space to future quarters according to the attributes of each structural category, such as wooden stand-alone homes and multi-dwelling residences, based on construction starts data. Therefore, the current lull in housing starts might restrict residential investments over the next few quarters. (4) Currency market: Slow-working, but potentially serious impact from the G7 statement While the real effective yen rate is trading below the level from the previous G7 meeting in Essen during February, the statement from the Washington G7 meeting held last weekend was largely unchanged and did not constitute an event. The yen lost ground at the start of this week as investors interpreted this stance as acceptance of a weak yen. However, G7 statements often work slowly with almost no initial impact on forex market trends. The latest statement reaffirms the danger of one-way bets with its assertion that “Japan’s recovery is on track and expected to continue. We remain confident that the implications of these developments will be recognized by market participants and will be incorporated in their assessments of risks”. Vice Minister of Finance for International Affairs Hiroshi Watanabe stressed the “bidirectional” nature of risk in response to a question from a participant in an IR tour organized by the MoF in early March, when unwinding of carry trades was disrupting the forex market. We find it highly unusual for G7 ministers and governors to repeatedly mention the dangers of weak-yen bets, albeit with indirect expressions, and we consider this a fairly strong warning. We personally think that it would be wise to shut down weak-yen bets at an appropriate time after the G7 meeting. While the March adjustments ended quickly, conditions in the US economy have worsened somewhat since early March, and the next adjustment might be longer. Sharp correction of yen weakness in a short amount of time could weaken stock prices along the lines of what happened from the end of February into early March, and could hurt consumer and corporate sentiment. Upside risks: 1) Other regions besides the US, 2) capital investments and 3) monetary conditions The Japanese economy faces risks in April-June as explained above, but they are not only to the downside. Initially, investors should be aware of potential decoupling in the global economy, with upbeat economic activity in Europe, Asia and other areas outside the US. In fact, the G7 statement stresses positive global economic momentum despite slower US activity. Japan might sustain export growth with healthy demand from other regions. Second, there is also the possibility of sustained robust capex in Japan, driven by non-manufacturing renewal demand fueling domestic demand, just as in F3/07. The recent BoJ Tankan survey reports manufacturing plans roughly on par with the average annual pattern and a strong start for non-manufacturing, led by large-scale renewal investments in electric power, transportation and other infrastructure areas. Third, the Japanese economy enjoys highly accommodative monetary conditions too, with stably low real interest rates and the steady weakening of the yen on a real effective basis. The consensus view anticipates additional BoJ rate hikes at intervals of more than six months from this summer, and money market participants are even more cautious, with pricing that reflects uncertainty about whether the BoJ will conduct a rate hike in F3/08. We assume an even longer interval. These expectations for stable low rates should have a positive impact on overall asset markets. We expect the Japanese economy to recover to an annual growth rate in the +2% range from October-December 2007, given these factors, and we expect any slowdown to be temporary and modest.
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