United States
Inflation: The Latest US Import?
April 20, 2007

By Richard Berner | New York

By any metric, US “core” inflation cooled significantly in March, renewing hopes for Fed ease and re-igniting risk appetite in global markets.  Measured by the CPI, core inflation slowed to 2.5% in the year ended in March from 2.7% in February.  Likewise, we estimate that measured by the core personal consumption price index (PCEPI) — the Fed’s preferred measure — core inflation slowed to just 2.1% in March.  Both readings are fully 50 basis points (bp) below their peaks of last September, apparently putting inflation on track to come in at rates consistent with what the Fed deems to be price stability. 

However, I think the March readings may represent a lull, and that some inflation risks are rising again.  Like many other things these days, those risks are no longer entirely home grown; as in the 1970s, we may now be importing them from abroad.  The upshot: Inflation has peaked, in my view, but there will continue to be flare-ups and the decline will still be gradual.  Here’s why.

There’s no mistaking the decline in core inflation measured by the CPI over the past six months.  While surging energy quotes drove up the headline rate to a 2.8% year/year gain in March — a seven-month high — the core rate decelerated to a ten-month low.  Yet, three factors that depressed core prices in March were likely transitory, and all three may reverse in April.  Seasonally adjusted hotel room rates plunged by 2.3%, as the actual increase failed by far to match the normal seasonal pre-vacation gains.  Although such rates measured by the CPI rose just 1.3% from a year ago, hotel industry revenue per average room data suggest gains of 6-8%, so a rebound in the CPI version seems likely next month.  Ditto for the 1% decline in apparel prices: This year they failed to match the normal increases accompanying the introduction of spring lines, and we suspect that a rebound is likely soon.  Third, medical care goods quotes (mostly for prescription drugs) fell by 0.3% in March, marking the fourth decline in the last five months.  With wholesale drug prices up by 3.5% in the last year, a rebound here also seems likely.

More important, several global factors seem likely to contribute to US inflation over the next few months.  Among them: Strong global demand and limits on supply are boosting food and energy quotes.  Energy quotes declined at an 11.5% annual rate in the three months ended in December, but jumped at a 22.9% annual clip in the three months ended in March.  Food prices, meanwhile, have accelerated from a 2% annual rate in the September-December span to a 3.9% annual rate in the past three months.  We believe that sellers typically pass some of these price hikes through to core prices with roughly a 2-4 month lag, via transport fares, some rents, and other goods and services.  Just as the energy price declines of late last year may thus have modestly cooled core inflation in the past few months, so will the recent acceleration likely, if temporarily, refuel the core composite in coming months. 

Perhaps more lasting, US consumer import prices are accelerating and the dollar’s recent decline may magnify their faster rise.  Over the year ended in March, import prices for consumer goods other than motor vehicles and parts accelerated to 1.8%, the fastest pace in more than eleven years.  The acceleration was broadly based, including in prescription drugs (from -0.9% to +2.5%, a 340 bp acceleration); toiletries and cosmetics (to 2.1%, a 200 bp swing); household goods (1.6%, a 140 bp swing); toys and sporting goods (up 140 bp to 1.4%).  The dollar’s decline probably influenced that acceleration; over the past year, the Fed‘s broad, nominal trade-weighted dollar index declined by 3.4%.  Not all of the dollar’s recent decline has yet shown up in quotes for imported goods, however.  If the dollar continues to slide, especially against the Asian currencies and to some extent Europe, as we suspect, import prices likely will accelerate further, and add a tenth of a percent or two to consumer inflation.

Importantly, the slipping dollar isn’t the whole story.  The boost to inflation from a weaker dollar has dwindled over the past two decades, reflecting weakening links between exchange rate changes and import prices and ultimately consumer prices.  Several Fed economists in a paper last year found that the decline is a global phenomenon.  Across G7 currencies, their work suggests that exchange rate pass-though to import prices has declined to 40% over the past 15 years from 70% in the 1970s and 1980s, and in the US, it has declined to only 30% (see Jane Ihrig et al. “Exchange-Rate Pass-through in the G7 Countries,” International Finance Discussion Paper 851, January 2006).  That is, a 10% sustained depreciation in the dollar might, other things equal, boost the import price level by 3% over a 2-3 year period. 

The empirical fact that such exchange-rate “pass-through” has apparently weakened over the past several years, like the flattening in the Phillips curve, may reflect good monetary policies.  As well, it probably results from the globalization of markets and production that has promoted “pricing to market.”  That is, exporters not wanting to surrender market share have more closely matched domestic-origin prices in setting their export prices in foreign currency, and they tend to hedge their currency risk either ‘naturally’ by sourcing abroad or financially.  That probably muted the pass-through and lengthened the lags from currency moves to changes in relative prices long before the dollar began its descent. 

Notwithstanding disinflationary monetary policy, I also suspect that the pass-through link varies with the cyclical state of the global economy and inflation expectations.  Considering those factors, the weaker dollar may explain half the recent increase in import prices.  And the booming global economy may have accounted for the other half, by increasing the pricing power of exporters to the US.  Looking ahead, the combined effect of the dollar’s decline and the global boom on US inflation now could be larger than it was over 2002-04 (for more discussion, see “The Dollar and Inflation,” Global Economic Forum, May 5, 2006).  The cyclical state of the domestic economy also matters for assessing the impact of all these global factors on US consumer price inflation.  Despite the sluggish pace of US economic activity over the past year, the level of resource utilization is still high, and sellers may thus succeed in passing such price hikes through to consumer inflation. 

Global factors — higher energy and import quotes and a weaker currency — may also contribute to US inflation by reviving inflation expectations.  So far, however, there’s little sign of that: Inflation compensation measured by 10-year TIPs spreads plunged by 10 bp on this week’s good inflation news, to 240 bp. To be sure, the reaction in distant-forward breakevens was more muted, amounting to 3-4 bp, hinting that these developments haven’t much altered market participants’ underlying inflation expectations.  In mild contrast, survey-based inflation expectations, such as the measure of 5-10 year expectations compiled by the University of Michigan ticked up to 3% in March.  But it’s early days for assessing the impact of these developments on expectations. 

The most important factor affecting inflation expectations is back home: The Fed.  Clear goals and objectives and a straightforward sense of how the Fed will get there are both critical to anchoring longer-term inflation expectations.  And by an large, the Fed has been successful in doing exactly that over the past several years.  Lately, however, when the Fed says inflation is too high, market participants aren’t sure how to calibrate such statements.  That’s partly because there has been some ambiguity over the Fed’s implicit inflation objective. 

Officials have described their preferences in terms of a 1% to 2% “comfort zone” for core PCE inflation, but for three years, core PCEPI has run above the upper end of that zone.  Many market participants thus assume that officials’ de facto target is 2% and not the 1½% mid-point of the “comfort zone.”  If the Fed were clearer about this critical issue — whether they pick one or the other — I think it would more firmly anchor inflation expectations.  Personally, I prefer 2%, because it builds in a bigger cushion for measurement error and disinflationary shocks (see “More Clarity, Less Guidance From the Fed,” Weekly International Briefing, March 30, 2007).  Either way, together with a set of global factors potentially pushing up inflation expectations, lingering questions about the Fed’s objectives may translate into market uncertainty, pushing up term premiums and steepening the yield curve.

That steepening seems to be irregularly underway, and is becoming a popular trade.  Some investors are assuming that the Fed now has a green light to ease and thus look for a bullish re-steepening.  Fixed-income markets now discount a better-than-even chance of a cut by September for the first time in about a month.  Don’t count on it: “Base effects” may cap year-on-year inflation for now, since comparisons with last spring are tough.  But one month’s good inflation data won’t likely be sufficient to convince the Fed that the risks are balanced, and officials also may worry that global fundamentals are no longer disinflationary.  Instead, the curve may steepen bearishly as term premiums rise and inflation prints turn a bit less favorable.  Investors in that context should also consider TIPs.  They’re more attractive now with some inflation upside, and seasonal “carry” is now relatively favorable (because TIPS are priced off the headline CPI before seasonal adjustment, and the seasonal upswing in gasoline and energy quotes is still underway).  According to Morgan Stanley Interest Rate Strategist George Goncalves, 10-year TIPS are priced for a widening of about 12 basis points from current levels.  I’m willing to bet that inflation surprises could easily take spreads higher.

There are risks in both directions, however.  A rebound in inflation could quickly undermine today’s financial-market bullishness.  The threat of protectionism could add another layer of risk to the inflation outlook, because it would block competition in US markets from cheaper overseas goods and services.  Escalating protectionism, moreover, might extend and/or intensify the dollar’s recent decline.  Perhaps the biggest irony in this context is that while many believe that globalization will be eternally disinflationary, courtesy of ever more tightly-integrated global supply chains and other global spillovers, globalization in these circumstances may have — at least for now — turned into an inflation tailwind.

 

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Currencies
No Need to Look Under the Rocks for Reasons
April 20, 2007

By Stephen Jen | London

Dollar weakness may last until the summer

The weakness in the dollar does not surprise me.  As the world de-couples and as risk-taking recovers, a weakening dollar is quite an obvious outcome.  I believe that the dollar will stay weak until the summer or the autumn, when the US is expected to start to show some signs of a recovery.  Before then, the dollar will continue to weaken against most currencies, except the JPY, in my opinion.   

The two key themes that will allow this cyclical dollar correction to continue are (i) global de-coupling of economic growth and (ii) healthy risk-taking appetite.  I strongly believe in both themes, and see the debate on these two issues as academic.  Any hesitance on either of these two issues will prove to be costly, in my view, in terms of foregone investment opportunities. 

This is not a new call of mine

On February 22, 2007, I issued a note with the title Buy USD/JPY, EUR/USD, EUR/JPY and EUR/CHF, in which I argued that global economic de-coupling and the continued decline in Japan’s ‘home bias’ should create the conditions for these powerful trends in the majors.  Unfortunately, the timing of this note was terrible, as a week after its publication, the financial markets went into a spontaneous risk-reduction mode.   I openly apologized for the bad timing of the call, but was never convinced of that round of risk-reduction, and argued that the markets would recover “much much quicker” than they did following the last round of risk-reduction last May/June.  I will return to this subject later, but for now, my point is that the trends we are witnessing in the majors actually began in mid-February, notwithstanding some confusion the risk-reduction episode may have caused. 

In a subsequent note I published on March 22 (Another Bout of Generalized USD Weakness in 2Q), I warned that the dollar was entering a vulnerable stage, driven by two themes.  First, the US drifting deeper into a soft patch is negative for the dollar, primarily because the US is likely to experience a mid-cycle soft landing that will not be strong enough to unsettle the recovery in the rest of the world.  Second, a general recovery in risk-taking will encourage investors to take a proactive stance in markets, including the currency markets.  The stronger the risk-taking appetite of investors, the more the dollar will be pushed lower in 2Q, in my view.  

In this note, I reaffirm my call that the dollar will stay weak at least until the summer, and offer the following thoughts for your consideration.

• Thought 1.  The global economic de-coupling is genuine; think about ‘alpha’ and not just ‘beta’.  There seems to be some confusion about the word ‘de-coupling’.  Several commentators, including our Chief Economist Steve Roach, have made the point that globalization should enhance the inter-linkages between economies, and therefore make the world more coupled.  I agree with this point.  However, I think that this is too narrow an interpretation of ‘de-coupling’.  Until recently, Europe and Japan had struggled to grow at their potential growth rates, while the US for several years grew at rates that were slightly above the potential growth rate.  The recent acceleration in growth in Europe and Japan cannot be completely attributed to external demand, as domestic demand in the rest of the world also began to show signs of strength.  In broad terms, the way I see Europe and Japan is that there is an ‘alpha’ and a ‘beta’ element to their recoveries, and that commentators doubting the de-coupling thesis are ignoring the ‘alpha’ element of this recovery. 

As the US slows, ceteris paribus, the rest of the world will be hurt: this is the ‘beta’ argument, one that I agree with.  To the extent that globalization has strengthened the inter-linkages between economies, this ‘beta’ is presumably bigger than it was in the 1970s.  However, in my view, the ‘alphas’ are likely to be powerful enough to overwhelm the negative beta effects.  This will give the visual impression that the world is de-coupling, even though weak US demand clearly hurts the rest of the world.  Further, and more importantly, since the betas are presumably higher now than in the 1970s, the strength in the rest of the world could actually echo back to help ensure that the US soft landing is a mid-cycle event, rather than a cycle-terminating event. 

One’s outlook on the global economy hinges on this distinction between ‘alpha’ and ‘beta’.  Fixating on ‘beta’ misses the point, I’m afraid. 

This discussion of de-coupling is also critically linked to my ‘20% balancing down; 80% balancing up’ scenario.  I began to write on this scenario at around the end of 2005.  The motive for my use of this term is to convey my belief that, for global imbalances to normalize, relative incomes must adjust.  But this pending relative income adjustment was not going to be 50:50, i.e., a vigorous US and a lethargic rest of the world converging toward the mid-point.  Rather, such a convergence would take place with global growth accelerating.  This is why I used the 20:80 split.  What we are currently witnessing is precisely what I had hoped would happen.  The dollar will be weak during this adjustment, but this would allow the US C/A deficit to fall.  When the US economy reasserts itself in 2H, buyers of USD will likely use the C/A argument to further justify their long-USD position. 

• Thought 2.  Risky assets should continue to do well.   Many commentators and investors have grossly under-estimated the ability of risky assets to recover.  The world’s equity market capitalization fully recovered in five weeks, after the February/March sell-off, compared to six months last year.  During this recent sell-off, I repeatedly warned that the recovery in risky assets would happen “much, much quicker” than it did last time, for various reasons I shall not repeat here.  But the key big-picture view I have on risky assets contains three main parts.  First, the world is still generating excess liquidity through a fundamental mismatch between savings and investment.  Second, the world is not generating enough financial assets for investors to buy.  Third, with the US soft landing and the recovery in the world, the risk to the global economy is now lower than it was before.  Combined, these three key factors should keep risky assets buoyant, in my view.

For the dollar, the greater the risk-taking appetite, the more vulnerable it is to further downside moves.  My guess is that many macro funds (real money and hedge funds) were, for a while, overweight on cash and watched the ‘melting-up’ of global equities from the sidelines.  They should now be more involved in the risky assets, in my view.  Similarly, some central banks and macro funds may have not expected the majors to break through the range they had been in for the best part of the past year.  As EUR/USD and cable have broken out, these funds will need to be involved.  I believe that this will give both risky assets and the USD another push (higher for risky assets, and lower for the dollar). 

• Thought 3.  Both the ECB and the BoE could be rather tolerant of currency strength.  I suspect that both the BoE and the ECB will be more tolerant of further USD weakness than many may think.  First, compared to late 2004, the TWIs of these two currencies have not risen that much (see Appendix 1), but the economic fundamentals of Euroland and the UK have improved since then.  Though both EUR/USD and cable remain over-valued, the current situation does not seem to be as serious as it was at end-2004. 

Second, both the ECB and the BoE are in a tightening mode.  The MCI (monetary conditions) trade-off ratios between interest rate and exchange rate changes that we have estimated for the Euroland and the UK suggest that it would take another 3.0% of EUR TWI appreciation and 2.5% of GBP TWI appreciation to substitute for the additional interest rate tightenings that have been priced in the markets for the rest of the year.  In other words, if the EUR TWI and the GBP TWI were to rise by another 3.0% and 2.5%, respectively, the ECB and BoE would not need to raise interest rates further, ceteris paribus.  If we further take note that European currencies (which tend to move as a group) account for about 40% of the EUR TWI and about 60% of the GBP TWI, the corresponding level of EUR/USD that would obviate the need for further ECB tightening is 1.42, and the level of GBP/USD needed to stop the BoE from tightening further is 2.10, in theory.  In short, there may be some scope for the USD to fall further against these currencies.  If these two central banks tighten only once more by this summer, 1.37 and 2.05 are within reach.  

Bottom line

I believe that the dollar should weaken further.  This is a cyclical move, not a structural one, and is fully consistent with de-coupling and a recovery in risk-taking.  I suspect that many macro investors and central banks may not be as short the dollar as I feel they should be, and the tolerance of the ECB and the BoE for further currency strength may be greater than many may think. 

 

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China
Faster Growth Could Speed Up Tightening Moves
April 20, 2007

By Denise Yam | Hong Kong

1Q07 economic growth reaccelerates

Despite the marginal slowdown in exports (+27.8% versus +29% in 4Q06), overall economic activity in China was buoyed once again by a rebound in fixed investment and resilient consumer demand.  Real GDP growth reaccelerated from 10.4% YoY in 4Q06 to 11.1% in 1Q07, beating our (10.6%) and market (10.3%) expectations.  Nominal GDP reached Rmb5.03 trillion in the quarter, up 14.7%.  The latest fixed investment figure bucked the soft-landing trend seen over the past year.  Urban fixed asset investment rose 25.3% YoY in 1Q07 (totaling Rmb1.45 trillion), and 26.8% in March alone, accelerating from 23.4% in January-February and 24.5% in 2006.  As we have mentioned earlier, a number higher than 25% often heightens expectation for more tightening measures.  Consumer demand continued to show resilience, with retail sales growing 15.3% YoY in March, faster than our expectation (14.5%).  Sales growth averaged 14.9% in 1Q07, the fastest in 10 years (excluding 2Q04, due to the one-off low base effect from SARS), up from 14.3% in 4Q06 and 13.7% in 2006.  Industrial production growth remained buoyant at 17.6% YoY in March, against our forecast of 15.5% (our conservative projection was due to the weak export data in the month), and averaged 18.3% in 1Q07, up sharply from 14.8% in 4Q06 and 16.6% in 2006.  A detailed breakdown of these individual economic indicators will be released on April 20.

The acceleration in consumer inflation of late has received much attention.  CPI inflation rose above the central bank’s target for the year (3%) in March, to 3.3%, and averaged 2.7% in 1Q, up from 2% in 4Q06.  Nevertheless, we had already expected headline inflation pressure to remain elevated, primarily due to food (especially meat) prices.  Indeed, food inflation is reported at 6.2% YoY in 1Q07, implying that the March rate will be 7.5-7.7%.  Non-food inflation therefore remained stable at 1.2% in March.  The National Bureau of Statistics also quoted that a ‘core’ measure of inflation in China that excludes food and energy, which is not usually officially announced, averaged a mild 0.9% in 1Q07.  Meanwhile, producer and raw materials prices showed stable gains.  The PPI rose 2.7% YoY in March (+2.6% in February) and 2.9% in 1Q (+2.9% in 4Q), while the RMPPI rose 3.7% in March (+4.0% in February) and 4.1% in 1Q (+5.1% in 4Q).  It continues to be the case that the latest pick-up in inflation was primarily driven by food, which should be less of a trigger for aggressive tightening than a pick-up in general inflation.

What’s next on tightening?

In our view, with sustained availability of low-cost capital from the balance of payments surplus, China remains vulnerable to a revival in speculative and unproductive fixed investment.  We had expected the government to maintain macro controls this year to prevent overheating again.

The 1Q07 economic report was seen as another opportunity to gauge China’s growth momentum and the likelihood of more tightening measures in the immediate term.  Even though the pick-up in inflation was primarily driven by food and should not be the key catalyst for immediate tightening, headline GDP growth and fixed investment growth breached our estimates of the trigger levels for more imminent tightening moves.  In other words, while we had already expected further increases in reserve requirements and interest rates this year, the latest dataset could have given the government a good excuse to bring forward the timing of the intended measures.  The NBS representative said at the press conference today that policymakers will use “frequent” and “moderate” macro controls, suggesting that we could expect more closely timed policy moves ahead.  The government could again make use of the week-long Labor Day holidays as a convenient time to make the next tightening announcement.

Reserve requirement or interest rate hikes?

Will the central bank hike the reserve requirement (RR) ratio or interest rates?  As we had explained before, China has found monetary policy relatively more effective when it addresses the quantity rather than price of available capital, as investment in China is still driven more by liquidity than returns.  RR hikes occurred more readily than interest rate hikes since tightening began in August 2003, with the RR increased eight times by a total of 4.5 percentage points, against only a 108bp (four times) hike in interest rates.

Nevertheless, we have always argued that interest rates are far below their neutral levels for China, and raising them steadily over time towards a level more consistent with the pace of economic growth will in our view help achieve better capital and resource allocation in China.  Moreover, further steep hikes in reserve requirements will hurt the profitability of the banking sector (required reserve deposits only earn 0.99%).  As it faces the task of striking a trade-off between the banking sector and the broader economy, we continue to expect the PBoC to roll out a combination of reserve requirement and interest rate hikes in the remainder of the year.

Following the strong 1Q07 results, we believe that the government needs to do more than we had earlier expected to cool and rebalance growth in the economy.  We now expect the reserve requirement ratio to be raised by another 150bp within this year to reach 12% by year-end, and the 1Y lending rate to be hiked by another 81bp to reach 7.2%.  The timing of China’s policy moves has always been difficult to predict, but our central case will be for a hike for each instrument — 50bp in RR and 27bp in the interest rate — in each quarter.

 

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