UK
The Bank of England’s May 2007 Inflation Report
May 17, 2007

By David Miles | London

The Bank of England’s latest (quarterly) assessment of where inflation pressures are heading in the UK comes at an interesting — and some might say awkward — time for the central bank.  Inflation moved above 3% a month or so back, and despite having moved back down to 2.8% in April there has been no shortage of people saying that the monetary policy committee has been slow to respond to rising inflation.  So in that context, it was not surprising to see that this new Inflation Report had more of an emphasis on upside risk to inflation than we have seen; the charge of complacency in the face of inflation still significantly above the target is one the BoE will have been keen to avoid.  And it has.

Yet the forecast for where inflation might be going — either on the basis of market expectations of interest rates (which imply a near 25bp rate rise by the end of this year) or on the basis of rates staying at 5.5% — does not suggest that further rate rises are inevitable, nor even particularly likely.  Looking at the assessed probabilities of where inflation might go if there were a small rise in rates (of 20 basis points) by the third quarter, the single most likely outcome is that inflation falls below the 2% target during the course of next year and then returns to the target during 2009 and settles there.

The Bank of England’s assessment is that the single most likely outcome on unchanged interest rates (at 5.5%) is inflation back to target by this autumn, a bit below it in 2008 and perhaps marginally above it by mid-2009. 

Neither of these central forecasts would suggest that the BoE sees further rate rises as clearly necessary.

Furthermore, these forecasts for the most likely inflation outcomes are based on an assessment that growth in output and demand continues at a pretty robust pace.  The best guess is that GDP growth is only slightly under 3% this year and next — a rate that we would judge to be somewhat above the trend rate.  This is a more optimistic assessment of the pace of demand growth in the UK than we see as likely. 

It implies relatively strong consumption growth.  But with much of the impact of the 1% rise in interest rates since the end of last summer still to come through — and with household balance sheets already stretched — we see consumer spending probably turning out weaker than in these central forecasts.  If that is so, inflation pressures from domestic demand will be somewhat lower.

The Inflation Report, nonetheless, sees more inflation risks to the upside than to the downside.

As the Bank of England sees it:

“As usual, there are substantial uncertainties surrounding these projections.  These include: the impact of stronger demand growth on companies’ prices; the evolution of inflation expectations; prospects for energy and import prices; and the degree of spare capacity in the economy.  As in February, there is greater-than-usual uncertainty over the outlook for inflation and the previous widening of the fan chart has been retained.  Overall, the risks to growth are judged to be balanced, while the risks to inflation are balanced in the near term but weighted to the upside in the medium term.”

A risk that is particularly emphasised is that firms may feel able to pass on cost increases to a greater extent than over the past few years.

“These risks will need to be monitored carefully against the data over the next few months.  For the medium-term outlook for inflation, indicators of pricing pressure are particularly important at present.  In the central case, such measures are expected to fall back gradually.  If they were to remain elevated, that would be consistent with the possibility that inflation expectations had moved more persistently upwards or mark-ups were being raised more aggressively.  In that case, the Committee would be likely to view the upside risks as crystallising.  Another significant indicator is the cost of labour which, in the central case, is expected to pick up moderately.  If, for example, wage pressures were to diminish, the Committee would be likely to view that as evidence that the upside risks had receded.”

There is less emphasis on the downside risk (both to demand and to inflation pressures) that continued low growth in real take-home pay may mean consumer expenditure stagnates in an environment where past rate rises reduce spending power for the great many households with mortgages.  That is a risk we judge to be very significant.

What it might mean for rates

Our single best guess is that rates stay where they are over the summer and into the early autumn — but by year-end we might see rates back at 5.25%.  The market consensus on the Inflation Report is likely to be different, with many seeing the discussion of upside risks to inflation as making rate increases now more likely.  Discussion of risks in the Inflation Report is clearly helpful in showing what the monetary policy committee will focus on and tells us something about its likely reaction to different events.  That in itself does not make rate increases more likely.  The key issue for outsiders — as Governor King emphasised in the press conference — is to figure out how they think the economy is evolving and how the monetary policy committee will react to that.

If things play out in line with the Bank of England’s central projection for inflation and growth (which of course is not very likely), it will be a close-run thing whether over the course of this year interest rates are kept steady or we see one more rate rise.  If, as we think likely, the BoE’s central projection for consumer spending turns out to be on the high side — but other factors evolve in line with its central forecast — then we believe that a rate rise will not be the most likely outcome; and indeed there would likely be a serious discussion about rate cuts before the end of the year.

 

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Turkey
The Politics of Misery and Expectations
May 17, 2007

By Serhan Cevik | London

Macroeconomic performance may not be enough to convince voters. Turkey’s macroeconomic progress has turned out to be even better than our out-of-consensus expectations five years ago. Breaking away from the boom-bust cycles of the past, the Turkish economy expanded at an above-trend pace, reaching an annual growth rate of 7.5%, as the budget deficit narrowed from 16.5% of GDP in 2001 to 0.7% last year and inflation declined from an average of 72% between 1990 and 2002 to the single-digit territory for the first time in 35 years. Even the rate and composition of employment growth have become welfare-enhancing, despite structural changes and constraints, and led to significant improvements in socioeconomic indicators, such as the poverty rate and income distribution (see The Rise of the Middle Class, May 14, 2007). Nevertheless, the strength of ‘macro’ performance may not be enough to convince frustrated voters, especially in rural areas and spiralling urban slums. Indeed, the latest opinion polls suggest a steady support for the ruling party, but no major improvement compared with its standing in the previous elections. Therefore, considering the likelihood of mean reversion in the voting behaviour, the risk of a relatively more fragmented parliament is now higher, in our view.

The rise of the middle class is great news, but we need to look deeper into the data. There are many ways to assess the effectiveness of economic policies in improving living standards, and one such gauge is the misery index based on inflation and unemployment rates. In the case of Turkey, the misery index (rebased to 100 in 2000) shows a sustained improvement in the post-crisis period, declining from an average of 142.1 in the 1990s and 102.1 in 2001 to 30.5 last year — the lowest reading in the past three decades. We also constructed an alternative misery index — consisting of public-sector borrowing requirement, interest rates, income growth, inflation and the unemployment rate (see Less Misérables, March 8, 2006). It, too, indicates a decline in social affliction, from an average of 139.1 in the 1990s and 147.6 in 2001 to below 25 last year. These results are also consistent with the latest data on poverty and income distribution. For example, the poverty rate declined from 28.1% of the population in 2003 to 20.5% in 2005. In other words, 4.5 million people moved out of poverty, just as the distribution of income kept improving after the crisis. However, although the overall progress is encouraging, there are geographical and social divergences in the level of misery.

Unemployed and poor voters are likely to determine the composition of the next parliament. Socioeconomic conditions have improved across the country, but relative developments (especially with regards to expectations) are also important for political cycles. Take, for example, the gap between urban and rural areas. While the rural poverty rate declined from 40% in 2004 to 33% in 2005, it is still 157% higher than the urban reading. Even though this is simply a result of extremely low productivity and institutional rigidities in the agriculture sector, discouraged voters may not be as understanding as economists judging from a distance. Likewise, unemployed and informally employed workers face a significantly higher risk of poverty, because of inadequate educational attainments and structural changes in the economy. If truth be told, while the number of employed increased by 3 million since 2002, the unemployment rate remains almost twice as high as the pre-crisis average (even with a substantial increase in the number of discouraged workers who have withdrawn from the labour market). With the ‘true’ jobless rate closer to 20%, Turkey’s young population suffers more than others from the challenges of economic normalisation and greater integration with the global economy. Of course, once again, we are not sure whether unemployed youth would appreciate, at least in the near future, the nature of productivity-driven growth and the transition from labour-intensive sectors to capital-intensive production that improves the quality of jobs but limits employment growth. Indeed, before the previous elections, we argued that the state of the labour market has a significant effect on voting behaviour, especially among young voters (see Rock the Vote, October 31, 2002). And now, with 4 million new voters, the channel of ‘greater expectations’ will only become more important in the coming elections.

 

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South Africa
Is The Tightening Over?
May 17, 2007

By Michael Kafe | Johannesburg

Summary

SARB monetary policy review sheds light on recent policy decisions. The South Africa Reserve Bank (SARB) released its bi-annual Monetary Policy Review (MPR) last Tuesday.  The Review provides some insight into the thinking of the Monetary Policy Committee (MPC) at the last three MPC meetings. Our take on the Review, as well as the question and answer session at the Monetary Policy Forum on Tuesday evening, reinforces our view that the SARB is done tightening, although there are still some upside risks to the inflation outlook. Essentially, we believe that the factors driving inflation are unlikely to deteriorate significantly from what the SARB has already priced in.

What drove the last three MPC decisions?

In December 2006, “uppermost on the list of concerns of the MPC was the responsiveness of domestic demand to the earlier interest rate increases”.  And the SARB felt it was prudent to hike again because the evidence (of a slowdown in demand excesses) at that stage was still unconvincing. Food prices were also regarded as a threat to the inflation outlook, as were the international price of oil and the volatile exchange rate of the rand.

Come February 2007, a key driver of the decision to hold fire was the fact that inflation was no longer expected to breach the upper end of the target. According to the MPR, “this improved outlook was ascribed to the monetary policy actions taken to date, as well as the improved outlook with regard to international oil price developments”. 

By the April 2007 MPC meeting, there was some deterioration in the inflation outlook, thanks largely to “increases in domestic petrol prices, which totaled R0.92 per litre in March and April”. But the MPC again chose to leave rates on hold because it regarded the petrol price increases as a short-term exogenous shock that did not really warrant policy action. According to the MPR, “The MPC has made it clear in the past that it would not react to first round effects of exogenous shocks such as petrol price increases.”

Other drivers behind the decision to keep rates on hold in April were the improvements in inflation expectations (wage settlements appeared to be under control), as well as the fact that a relatively stable currency and a benign global backdrop were all supportive of monetary policy. There was some concern that the economy was probably operating at levels which were at or slightly above the potential growth rate. Nevertheless, it was felt that “the positive trends with respect to investment growth implied that the potential output of the economy was probably increasing as well, and therefore the strong growth performance of the economy did not necessarily pose an immediate threat to the inflation outlook”. Finally, the SARB’s own analysis of the credit numbers showed that “the strong growth in credit extension was now being driven by companies financing investment expenditure, rather than by households borrowing for consumption purposes”.

Why do we think the SARB is done tightening?

In June last year, our assessment of the prevailing economic conditions and previous tightening cycles pointed to the need for 200bp of tightening, in clips of 50bp, ending December 2006. After this, we had expected the SARB to be on hold in 2007 (see South Africa: Burgeoning Current Account Deficit: The Devil's in the Detail, June 26, 2007). And, after having read through the MPR, and after meeting with officials at the presentation early this week, we are even more convinced about our call. We believe that the SARB is done tightening for the following reasons:

1. The SARB’s inflation fan chart now shows that the peak of 5.9% in CPIX is only expected to last until 1Q08, and not 2Q08 as published in the April MPC statement. This means that even if food pressures mount beyond what is currently priced in, the possible breach is likely to be more short-lived now than we had thought it would be in April, raising the probability that the SARB could choose to ignore such a temporary breach. Besides, one must remember that with every passing day, 1Q08 is nearing, and given that monetary policy decisions in South Africa are forward-looking, the probability that the SARB takes the view that it is too late to do anything about a breach in 4Q07 and/or 1Q08 is rising.
2. The MPR was careful to admit that previous increases in oil prices could ultimately pass through to more generalized price increases (i.e., so-called second-round inflation). Nevertheless, the Review made it clear that it regarded the recent increases in March/April (and by the same argument, the May and upcoming June petrol price increases) as exogenous shocks that do no warrant a monetary policy response just yet. In fact, the SARB was at pains to show a breakdown of the contributors to inflation which highlighted the disproportionate contribution from food and transport costs, and concluded that “the MPC would watch these developments very carefully, but at the same time the view is that interest rates should not be adjusted each time the international oil price increases or decreases”.
3. The SARB’s view is that “though oil price risks have declined from their peak in recent weeks, geopolitical developments could raise volatility in the coming months and the possibility of a continued upsurge in oil prices cannot be ruled out”.  It then goes on to highlight that the futures market points to Brent crude oil prices at US$70/barrel for 4Q07 delivery. Although we cannot prove this, we are inclined to believe that this is the minimum floor that it was willing to tolerate in its forecasting exercise. In fact, chances are that it has oil prices above US$70/barrel in its model. This would explain why it has such a high CPIX reading of 5.9% between 4Q07 and 1Q08, compared to our recently revised forecast of 5.4% and 5.7% for 4Q07 and 1Q08, respectively, based on our oil price profile of US$62.3/barrel for 4Q07 and US$60.5/barrel for 1Q08. (see South Africa: Slight Upward Revision to Oil and CPIX Forecasts, May 14, 2007 and A Higher Risk Premium on Oil Prices by Eric Chaney and Richard Berner, May 9, 2007).
4. Based on our current view on oil prices, we expect the SARB to undershoot its inflation forecast. In fact, at present, the nominal effective exchange rate of the rand has appreciated since the April MPC, dated Brent prices as well as both white and yellow maize futures prices are down, and wheat futures prices have tracked sideways, suggesting that were the SARB to mark its forecasts to market today, its CPIX trajectory should come in lower than that published in April.
5. In April, we were somewhat worried that the SARB’s focus would shift from concerns about demand-side excesses to the supply-side issue of capacity utilization, given what appeared to be a concern about a positive output gap. However, details in the MPR show that we were wrong.  As quoted above, the SARB clearly does not think that the strong performance of the economy necessarily poses an immediate threat to the inflation outlook. Hence, there is no need for pre-emptive tightening. In fact, in response to a question about the output gap on Tuesday evening, the authorities said that (i) the output gap was not worrisome at this stage, (ii) it did not pose an excessive threat to inflation, (iii) they now expect the policy action taken in 2H06 to result in a possible slowdown in growth during the latter part of this year, so they would not want to slam the brakes unnecessarily.
6.            The controversy around credit growth has now been settled. Clearly, the SARB is now less worried about credit growth than it was in 2H06. At the moment, its analysis shows that some 80-85% of total credit is going to mortgages and corporate expansions, rather than households borrowing for consumption purposes. It was also careful to mention on Tuesday that although the strong growth in credit cards is undesirable (40.8%Y in 2006), it is aware that credit cards account for only a small proportion of total credit advances (2.1% of banks’ assets in 2006).
7. The SARB appears to be concerned about possible upward pressures from food prices. We share this concern and are equally surprised that the pass-through from the huge jump in cereal futures prices this year appears muted thus far. In fact, given what we think its oil price level is, we are inclined to believe that Morgan Stanley has a more aggressive forecast on food price inflation than the SARB. Yet, we still do not see a breach of target in the forecast horizon. In any case, grain futures prices appear to be consolidating right now and could come down over the course of the year as weather conditions improve. Hence, while we view this as a possible threat to inflation, our bias remains one of cautious optimism.
8. Finally, although the SARB appears to be concerned – and rightly so – that the expenditure response to the tighter monetary stance is still tentative, it is important to note that its own analysis in the MPR (which Morgan Stanley shares) shows that “consumer demand, which has been resilient and remains buoyant, is however likely to slow somewhat during the year as the effects of previous monetary policy actions become more apparent”. We share the latter view and point out that new vehicle sales growth is now in negative territory (although this was due in part to teething problems surrounding the implementation of the new national traffic intelligence system), and that both the Investec PMI and manufacturing production appear to be consolidating.

Risks

As always, there are risks to our call. Foremost is the international price of oil. As we pointed out, despite improving fundamentals in the oil market, prices have remained quite firm, and with the hurricane season coming up soon, the risk of another spike in oil prices cannot be ruled out. Clearly, a sustained break of US$70/barrel could prove problematic.

Also, although cereal prices appear to be consolidating right now, any pressure from international sources could lead to a deterioration in our food price outlook.

Finally, the rand has held up fairly well lately, and we maintain our cautious optimism on the currency. However, history has shown that any wave of emerging market risk aversion could hurt the currency – given the country’s high current account deficit, and the market’s apparent unwillingness to acknowledge that the surplus on the country’s fiscal accounts reduces the funding risk of the contingent liability on the current account by a large measure.

All in all, however, we maintain our call for no policy rate move in 2007.

 

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