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China
Upgrade to Our GDP Growth Forecasts June 18, 2007 By Qing Wang | Hong Kong Conclusion: We upgrade our 2007 GDP growth forecast to 10.5% from 9.3% and CPI inflation forecast to 2.9% from 2.5% on stronger-than-expected developments in the first five months of the year and a more favorable external environment going forward. We revise up our 2008 forecasts accordingly. What's New: Latest data through May indicate very buoyant activity in almost every area of the economy, including fixed-asset investment, retail sales, external trade, and industrial production. Headline CPI inflation reached 3.4%YoY in May driven largely by a sharp rise in food prices. At the same time, the latest readings of key data indicate the remarkable strength of the Implications: Our revised forecasts suggest that Risks: We see a broadly balanced risk to our revised outlook for 2007 and 2008. The political cycle in All-round Buoyant Economic Activity Latest data through May indicate very buoyant activity in almost every aspect of the economy. A rebound in fixed asset investment growth, which is keenly watched by the authorities as one of the most important indicators of potential economic overheating, continued in May. Investment spending totaled Rmb3.2 trillion in January-May, gaining 25.9% YoY, up from the 25.5% rise in January-April. For May alone, we estimate that investment spending rose 27.1% YoY, against 25.8% in April. Retail sales also ran full steam ahead. The growth rate accelerated in May, up 15.9% YoY, from 15.5% in April and 14.9% in 1Q07. For the first 5 months, sales grew an average of 15.2% YoY. The external trade surplus widened to US$22.4 billion in May from US$16.90 billion in April, with export growth (+29% YoY) continuing to outpace import growth (+19% YoY) by a wide margin. On the production side, industrial value-added increased by 18% YoY in May, accelerating sharply from 17% in April. Headline CPI inflation picked up to 3.4% YoY in May due to strong food price inflation. CPI inflation averaged 2.9% YoY in the first 5 months, only a notch below the central bank's tightening threshold of 3% for the year. We consider the sharp rise of food price inflation symptomatic of underlying inflationary pressures. In our recent research (see “Pork Crisis and Timing of the Next Rate Hike”, June 4, 2007), we put forward our view that the recent pick-up in food inflation is not just a function of a supply shock. Indeed, supply-side factors have triggered the price hikes, but we believe that, given the relatively inelastic supply of food (versus other manufactured consumer goods), strong consumer demand buoyed by the lag effect of loose monetary conditions from a year ago sparked the food price inflation, exacerbating the impact of a supply shock. Factors Contributing to the Strong Performance Several factors help explain the very buoyant Chinese economy so far this year, in our view. First, the administrative measures to curb investment growth, which were launched last summer and helped slow investment growth markedly toward the end of last year, have lost their effectiveness faster than we initially envisaged, contributing to the strong rebound in fixed-asset investment growth. Second, corporate earnings continued to be very strong, with industrial profits up by 44% YoY in the first two months of the year on the back of 31% growth last year. Third, the momentum for consumption growth appears to be gaining additional traction, as more consumers appear to have assumed that rapid income gains in recent years are permanent and thus have become more willing to spend. In this regard, the wealth effect created by the bubbly stock market—albeit still small—appears also to have played a positive role on the margin. Fourth, more-resilient-than-initially-expected external demand, underpinned in particular by the remarkable strength of the Domestic financial conditions have also been supportive. M2 growth in May was 16.7% YoY, still above the central bank’s target (16%) for the year. Although growth in outstanding loans by end May were stable at 16.5% YoY, loan creation in the first 5 months rose 17.5% YoY to a total of Rmb2.09 trillion, already exceeding 65% of the 2006 total (Rmb3.18 trillion). One-year base lending rates have reached 6.57% in May after being raised by 45bps so far this year; however, real interest rates (after being adjusted for CPI inflation) are still quite low, especially compared to the returns from alternative investments (e.g., real and financial investments), making them a non-binding constraint on investment decisions, in our view. At the same time, inter-bank interest rates (in the form of yields on one-year PBOC bills) have been broadly stable, suggesting that the overall liquidity situation remains largely unchanged, despite PBOC’s aggressive withdrawal of liquidity (through open market operations and raising the ratio for required reserves). The gradual appreciation in the Renminbi may not have meaningfully corrected its underlying undervaluation. The appreciation of the Renminbi against the USD has accelerated visibly since May, contributing to a cumulative appreciation of 2.5% since the beginning of the year and about 6.3% since the one-off revaluation on July 22, 2005. However, we estimate that the real effective appreciation of the Renminbi, the meaningful gauge of a currency’s strength, has been less than 3% since July 2005. While it is difficult to quantify the exact extent of the Renminbi undervaluation, the slow appreciation of the currency in real effective terms is unlikely to significantly reduce the degree of its undervaluation. This is because the underlying real equilibrium exchange rate for the Renminbi may be also appreciating over time given rapid productivity gains in the tradable sectors in A New Round of Macroeconomic Tightening Against this background, the State Council concluded a meeting on June 13 called to discuss several "outstanding" problems with the current economic situation, including overly rapid industrial production growth, an excessive trade surplus, persistently strong fixed-asset investment growth, excess liquidity, growing inflationary pressures and a serious challenge to energy conservation efforts. The State Council has emphasized the need to give high priority to these issues and to guard against the risk of overly rapid growth turning into general economic overheating. In particular, it believes that monetary policy should turn "appropriately tight" and comprehensive measures should be employed to ease the excess liquidity situation, including "financial and tax measures". We think that the Chinese authorities are poised to initiate a new round of macroeconomic tightening. Potential policy measures include stricter administrative measures to curb investment growth, more aggressive monetary tightening (e.g. interest rate and RRR hikes) and a broad-based cut in VAT rebate rates for exports. In particular, our sense is that tight monetary policy tools instead of administrative measures would likely be given a more prominent role in the policy package this time. However, compared to the previous two rounds of heavy-handed macroeconomic tightening that were initiated in 2Q04 and early 3Q06, respectively, and based on our reading of the substance and tone of the official press release, this upcoming round of tightening appears relatively mild. At the same time, this is an indication that the authorities have become more vigilant of the risk of overheating and willing to take pre-emptive policy moves to address any emerging problems. Growth Forecast Upgrade In view of the stronger-than-expected developments in the first five months of the year, we upgrade our 2007 GDP growth forecast to 10.5% from 9.3% and CPI inflation forecast to 2.9% from 2.5% to reflect the broadly stable policy environment and favorable external demand outlook going forward. We revise up our 2008 forecasts accordingly, boosting our GDP growth forecast to 10% from 8.5%. This is despite the upcoming round of macroeconomic tightening. Fixed-asset investment is the most important growth driver in In this political-economic context, we believe that the domestic macroeconomic policy environment that has underpinned the buoyant Chinese economy so far this year is unlikely to change significantly throughout the remainder of the year. First, we expect PBOC to tighten monetary policy further through interest rate hikes and the mopping up of excess liquidity. We call for two more rate hikes, each by 27bps, and 2-3 RRR hikes in the remainder of the year. We, however, view these moves as an effort to make underlying monetary conditions less accommodative instead of typical outright tightening. Second, in terms of exchange rate policy, we believe the authorities will stick to their current strategy of allowing a gradual appreciation of the Renminbi against the US dollar and expect the Renminbi to appreciate by 4-6% against the US dollar over the course of 2007. Therefore, the Renminbi exchange rate would continue to be significantly undervalued. In this regard, the potential broad-based reduction of VAT rebates on exports may help dampen the rapid expansion of Chinese exports, offsetting in part the simulative impact of an undervalued currency on exports. Third, while we expect the new round of administrative measures to help slow investment growth, the authorities are unlikely to launch the type of heavy-handed administrative tightening witnessed in 2Q04 and early 3Q06, in our view. This call is partially based on the political-economic considerations as noted above. Moreover, previous administrative tightening measures were largely prompted by the emergence of sectoral bottlenecks (e.g., energy supply, transportation) and concerns over production overcapacity in certain sectors. Although there have been anecdotal reports of electricity shortages in some regions, this does not appear to be an economy-wide phenomenon at this stage. The broadly stable domestic policy environment aside, With the two main growth engines – investment and exports – powering on, we expect consumption growth to sustain the growth momentum demonstrated so far this year, as households become confident over the sustainability of the improvement in their earning power on the back of rapid income gains in recent years. We expect average CPI inflation to reach 2.9% in 2007. The headline CPI inflation would likely moderate from the current high levels toward the year end, in our view. We believe that the lag effect of the marked deceleration in money (M2) growth since mid 2006 should, ceteris paribus, cap the upside in headline inflation going forward, especially if the supply shocks that initially triggered the food price increase prove to be temporary. Moreover, potential monetary tightening moves (including interest rate and RRR hikes) should help anchor inflationary expectations and contain the second-round effect of food price inflation. If the headline CPI were to persist at current levels, we think the authorities may postpone rolling out energy price reform, which, if implemented, is expected to add to inflationary pressures. A Balanced Risk to Our Forecast We see a broadly balanced risk to our revised outlook for 2007 and 2008. The political cycle, together with generally low interest rates, an undervalued exchange rate, strong corporate earnings and favorable external environment, suggests considerable upside risks even to our revised forecasts. To the downside, the rising risk of protectionist measures from Bullish On Our revised forecasts suggest that
United States
Will Core Inflation Decline Further? June 18, 2007 By Richard Berner | New York Core inflation has declined in the past three months by any measure, and the decline has come faster than we thought. For example, measured by the CPI excluding food and energy, core inflation declined by 0.4 percentage points between February and May to just 2.3% — the lowest year-over-year rate in more than a year. Likewise, measured by the Fed’s preferred inflation gauge, the personal consumption price index (PCEPI), we estimate that core inflation dipped just under 2% in the year ended in May. If it continued, such a decline would bring underlying inflation back inside the Fed’s presumed 1-2% “comfort zone” for the first time in three years. Can it continue? In our view, core inflation peaked last year, but the fundamentals point to lingering upside risks. Thus, further declines in inflation will come slowly. Moreover, there remains uncertainty over inflation measurement and over key inflation determinants and thus about the outlook (see “Inflation Uncertainty,” Global Economic Forum, December 15, 2006). But the current low starting point for core inflation does mean that those upside inflation risks are smaller than we thought a month ago. Details follow. The case for lingering upside inflation risks stems partly from domestic and partly from global factors. Among them: Inflation expectations are still slightly elevated, the amount of slack in the US economy still appears to be limited, and companies may thus be able to pass through past increases in costs to prices of goods and services. Moreover, strong growth and dwindling slack abroad, coupled with past declines in the dollar’s value in foreign exchange markets, are contributing to rising food, energy and consumer import prices. Escalating protectionism could add to those risks. But the Fed’s resolve to cap any upside means they won’t last long. Rising energy and food quotes and perhaps other factors have recently pushed up inflation expectations again. Measured by the Slack in US product and labor markets has probably increased, but only slightly in the past year. As evidence, the economy grew by just 1.9% in the year ended in the first quarter, well below anyone’s estimate of potential growth (ours remains close to 3%). But there is uncertainty over the economy’s potential growth rate, as productivity growth has slowed significantly over the past two years, and to just 0.9% over the past year. And we think the second-quarter pickup in growth to roughly 4% marks the start of a slow return to trend growth, so economic slack is unlikely to grow significantly. Industry operating rates have declined by about a percentage point over the past year but remain above historical norms. The unemployment rate has risen by 0.1% from its low of 4.4% in March, and job opening or vacancy rates have ticked down by 0.2% from a peak of 3.1% in December. In any case, a looser and less-certain relationship between slack and inflation than in the past (the so-called flatter Phillips curve) implies that inflation will decline slowly. Moreover, courtesy of booming global growth over the past five years, slack in the global economy has dwindled, so the notion that excess global capacity will hold inflation down may be losing force. Unemployment rates among the Global influences on The upshot: We still think that core inflation will move up slightly over the next few months, and that the dispersion of inflation risks has risen. Nonetheless, the recent performance of inflation and the lower starting point for core inflation means that those risks have dwindled. Perhaps most important, the decline in core inflation should ease concerns that Fed officials are tolerant of higher inflation. Indeed, some officials, such as Richmond Fed President Jeff Lacker, worried that the fact that core inflation measured by the PCEPI had lingered above 2% for three years would erode public confidence in policymakers’ inflation vigilance and result in rising inflation expectations. While the Fed’s presumed 1-2% “comfort zone” for core inflation doesn’t represent a range around an official numerical inflation objective, most Fed officials believe that a number near or slightly below 2% would reasonably qualify. It is worth looking at the components of inflation that have contributed to the decline in core inflation. To be sure, examination of inflation components risks merely looking at relative price changes rather than at the factors influencing the price level. But I think dissecting those contributions can sharpen inflation analysis for two reasons. First, we expect further declines in at least some of those components — ones that are important and thus have a significant weight in inflation gauges. Second, the recent declines have been broadly based, which suggests that inflation’s momentum could be fading. Over the past three months, decelerating prices for owners’ equivalent rent (OER) and apparel have accounted for nearly all of the decline in core CPI inflation in the past three months. The housing recession is helping to reduce the increases in both rents and owners’ equivalent rents, with the latter decelerating to 3.5% from 4.2% in February. With housing markets likely to stay soft, more weakness seems likely for these two components that account for nearly two-fifths of core CPI inflation. The decline in core inflation measured by the PCEPI won’t get the same assist from rents, because their weight in that gauge is half that in the CPI, so the two core measures should continue to converge. The recent sharp deceleration in apparel prices (by 2.9 percentage points to -0.8% in May) may reflect abnormal weather and buying patterns, but slower growth in consumer demand should help cap apparel price increases. Over a longer time frame (the past eight months), core CPI inflation has declined by 0.6 percentage point from its peak, with a broader array of components contributing to the deceleration. Besides OER and apparel, declines in price increases for household furnishings and operations; for public transportation, especially for airfares; for new and used vehicles; and for drugs and medical equipment all contributed. Weakness in housing and home remodeling likely will depress demand for furnishings and thus prices, while consumer incentives may further depress vehicle quotes. Deceleration in medical services may reduce core inflation measured by the PCEPI (medical services has a larger weight in the PCEPI than in the CPI, and the former uses a different measure for that component). In contrast, rising fuel costs and accelerating prices for imported apparel and drugs could reverse recent declines in those components in both yardsticks. Sharp movements in relative prices — even those for food and energy — raise questions of which measure matters more. For Fed officials, the lingering upside risks to inflation and the uncertainty surrounding the inflation outlook continue to imply that there are high hurdles to changing monetary policy in either direction. With inflation now low, if it stabilizes or even rises slightly, as we expect, the Fed is unlikely to tighten policy to bring it down again. Conversely, if inflation falls slightly further, firming economic growth seems likely to keep the Fed on hold. The decline in core inflation has failed to rally bond markets, underscoring our view that it was a re-rating of global growth — and not directly inflation fears — that triggered the recent bond-market selloff and changed perceptions about monetary policy. Market participants thus seem to think that changes in the outlook for growth are more important for the Fed than are changes in the inflation prognosis. We disagree. If core inflation declines significantly further, we think officials would want to reduce nominal rates to avoid the “passive” policy tightening that would result from steady nominal and rising real rates.
Sweden
Monetary Tightening + Rising Global Yields June 18, 2007 By Thomas Gade | London Aggressive market pricing, but mind rising global yields The Executive Board will meet this week to decide on the future trajectory of monetary policy. A 25 bp rate hike this Thursday - bringing the repo rate to 3.5% - is signalled by most members of the Executive Board and therefore also widely expected by financial markets. The decision on the very short-term monetary policy rate therefore seems almost like a non-event. More importantly, all eyes will be on the fresh interest rate forecast from the Riksbank. An upward revision as suggested in recent communication from the Riksbank is certainly very likely. The magnitude and timing is of course less clear. We continue to bang the drum that current market pricing of future short-term monetary policy tightening still seems aggressive, despite having taken out some of the monetary tightening priced in by year-end. The recent sharp rise in global yields now acts in addition to monetary tightening. On balance, we think the Riksbank will revise up its interest rate path by 25 bp this year, while it might add at least 50 bp of monetary tightening next year. This is below market expectations. The risks - in particular next year – tilt to the upside and a possible 100 bp of tightening next year is no longer a completely unlikely scenario, although not our baseline case. Real economic factors all point to higher inflation, yet …
Additional tightening from rising global yields
France
Reforms Yes, Fiscal Shock No (Part 1) June 18, 2007 By Eric Chaney | London After his decisive victory in the presidential election, Nicolas Sarkozy’s political allies are likely to crop a landslide victory at the final round of the general elections, this coming Sunday. Polls are predicting that UMP and allies could win between 400 and 450 of the 577 seats of the lower House (the National Assembly). The new cabinet, led by Francois Fillon is likely to remain barely unchanged, and the new National Assembly will convene in early July. The first bills prepared by the government should pass easily. Investors are likely to focus on the fiscal dimension of these bills, which are likely to imply higher borrowing requirements this year and next year. Since PM Fillon has publicly acknowledged that the cost of the new measures will amount to €11bn (0.6% of GDP), tensions with the Ecofin and the EU Commission have already started to build up. In addition, the prospect of a tax base shift from payrolls to consumption (VAT), although not for the immediate future, will raise questions about its macro impact. While fiscal and tax issues deserve attention, especially in the context of rising interest rates, I believe that investors should keep the big picture in mind, which, in my view, is that the reform process that has just started is unequivocally positive for the French economy. From costly and unnecessary to cheap and smart Put succinctly, some of the first decisions taken by the government imply a fiscal stimulus that was not justified by current business conditions without having an impact on long-term growth. This is the case for tax breaks on existing housing loans: this was unnecessary and will reduce the scope for action by the government when key structural reforms are implemented. I would call some other measures opportunistic and costly, but probably positive in the long run, such as the same tax breaks for future loans. Then, there are measures such as tax breaks on overtime hours or the cap on income and wealth taxes, which, I believe, are positive for the supply side of the economy, but may have a high fiscal cost. The last category, which includes a bill limiting the scope of industrial action in public services, such as transportation, the possibility given to universities to become autonomous or the rebalancing of the funding of some welfare funds, are positive for long-term growth without significant fiscal cost. Before going into the detail, I believe that two things should be kept in mind. First, the fiscal cost of these early decisions has to be framed in the context of the 2008 budgets (state and social protection), which are likely to include some significant spending cuts. Second, this is only the beginning of a more ambitious programme of structural reforms, which will continue this autumn with the most important item of Nicolas Sarkozy’s platform: the reform of the labour market. Tax breaks for housing loans: more collateral for households This was clearly stated in the Sarkozy’s election platform: interest payments on housing loans would become tax deductible, the purpose being to encourage home ownership in Tax breaks for overtime hours: costly but likely to reverse the long-term trend for ever-shorter working hours As early as October, overtime hours above 35 hours per week will get a 25% bonus (instead of 10% as of now) and will benefit from special tax treatment; a social charge (payroll taxes) and an income tax credit. Hence, both companies and employees will have incentives to increase the demand and supply of labour. The fiscal cost of this measure, which is nothing other than a subsidy for labour at the margin, could be quite important. So where is the benefit? Practically, it will cut the cost of labour at the margin. This should be favourable for low skilled workers, for which market clearing is distorted by the minimum wage. The best outcome, in my view, would have been to get rid of the concept of ‘a legal working time’, which has become anachronistic in today’s globalised world. The French public is certainly not ready to accept this truth. A second best would have been to return to the 40 hour week (before 1982), but this would have been perceived as a political provocation. The tax break on overtime hours is in my view a fair compromise between diverging economic and political constraints. It is likely to reverse the long-term trend toward ever lower working hours, a reversal that has already taken place in many high income countries (US, UK, Japan, Nordic economies), and which is an absolute necessity, if French workers want to preserve their standard of living during the next demographic transition.
The ‘tax shield’: a cap on the top marginal income tax Called a tax shield in French political jargon, this measure is a cap on income and wealth-based taxes (as opposed to payroll taxes, often called ‘social charges’). It already exists, with the income and wealth tax capped at 60% of taxable income: practically, taxpayers who pay more than 60% are eligible for a tax credit. The new measure goes further: the cap will be 50% and will include all income-based taxes, including the CSG (a tax designed to finance welfare funds). In practice, taxpayers who believe that they are eligible will have to ask the IRS for a tax credit. This should give some insurance of ‘sincerity’ from these wealthy taxpayers, since, by doing so, they will draw the attention of the IRS. Again, this measure could be costly, although there is a large uncertainty about the number of taxpayers who will apply. So what about the economics? I personally believe that excessive taxation kills two birds: the incentive to work more for the most productive workers, and, in the end, tax income itself, as Arthur Laffer’s famous curve argued. Is The ‘minimum service bill’: removing a serious obstacle to reforms It is well known that French unions are powerful because they have the ability to paralyse the economy, as in December 1995, for instance. The source of this power is less known. In fact, French unions are the weakest in the industrialized world, if judged by the unionization rate (below 9%), or their bargaining power for wages, benefits or employment. Have you ever heard of wage negotiations in Reforming universities: a first step to raise the scientific and innovative potential of Also in July, the Assembly will discuss a bill allowing universities to become more independent on several grounds, such as the selection of their professors and researchers, the academic courses they want to develop, and their financial links with private companies or foundations. The economic rationale here is to stimulate the production of world-class research and to attract and train the best brains. For economies at or close to the efficiency frontier, it is much harder to grow faster than when catching up. Philippe Aghion of Harvard has shown that, for these economies, innovation and investment in human capital and research has a higher return than in ‘catching-up’ economies. More competition and more freedom within and between French universities is a step in this direction. Could students, who in
France
Sarkozy’s Majority Smaller than Expected June 18, 2007 By Eric Chaney | Paris President Sarkozy's supporters (UMP and The tax base shift that the French didn’t like As a reminder, the ‘social VAT' is a shift in the tax base from payroll taxes to consumption tax, in order to finance welfare funds such as healthcare. It is a pro-labour tax, which makes sense in a country of high unemployment and wide tax wedges. In theory, it should be neutral, including for prices, but in reality, cutting payroll taxes paid by employers leaves the choice to companies: either to cut gross prices or to inflate profit margins. Since companies are heterogeneous, it is hard to believe that none of them would have such a lack of pricing power that they would be forced to keep prices unchanged despite a 3 to 5 points rise in the VAT rate. In plain English, social or not, a VAT hike is likely to raise prices, even if the pass-trough is limited in the case of the social VAT. This is something the French public did not like. Since the trauma of large price rises at the micro level when the euro was introduced, the French are even more sensitive than before to upside risks to retail prices. No significant change in the reform agenda, but for the ‘social VAT’ Despite this unexpected political backdrop, I believe that Nicolas Sarkozy's reform agenda should not change significantly: voters gave the new President the legitimacy to implement the reforms that were clearly stated in his platform (including labour market reforms) and his government has now a comfortable, although not massive, 60% majority at the lower House. However, I see two possible drawbacks:
There are implications for the financial markets The main consequence of the 2nd round is that it is premature to play a significant widening of the breakevens between OATis (French treasury bonds indexed on French inflation) and OATeis (treasury bonds indexed on euro area inflation). After all, the social VAT could be the main casualty of this election. Among equity investors, the skeptical camp is likely to feel vindicated in its 'wait for the reforms and see' strategy.
Japan
Forecasting a Policy Mistake June 18, 2007 By Takehiro Sato | London Reverting to our early-2007 rate forecast We had expected a pace of one rate hike every six months but no rate hike in the summer because of the negative CPI rate. It has become clear, however, that the current price trends matter less to the BoJ than we expected. In addition, the BoJ maintains that it can smoothly realize sustained economic activity and prices in line with its forecasts if it adjusts its policy rate as the market expects. We thus find it difficult to continue to ignore the fact that the OIS market has priced in a 100% probability of an August rate hike. We are abandoning our previous, out-of-consensus forecast, and now expect the next rate hike to come at the August 22–23 meeting, more or less as we expected before the February rate hike. As difficult as it is to take losses on negative-carry positions, we think it is a good time to do so, from a contrarian perspective, now that the fixed income market has rebounded somewhat, following Governor Fukui’s cautious remarks after the June meeting. Yet, there is a risk that the markets will not react favourably in the medium/long term, if the Bank continues hiking under sluggish prices. Reasons for We were not surprised by Outline of interest rate outlook Assuming no rate hike in July, we expect the BoJ will look to raise rates in August, based on its thinking that not raising rates as the market expects might lead to excessive volatility in economic activity and prices. We think it will then stick to a pace of one rate hike every six months thereafter, and not particularly pick up or slow down the pace. This policy stance will probably be maintained under the new governor starting in March 2008, assuming it is Deputy Governor Toshiro Muto, as the market expects, and that the economy does not slow substantially. We thus forecast a target policy rate of 1.00% at end-March 2008 and 1.50% at end-March 2009. At a target policy rate of 1.00%, the spread over the Lombard Rate would widen to 50bp from 25bp. However, the BoJ thinking we noted above has inconsistencies, and if the central bank continues to raise rates even without much improvement in prices, the moves would have a restrictive impact at some point and make further rate hikes difficult. In this sense, central banks regard the neutral level for their policy rates as the level at which the economy starts to show signs of slowing, at which point they tend to pause their rate hikes. This is exactly the approach that the Fed took in 2006, and the ECB is moving into the final stage of this approach. In this way, the neutral rate is a kind of expedient for central banks to normalize their policy rates. We think it is more difficult to estimate the neutral level for the policy rate in As for the long-term yield, we do not expect it to rise fully in response to BoJ rate hikes. An August rate hike, in line with the consensus market expectation, would be a non-event for the bond market. However, rate hikes in a disinflationary environment would not be steadily supported by fixed-income investors, would tend to lead to further bear flattening of the yield curve, and are incomprehensible to overseas stock investors. We think investors are starting to sense the possibility of a stock market correction, which would be a positive for bonds. On the supply-demand front, banks are no longer major bond buyers, but life insurers and other real-money investors are steadily boosting their presence in the bond market, especially in the super-long end of the curve. These investors probably find a 10-year yield of 2% quite attractive relative to liability costs such as the guaranteed rate for policy holders. We thus do not expect the 10-year JGB yield to go much higher than 2% even if the BoJ raises its target policy rate to 1.5%. Risks of circular trap One risk, in our view, is that the market may push the BoJ to raise rates more quickly. The BoJ still believes that raising rates in line with the market’s expectations will lead to sustained growth, but this view suffers from circular reasoning. In other words, if the market expects a rate hike sometime soon, the BoJ feels all the more need to hasten its rate hike cycle, resulting in a situation similar to a dog chasing its own tail. The rate hike cycle would move up regardless of the latest economic trends, but with the YoY change in prices close to 0%, a slowdown in the economy would make further rate hikes difficult. If inflation picks up overseas and the tightening bias of the Fed and the ECB strengthens, the BoJ would be in an increasingly difficult position because rate hikes by overseas central banks, in response to inflation risks, are likely to affect not only global demand but also global asset prices. In this sense, overseas inflation is actually deflationary for
France
Reforms Yes, Fiscal Shock No (Part 2) June 18, 2007 By Eric Chaney | London In the first part of this article, we looked at the first reforms announced by PM Francois Fillon: tax breaks on housing loans, tax breaks on overtime hours, ‘tax shield’, minimum service bill and University autonomy. We now look at the bill and analyze the possible consequences of a tax base shift from wages to consumption, in 2009, although this policy could be questioned after the less favourable than expected results of the second round of the general elections. The fiscal bill: A limited fiscal stimulus for 2008, while a neutral or restrictive policy would have helped One of President Sarkozy’s advisors even used the word ‘fiscal shock’. I believe that the government would have been better inspired if the very concept of demand stimulus or management, even in the new clothes of a ‘fiscal shock’, had been put on a back shelf. Stimulating demand in highly open and complex economies with developed financial markets that allow economic agents to invest based on their expectations just does not work anymore. The first measures announced by PM Fillon have borrowed too much from so-called Keynesian theories of demand management, maybe because of the nostalgia for the era when demand management worked (the reconstruction period post WW II). While on balance positive for the long-term potential growth of the French economy, this first pack of reforms comes at a very high cost: €11bn or 0.6% of GDP. PM Fillon made clear that the state and social protection budgets will include important spending cuts, in particular a significant reduction in the civil service headcount and a reduction in healthcare reimbursement. However, I find it hard to believe that the whole pack will be financed by spending cuts and, at this stage, anticipate a moderate fiscal stimulus of around 0.3% of GDP, instead of the 0.5% reduction in the structural deficit the EU Commission is asking for. In the context of a powerful recovery in the euro area, led by the revival of The outlook beyond 2008: a large VAT hike in 2009? Before his election, President Nicolas Sarkozy made clear that a ‘social VAT’ was an option he would consider if elected, in order to reform the financing of the very costly French welfare funds in a way that would alleviate the burden of taxes on labour. Therefore, it was not a big surprise when Francois Fillon mentioned explicitly in the media (France 2, 11 June) that, indeed, this would be seriously considered. He was very clear on a very important point: the rise in the VAT rate would be a quid-pro-quo for a reduction in payroll taxes paid by employers, so that it would not be a hidden tax increase. He mentioned that the normal VAT rate (currently 19.6%) could rise by up to 5 points and asked cabinet members Jean-Louis Borloo and Eric Besson to study the feasibility of the project. He also added that the VAT rate would not increase in 2008, which indicates that the government’s agenda is to have a reform of the way social protection is financed ready for the 2009 budget, which leaves a lot of time for debate. A quid-pro-quo for wage tax cuts Before going into the detail, let me say that, in principle, this reform makes sense for the French labour market and for the competitiveness of French companies. As I argued when former President Chirac floated the idea of a ‘value added contribution’, the best way to reduce the tax burden is to cut welfare spending where it is a waste or misuse of taxpayers’ money. Yet, since welfare funds (healthcare and family support, in particular), even leaner and more efficient, will remain, their financing should be judged according to its effects on the economy and its potential. In this regard, the value-added tax, a flat rate levy on private consumption, is a much better tax base than gross wages or value added. The two sides of this shift: cutting labour costs and … devaluing the French euro 1. It would transfer the burden of financing a part of the welfare funds (healthcare and family) from payrolls (employers' contributions, that is, taxes paid by companies based on their payrolls) to a broader tax base, i.e. private consumption. The purpose here is to reduce the cost of labour and the tax wedge (gap between gross and net wages). On our estimates, a 5-point increase in the normal VAT rate would finance a 33% cut in the payroll taxes targeted by the government, which would result in a 4.5% cut in the gross wage bill. 2. It would be equivalent to devaluation, since France-based exporters would be able to cut export prices without squeezing profit margins, while imported products would bear a higher VAT rate. Referring implicitly to this angle, Fillon said that he would rather call the tax shift an 'anti-outsourcing' VAT rather than a 'social VAT'. The economics of the reform are sound: They do not increase the tax burden on capital. 1. The shift from payroll to consumer tax is by definition budgetary neutral (in this regard, it is different from the German hike last January, which was partially used to plug budget holes). Accordingly, its first round impact on demand should be small, at the end of the day, even though some sharp fluctuations could blur the short-term outlook, depending on the impact on retail prices. 2. Because of the size of welfare funds (24% of GDP), the financing burden creates huge distortions when it rests on only one factor of production, in this case, the labour input. Hence, it makes sense to shift the burden to a neutral tax base, which is precisely what a consumer tax is. However, the VAT is not really a tax on value added, since corporate investment is exempt of VAT (companies do not have to pay the VAT on fixed investment). In this regard, the 'social VAT' is a much better idea than the 'value added contribution' floated by former President Chirac last year: the VAC would have increased the tax burden on capital, which is mobile. The main difference between employers' contribution (payroll taxes) and the VAT is that the former is taxing only employees, while the latter is taxing all consumers, including the non-working population. 3. The de facto devaluation implied by this tax shift is positive for competitiveness and thus for production and jobs in the short term, especially if nominal wages adjust slowly to higher prices (which is likely to be the case). However, in the long run, these positive effects will dissipate, as domestic and foreign wages adjust. A roller coaster for consumers, a boon for exporters The short-term impact is likely to be, first, a boost to sales of big-ticket items, then a drop. On a net basis, the impact on consumption should be slightly negative and, of course, sensitive to the size of the VAT rate hike and to the final pass-through. On the other hand, net exports should accelerate in the first two years following the change, as French producers benefit from the de facto devaluation of the French euro. Last, the reduction in employers' contribution should result into a mix of lower gross retail prices (thus offsetting a part of the VAT hike) and higher profit margins. My guess is that exporters will probably cut prices instead of cashing in the tax cut. Our quantitative simulations: a 1-point VAT increase would add 0.5pp to inflation and cut the wage bill by 4.5% We have run some simple simulations, both on the impact of the tax shift on prices and on profits. On prices, our rule of thumb is that a 1 percentage point in the top VAT rate (currently 19.6%) would add 0.5% to the level of prices in the first six months (actually, the rise in prices would probably start a couple of months before the official VAT hike), and 0.36pp to the average rate of inflation in the first year. For instance, a 5pp increase would add 2.7% to the level of prices in the first six months, and 1.8pp to average inflation in the first year. In conclusion, the main advantage of the ‘anti-outsourcing’ VAT is to boost employment and competitiveness, although the latter is likely to fade away. Simultaneously, an important consequence for France-based companies is an immediate reduction in the wage bill, which could either help cutting gross prices – this is clearly what the government will push for – or improving profit margins (this should be the case in the less profitable sectors). What is the probability that the VAT reform will be pushed through? It seems that PM Fillon is still not fully convinced that the political cost (an unpopular rise in retail prices) will be offset by stronger employment and more competitive exports. Since the Socialist Party and the left seem to have benefited from their vocal opposition to any VAT hike at the second round of the general election, the probability of this tax change looks thinner than it was only three days ago. However, President Sarkozy will have the last word, and it remains a possibility, although not a probability, that, in January 2009, the VAT rate could rise from 19.6% to 22.6%, the healthcare and family payroll taxes could be cut by 2.7% and inflation could rise up to 3%. If, because of the VAT hike or other circumstances, consumption takes a dive, we would be back to square one in 2010, I would guess. Sarkozy’s Majority Smaller than Expected Eric Chaney ( President Sarkozy's supporters (UMP and The tax base shift that the French didn’t like As a reminder, the ‘social VAT' is a shift in the tax base from payroll taxes to consumption tax, in order to finance welfare funds such as healthcare. It is a pro-labour tax, which makes sense in a country of high unemployment and wide tax wedges. In theory, it should be neutral, including for prices, but in reality, cutting payroll taxes paid by employers leaves the choice to companies: either to cut gross prices or to inflate profit margins. Since companies are heterogeneous, it is hard to believe that none of them would have such a lack of pricing power that they would be forced to keep prices unchanged despite a 3 to 5 points rise in the VAT rate. In plain English, social or not, a VAT hike is likely to raise prices, even if the pass-trough is limited in the case of the social VAT. This is something the French public did not like. Since the trauma of large price rises at the micro level when the euro was introduced, the French are even more sensitive than before to upside risks to retail prices. No significant change in the reform agenda, but for the ‘social VAT’ Despite this unexpected political backdrop, I believe that Nicolas Sarkozy's reform agenda should not change significantly: voters gave the new President the legitimacy to implement the reforms that were clearly stated in his platform (including labour market reforms) and his government has now a comfortable, although not massive, 60% majority at the lower House. However, I see two possible drawbacks:
There are implications for the financial markets The main consequence of the 2nd round is that it is premature to play a significant widening of the breakevens between OATis (French treasury bonds indexed on French inflation) and OATeis (treasury bonds indexed on euro area inflation). After all, the social VAT could be the main casualty of this election. Among equity investors, the skeptical camp is likely to feel vindicated in its 'wait for the reforms and see' strategy.
United States
Review and Preview June 18, 2007 By Ted Wieseman and David Greenlaw | New York, New York Treasuries fell for a sixth straight week in the latest week, but the market finally appeared to find its footing over the course of the week after another mortgage-driven rout on Tuesday and into Wednesday morning seemed to exhaust mortgage duration related selling needs for now — and in the analysis of our interest rate strategy team further convexity related paying should be greatly reduced in any further sell-off, with almost the entire fixed-rate mortgage market now unrefinanceable — and a third straight much better than expected inflation report eased a bit nervousness that has been starting to creep into the market about the possibility of Fed rate hikes. The benign inflation report combined with further confirmation of a sharp rebound in growth in Q2 after the very sluggish first quarter to portray at least a near-term goldilocks scenario. This prompted good gains in stocks after some significant early week softness as bonds tumbled to their Wednesday morning lows. A strong gain, as expected, in the key retail control component of the May retail sales report, combined with a lower expectation for overall PCE inflation in May after we translated the CPI results, led us to boost our Q2 consumption forecast to +2.2% from +2.0%. This upside was partly tempered by relatively weak high tech output growth in the industrial production report that led us to trim our investment forecast a bit. We also decided to build in a slightly more conservative (but still very positive) inventory outlook given the strength in May retail sales and softer May auto assemblies. But we still lifted our Q2 GDP forecast another tenth on the week to +4.2% after an expected upward adjustment to Q1 to +0.8% from +0.6%. Benchmark Treasury coupon yields rose 3 to 5 bp on the week, with the 2-year yield up 3 bp to 5.035%, the 3-year and 5-year 4 bp each to 5.07% and 5.10%, the 10-year 5 bp to 5.165%, and the 30-year 4 bp to 5.26%. TIPS outperformed slightly, with the 5-year TIPS yield up 2 bp to 2.75% and the 10-year 4 bp to 2.74%. With heavy weekly net bill paydowns resuming at this past Thursday’s regular bill settlement (after a brief respite following the huge paydowns in April and early May), the squeeze in the bill sector reached new extremes. The bond equivalent 4-week bill yield plunged 31 bp to 4.43%, the 3-month 22 bp to 4.55%, and the 6-month 6 bp to 4.86%. We estimate that more than 20% of the publicly held bill market will have disappeared from the end of Q1 to the end of Q2, creating a major supply/demand imbalance in the sector, particularly at a time when increased volatility in various markets appears to have increased demand for cash. The small net losses for the week in benchmark coupons came after a sharp further sell-off that carried through Wednesday morning was followed by a sizable rebound off these lows through the rest of the week. Tuesday in particular saw another absolute rout that was driven, just like the collapse on the prior Thursday, by very heavy mortgage related selling pressures, with paying in swaps, liquidation of MBS, and outright selling of Treasuries. It had appeared - after the sharp backup in yields through the end of the prior week and the severe pressure that mortgage duration related selling put on the market in the last leg of that collapse - that the mortgage trade might be over. Indeed, according to an analysis by our mortgage strategy team — see the report “Is There More Convexity Paying to Come?” by Janaki Rao — even before Tuesday’s rout, 95% of the fixed-rate mortgage universe was already unrefinanceable, so the market should have been nearing a point where any further weakness would prompt greatly lessened mortgage duration related selling needs. But there was a major final wave of mortgage related paying and selling (both of MBS and Treasuries) on Tuesday that carried into Wednesday’s market trough. Apparently, the backup in rates recently was so sharp and so fast that there was still a significant amount of catch up mortgage convexity hedging to be done to get back into a more balanced position. But by Wednesday morning this trade appeared to have run its course. Mortgage related paying in swaps essentially ended and the benchmark 10-year swap spread narrowed from an intraday peak of 65 bp early Wednesday to close the week at 59.5 bp. And after sharply underperforming through Wednesday morning, big buying from various investor types emerged over the course of the day on Wednesday and especially into Thursday, leading to decent MBS outperformance in the second half of the week. The end of these selling pressures finally allowed Treasuries to find a bottom and rally sharply off the lows hit Wednesday morning, with the 10-year yield rallying back from a peak of 5.32% Wednesday morning to its 5.165% Friday close. Some added fundamental help came on Friday from the CPI report on top of the greatly improved technical/flow backdrop. A more hawkish Fed path continued to be priced into futures market, with a marginal risk now seen of a near-term tightening. Interestingly, while the benign CPI report slowed this trend towards pricing in tightening risk, it didn’t actually do much to reverse it, with only marginal gains in fed funds futures Friday. For the week, the October and November fed funds contracts both fell 1.5 bp to 5.25% and the December and January contracts each lost 3 bp to 5.255% and 5.26%. This slight elevation in the January fed funds contract along with a 2.5 bp drop in the Dec 07 eurodollar contract to 5.38% pointed to a marginal risk of a Fed rate hike late this year or early next year, even after Friday’s CPI surprise. Apparently, the market considers growth significantly more important in the Fed’s reaction function than inflation — a dubious idea. After a decent rally Friday, there’s still a marginal amount of Fed easing priced in on a medium-term basis. The red eurodollars (June 08 to Mar 09) were the worst performers in that market on the week, losing 4.5 bp to 5 bp, though the low rate June 08 contract at 5.345% still closed slightly stronger than the front month June 07 contract at 5.36%. Underlying inflation was surprisingly benign for a third straight month in May. The overall consumer price index surged 0.7% for a 2.7% year/year gain, boosted by a 10.5% surge in gasoline prices that lifted the overall energy component 5.4%. Gasoline prices have come off their mid-May peaks in recent weeks, so headline CPI should moderate sharply in June. In contrast to the headline spike, the core just barely rounded down to +0.1% in May, a third straight benign reading that reduced the annual pace to a 14-month low of +2.2% from +2.7% in February. The main source of moderation was the smallest gain in the key owners’ equivalent rent category (+0.1%) in four years. An unusually large gap has now opened up between the year/year pace of rent inflation at +4.4% and owners’ equivalent rent at +3.5%, particularly considering that with moderate utilities inflation of +3.3% there is no rent to “pure rent” distortion to explain the gap. Instead, according to a BLS economist interviewed by Market News, rents are rising faster in renter-dominated areas than they are in locations with high owner occupancy. This development is also consistent with the notion that a supply-induced rise in rental supply — tied to the high inventory of unsold homes and condominiums — has been holding down OER and likely will continue to do so going forward. In addition to the OER moderation, softness in apparel, airfares, drugs, and new motor vehicles also contributed to the benign core CPI, offsetting a second straight sharp gain in hotel prices after a plunge in March. Translating the CPI results into PCE inflation, we expect the core PCE to rise 0.15% in May, which would leave the year/year pace right between 1.9% and 2.0%, potentially returning it to within the Fed’s 1% to 2% comfort zone depending on rounding. While we still see upside inflation risks and expect this recent moderation will prove temporary and that core inflation will tick up in coming months and remain sticky a bit above 2% for a while, keeping the Fed on hold for some time, the recent moderation should end any incipient fears that the Fed might be on the verge of hiking rates. Meanwhile, we now look for a 0.5% rise in overall PCE inflation in May, below the +0.7% we had previously built into our GDP forecasts, which had positive implications for our Q2 consumption outlook. Retail sales surged 1.4% in May, boosted by a strange gain in auto dealers’ receipts (+1.8%) that contrasted with softer unit sales results. Excluding autos, sales jumped 1.3%. While this was boosted by a sharp price related gain at gas stations (+3.8%), sales excluding autos and gas still surged 1.0%. In line with the improved chain store sales results, good gains were seen in the general merchandise (+1.0%), clothing (+2.7%), electronics and appliances (+1.3%), and restaurant (+0.7%) categories. Stripping out a significant gain in building materials (+2.1%), the key retail control component (sales excluding motor vehicle dealers and building materials stores) gained 1.2%. This was in line with our forecast and did not initially alter our Q2 consumption forecast. We had been assuming a 0.7% rise in headline PCE inflation in May, however, and when we translated the CPI details into a PCE forecast, we came up with 0.5% instead. This boosted our estimate for real consumer spending in May to +0.1 from -0.1% and lifted our forecast for Q2 as a whole to +2.2% from +2.0%. There were two modest offsets to this stronger consumption profile in investment and inventories. Industrial production was flat overall in May, while the key manufacturing gauge ticked up 0.1%, in line with the softness in factory hours worked in the employment report. Motor vehicle assemblies dipped 1.4% in May but the Q2 average is still running 19% annualized above the Q1 average, implying a significant add to Q2 GDP from the motor vehicle sector — we are building in a 0.4pp add to Q2 growth from motor vehicles. Excluding autos, factory output gained 0.1%, restrained by an unusually small rise in high tech output (+0.3%) and a second straight marginal gain (+0.1%) in output excluding motor vehicles and tech, with mixed results across key categories. The overall capacity utilization rate dipped 0.2pp to 81.3%, about a percentage point above the long-term average. Investment in computers in the GDP accounts mostly sourced to computers IP rather than factory shipments, so the soft results for high tech output were a modest negative for investment. We trimmed our forecast for Q2 equipment and software investment to +7.5% from +7.9%. In addition, we took a marginally more conservative stance on inventories in Q2. In light of the surge in retail sales in May, we decided to trim our assumption for ex auto retail inventories (to 0.0% from +0.1%). And the auto assembly numbers in the IP report were a bit lower than we had expected based on industry data, so we cut our assumption for car unit inventories a bit. The combined result of this was to slightly lower our forecast for the add to Q2 growth from inventories to +0.8pp from +0.9pp. Combining the upside in consumption with the slight negative offsets from investment and inventories, we upped our Q2 GDP forecast marginally to +4.2% from +4.1%. We continue to expect Q1 to be revised up to +0.8% from +0.6%, though with a marginally more negative final demand/inventories mix after incorporating a downward revision to March retail control that was offset by an upward revision to March ex auto retail inventories. The upcoming week has a very quiet calendar. There are a number of Fed speakers scheduled, but with the traditional quiet period ahead of the June 27-28 FOMC meeting starting, it is quite unlikely that any of them will remark directly on the current economic or policy outlook. There will be supply news with the announcement on Thursday of the 2-year and 5-year notes that will be auctioned the following Tuesday and Wednesday. We expect unchanged $18 billion and $13 billion sizes, respectively. The economic data calendar is quite light. The Philly Fed survey Thursday will help set expectations for the June ISM. The The only other releases of note are housing starts Tuesday (with the preceding homebuilders’ survey Monday) and leading indicators Thursday: * We look for a 3.5% drop in May housing starts to a 1.475 million unit annual rate after the surprising upside seen the prior three months. Even though we don’t put too much emphasis on the permits data as a leading indicator for starts, the unusually large gap last month between starts and permits, which are based on a separate sample, suggests the surprisingly strong starts result may have been an aberration. We continue to expect the ongoing downturn in residential construction to continue for at least the next couple of quarters. * Based on the components available at this point, the index of leading economic indicators should post a 0.2% rise in May, with the biggest positive contributor being jobless claims. Stock prices and consumer confidence should make small positive contributions, and the manufacturing workweek, yield curve, and real money supply small negatives.
Poland
Goldilocks No More? June 18, 2007 By Pasquale Diana | London On June 6, we visited Over recent years, More tightening in store, but NBP is not on autopilot It is very likely that the April rate increase was not a one-off, and more rate hikes are likely to follow. The key questions are when and by how much. The recent data suggest that the hawks, who have consistently argued for higher rates since last October, should have the upper hand now. Growth remains very strong, driven by consumption, not exports (thereby more inflationary); wage growth has surprised on the upside, as the labor market continues to tighten; and the inflation outlook does not leave any room for complacency. That said, our sense following our visit is that the MPC remains profoundly divided. The MPC doves, also supported by the research staff, argue that productivity growth remains strong and should offset faster wage growth, keeping unit labor cost growth in check. Also, they contend that the beneficial effects of globalization on inflation are not over, and that high profit margins in the corporate sector still allow corporates to absorb a rise in input prices without passing it onto consumers. Therefore, while we think that the NBP remains biased to tighten, we also believe that more pieces of data are needed for the hawks to once again convince middle-ground MPC members (such as Messrs Czekaj or Owsiak) to support another rate increase. · First, net inflation. The new ECMOD model projection shows that net inflation (CPI ex-food and fuels) should remain fairly stable at the current level (1.5-1.6%Y) in the coming few months, and then edge higher in 2H, but remain below 2%. If this forecast proves correct, this would likely boost the doves’ case that inflationary pressures are not serious. Vice versa, should net inflation break out above the 1.5-1.6% range in the coming months, the hawks could convincingly argue that ECMOD is underestimating underlying inflationary pressures, and that the new inflation projection is too benign. · Second, wage data and productivity trends. Our impression is that the strength of the wage data towards the end of 1Q was key in determining the April hike. Also, as we have noted regularly in the EM Economist, the combination of strong employment gains and faster wage growth implies that unit labor costs in manufacturing are no longer falling in annual terms. Continued labor market tightness (faster wage and employment growth) and a likely slowdown in industrial output growth from the 1Q boom should reinforce this trend in the coming months, we think. · Third, credit growth and retail sales. The acceleration in credit growth over the last few years has been truly impressive. Household borrowing rose at a 38% annual clip year-to-date, almost three times as fast as in 2004. Private sector credit (household and non-financial corps) remains quite low, at 33% of GDP (compared for example to In our view, not all these data need to point to faster growth/inflation in order for the NBP to deliver another rate increase. However, a sufficient number of them need to suggest intensifying pressures in order to get further rate hikes. Our current forecasts show that core inflation should hold fairly stable at around 1.6% in the coming months, while headline inflation falls due to base effects, related to food prices (they rose sharply last summer). Note, however, that while the news on the Polish grain harvest in 2007 (+27%Y) is reassuring, fresh food prices look to pose a threat to inflation, not just in Similarly, retail sales in 2Q are likely to moderate somewhat from the torrid 1Q pace, also due to base effects. At the same time, we think it is likely that unit labor costs in manufacturing will start to move into positive territory, and that credit growth will continue on its present trend. Also, the recent data have shown faster headline inflation than we anticipated, thanks to food prices, but also to rising demand-sensitive components (services). This suggests some upside risks to our inflation forecast. All things considered, we stick with our forecast of another 25bp hike this year (our preference is for 4Q), to 4.50%. At present, we see risks tilted towards earlier (and possibly more) tightening. Next year, we see a further 50bp of tightening, to take rates to 5%. We note also that failure to hike sufficiently may mean that the NBP gets ‘behind the curve’ and has to deliver more aggressive tightening in the future. Globalization matters One interesting topic in our meetings at the NBP was the issue of globalization and its impact on inflation. Over recent years, the NBP has pointed to the benign impact of globalization on overall inflation as one of the main reasons for low inflation in Fiscal policy: Another undershoot this year but no clarity in the medium term GDP growth this year is likely to exceed the MoF growth assumption of 4.6% by nearly two percentage points. As a result, the budget numbers are showing continued outperformance relative to the 2007 target. In the first four months of 2007, revenues reached 35.5% of the total annual target, compared to 32.5% last year. As a result, the cumulative January-April budget deficit reached just 6.9% of the full year target (compared to 32.8% in January-April 2006). According to the Ministry, this year’s PLN 30 billion cash deficit target is likely to be undershot (a PLN 25 billion deficit is likely). For next year, the government plans to maintain the PLN 30 billion deficit anchor, assuming that growth slows down to 5.7% (revised up from 5.5%Y). If realized, such an outcome would correspond to a de facto pro-cyclical fiscal easing between 2007 and 2008. Note that there are a series of expansionary fiscal measures in the pipeline. First, the government is planning to cut social security contributions for employees by 3% in July, and a further 4% (2% for employers, 2% for employees) in January 2008. The total cost for the budget should be PLN 3 billion this year and a total of PLN 19 billion next year, which is apparently already accounted for in the recently provided draft budget. Second, the return to annual pension indexation (in line with CPI and 20% of average wage growth) starting next year should cost around PLN 4.4 billion (but note that, at 2.3%, the CPI assumption in the 2008 budget looks low so the costs here might be higher). Third, starting in 2009, personal income tax rates will be decreased, to 18% and 32%, which should cost around PLN 9 billion. While the government is on paper planning to save around 1% of GDP per year (around PLN 10 billion) over the next 2-3 years by downsizing the public sector, there does not seem to be much more detail on how these extra costs (or reduced revenues) will be financed. The assumption that strong growth will continue to bail out public finances looks too optimistic, and eventually a downturn could have severe consequences for public finances. In addition, it seems hardly optimal to ease fiscal policy at a time when growth is so buoyant. Finally, from a more medium-term perspective, Poland’s task of hosting Euro 2012 (jointly with Ukraine) could put further strain on the budget in coming years, as large infrastructure projects are undertaken. At present, estimates of the cost are huge, with some local sources saying that investments might total PLN 200 billion, or roughly 18% of GDP. While the EU would likely finance a significant chunk of this (note that EU commitments are set to go up hugely in the coming years), Poland will still need to co-finance some projects, and would likely seek to concentrate most spending in 2010-11, ahead of the event. While there is no official euro adoption target date, this would point to EMU adoption beyond 2012, the year currently expected by markets. |