Strong Euro: A Shield Against Higher Oil Price?
July 17, 2007
By Eric Chaney | from Milan
Oil and euro at record levels On July 16, the euro-dollar rate reached 1.38, the euro trade-weighted index at 108 was a whisker from the December 2004 peak (108.4), and the barrel of Brent for immediate delivery broke US$79/bbl. This raises several questions:
1/ Is there a link between the strength of the euro and ever higher oil prices?
2/ For the euro area, is a strong euro providing an effective protection against the inflationary consequences of higher oil prices?
3/ If the answer to 2/ is yes, then what about the impact on aggregate demand and real GDP growth? We try to give some answers to these questions, using our previous work on the crude oil markets and some quantitative estimates of the macro impact of changes in exchange rates and the price of crude oil. Weak dollar, high oil price: there is a linkFirst, we believe that the strength of the euro (and of the pound) and the rise in crude oil prices are related. More precisely, we think that the causality goes from the weakness of the US$ to the price of crude oil in dollars. A weak dollar undermines the purchasing power of OPEC countries, especially those importing finished goods mostly from Europe. This is the case for instance for Saudi Arabia and the Gulf states. It can be shown that the income elasticity of oil exporters is negatively linked to their market share: this implies that the incentive to produce less in order to raise the price of oil is stronger when the OPEC’s market share is high (see Oil: Revisiting $80/bbl? Eric Chaney and Richard Berner, July 9, 2007). Since OPEC has fully re-built its market share, within OPEC the cartel is more able to influence prices by checking production and shipments on a daily basis. Our consultant Norwegian Energy wrote in its latest report: “Our Oil Movement estimates of sailings through to the end of this month show no sign of any significant increase in OPEC production. The recent sharp fall in long-haul tanker rates support this. With Saudi Arabia maintaining the production cuts for August and the OPEC meeting coming up on September 11, we do not expect any significant increase in OPEC supply in the third quarter.” This is consistent with our analysis. Besides, it is striking that, over the last three months, the price of Brent in euro terms averaged €52.8/bbl, not significantly more than the average price posted in 2006 (€51.9/bbl). Of course, the price of crude oil is also overshooting in euros, because there are other factors underpinning its rise. Even so, over the last 12 months the volatility of oil quotes (measured by the coefficient of variation) in dollars has been 4.5% higher than in euro terms. The euro is providing some protection against inflation …Against this backdrop, the strength of the euro has some macroeconomic advantages for the euro area. First, it has limited the rise in import prices and thus imported inflation. Second, by reducing output growth, other things being equal, it has alleviated tensions between supply and demand in the domestic economy. The latter factor is more relevant today than it was in 2003, when the euro rose by 11.7% on average, because there is much less slack in the economy today than then. According to OECD estimates, a 10% rise of the trade-weighted exchange rate of the euro would cut inflation by 0.7% in the first year following the rise. Since the trade-weighted index (TWI) of the euro has increased by 3.2% over the last 12 months, inflation might be today 20 basis points lower than it would be otherwise. Because the ECB wants to keep inflation below 2.0%, this euro effect, although small in absolute, is not negligible: current inflation is just 1.9%. … at a price: slower GDP growth and possible structural consequencesThe protection against inflation provided by the euro has a price in terms of GDP growth. Even though euro area producers are not complaining too loudly about the rise of the euro, it is hard to argue that euro area economies are totally immune to currency fluctuations. Model-based simulations suggest that a 10% rise in the euro TWI would cut GDP growth by 0.8% in the first year following the rise. Accordingly, the 3.2% rise of the single currency since July 2006 may cost 0.2-0.3% of GDP growth. In addition, a long period of excessive strength of the euro — on our estimates the euro is currently 10% over-valued in real terms (see Exchange Rates Do Not Reflect Fundamentals, Eric Chaney, April 18,, 2007) — may have long-term consequences on the supply side of the economy that are not captured by traditional econometric models. The combined impact of oil and euro is small …Since a stronger euro provides some protection against imported inflation, which would have negative consequences on consumers’ purchasing power and thus on GDP growth, some policy makers have argued that a strong euro is good for the economy. Because the real exchange rate has an impact on real demand, the relevant question is: what is the net effect of these diverging forces, higher oil prices and stronger euro, on the real economy? To answer it, we have estimated the net impact of all past changes in both the euro TWI and the price of crude oil (Brent), on quarterly GDP growth in the euro area, using the multipliers of the Insee model MZE-2003. At this stage, this impact is slightly negative for GDP growth in 2007 (-0.1%), as it already was in 2006. There are large uncertainties around these model-based estimates; however, the qualitative conclusion is clear, in my view: this impact is far too small to jeopardize the recovery in the euro area. … but cannot be (and is not) ignored by the ECBYet, the ECB cannot ignore the consequences of the rise of the euro. By limiting the acceleration of inflation that should be the consequence of higher energy prices and of supply-side tensions, the euro is helping the ECB to achieve its price stability goal. And since there are real costs associated with the strength of the euro, this powerful weapon must be used with parsimony. I believe that the exchange rate is likely to assume a growing importance in ECB’s policy decisions. In my view, a rise above 110 for the TWI, which would be consistent with a euro/dollar rate at 1.45, would convince the ECB to change its communication, in order to reduce the very high probability that markets are currently assigning to two more 25bp hikes for the refi rate. We are not yet there, but if crude oil prices rose significantly above US$80/bbl, this could hit US consumers badly and thus weaken the US dollar further, fuelling a large overshooting of the euro. In that case, only the ECB could break this vicious circle, and I believe that this is exactly what its Governing Council would do.
Important Disclosure Information at the end of this Forum
The Real Is Royal
July 17, 2007
By Marcelo Carvalho | Sao Paulo
Look for a 50bp rate cut, in a split decision It’s probably a 50bp rate cut again this time. Brazil’s monetary policy committee (Copom) is set to cut policy interest rates this week, on July 18. We and the market consensus look for a 50bp rate cut, to 11.50%. Despite signs of rising domestic demand and worries of possible eventual upward pressure on inflation down the road, ongoing currency appreciation significantly alleviates near-term concerns. Moreover, projected inflation remains comfortably below the inflation target over the forecast horizon. Watch the voting score. The policy decision will probably be a split vote, and market participants will likely read the voting score as a signal for subsequent future policy moves. Last month’s vote for a 50bp rate cut was already a divided decision, as two out of the seven voting members were in favor of a 25bp cut. If, for instance, the voting score this time tilts towards three votes in favor of a 25bp cut (against a winning majority of four votes in favor of a 50bp rate cut), then observers will likely start to wonder whether the subsequent decision, in September, would bring a slowdown in the pace of policy rate cuts, to 25bp. If, instead, the score this time tilts towards just one minority vote in favor of a 25bp move (against a winning majority of six votes in favor of a 50bp rate cut), then the perceived likelihood increases of another 50bp rate cut in September. Of course, as always, the edited Copom notes (to be released a week after the meeting) will be scrutinized for clues on the central bank’s latest thinking. Our forecast sees further rate cuts down the road. Beyond this week’s likely 50bp cut, our forecast sees a slowdown in the rate-cutting pace to 25bp, tentatively starting at the September meeting. That said, the risks seem biased to the downside: currency appreciation could keep the central bank cutting policy rates at a 50bp pace for longer. Would Copom take a tough line now, just as a political statement? Some analysts have argued that the central bank could already now opt for a 25bp rate cut, just in order to underscore its political strength and reaffirm its inflation-fighting credentials. The National Monetary Council recently decided to maintain the inflation target at 4.5% in 2009, despite the market’s and the central bank’s preference for a 4.0% figure (see “Brazil: Will the Real Inflation Target Please Stand Up?” Global Economic Forum, July 3, 2007). In our view, Copom decisions are based on technical considerations. It would be sad if it were otherwise. Divided we stand The likely split vote this week reflects a divided board. The tug-of-war between external and domestic factors has probably exacerbated in the eyes of the Copom. On the one hand, the external sector (read: currency appreciation) has amplified the domestic supply, thereby helping the inflation outlook. On the other hand, however, rapidly rising domestic demand could eventually push inflation up. Hawks as well as doves will thus have further ammunition to support their opposing cases. On the dovish side, Copom members can argue first of all that the international market environment remains supportive, despite short-run volatility. Second, they can argue that domestic demand data still suggest a low probability of significant upward pressure on near-term inflation, especially as inflation expectations for 2007 and 2008 remain well anchored. Third, and crucially, the Copom members favoring a 50bp cut can argue that the benefits from currency appreciation may prove stronger than initially foreseen, through three channels. Currency appreciation dampens tradable price inflation, drives inflation expectations lower, and facilitates rising imports of capital goods; this, in turn, supports the expansion of domestic supply through rising investment. On the hawkish side, Copom members can argue first that industrial capacity utilization has risen steadily since late 2006, recently reaching a historical peak. Second, the hawks can argue that domestic demand expansion does not yet fully reflect the cumulative impact of rate cuts already implemented so far in the current monetary easing cycle. Third, they can note that there are uncertainties on the monetary policy transmission channel, regarding its magnitude and time lags. The reasoning here is that the central case remains benign, but the risks around that central case could inspire caution. A race against time? The conservative view inside the Copom would argue that good things do not last forever. At some point, low tradable price inflation would not be able to offset fully higher non-tradable price inflation. According to this line of thought, it is a race against time: the Copom should be ready to face eventual upward inflation pressures coming from rising domestic demand, as benefits from currency appreciation eventually fade. So far, this has been a minority view among Copom members. Our view: The Real is royal Food for thought. Recent CPI inflation readings have been at the high end of market expectations, on the back of higher food price inflation. June IPCA inflation, for instance, ended up at 0.3% mom, against initial expectations for a 0.1% mom reading. The recent surprise in consumer price inflation is seen as temporary, however. True, food price inflation has been a global concern, on the heels of competition from bio-fuels as well as rising demand for protein-rich food from emerging Asia. Luckily, however, Brazil is a net exporter of key commodities, including grains, and thus its currency actually benefits from rising international commodity prices. Has inflation bottomed? While forecasts for 2007 inflation tend to mathematically edge up in light of recent upward surprises, underlying inflation trends remain favorable: The range of forecasts for IPCA inflation in 2007 remains firmly in the 3.0-4.0% range, comfortably below the 4.5% target for 2007 and beyond. Even if significant downward inflation surprises seen in previous quarters do not repeat going ahead, the inflation outlook remains benign. Importantly, market consensus expectations for 2008 inflation remain well anchored at 4.0%. The world is flat. Ok, maybe not. But the Phillips curve is definitely flatter across the globe. Brazil is no exception. And that helps alleviate concerns about rising domestic demand. True, Brazil’s industrial capacity utilization has risen to historical heights. But how much does it really matter? First, other measures of resource utilization, such as output gap or slack in the labor market, seem to paint a much less dramatic picture. Second, investment is rising, faster than overall growth, thereby increasing the economy’s ability to expand without much inflation trouble. Third, the sensitivity of inflation to the economic expansion is less now than in the past. Or, as economists like to say in their impenetrable jargon, the Phillips curve is now flatter. Such flattening is a well-documented global phenomenon, and is normally attributed to increasing central bank policy credibility and effectiveness[1]. Indeed, Brazil’s Phillips curve has improved. We have conducted an econometric exercise looking at inflation (measured as the residual actual inflation that could not be explained by inflation inertia, by inflation expectations, or by the currency) against a measure of the real GDP output gap. The results suggest two different regimes: before 2003 and after 2003. As expected, in both cases, as the economy expands, inflation would tend to increase. The interesting result, however, is how the relationship has improved in recent years: for any given measure of resource utilization, inflation is now lower than before. To be fair, cautious Copom members might argue that these are still relatively recent developments, and that there are uncertainties regarding Brazil’s new Phillips curve, as it might prove non-linear: that is, one concern is that inflation eventually starts to deteriorate more rapidly for a sufficiently fast pace of economic expansion. The currency is king. Econometric exercises strongly suggest that, although still relevant, the output gap is relatively less important to explain actual inflation. In Brazil, as in the international experience, inflation expectations have proved a major driver for actual inflation. In turn, inflation expectations in Brazil are strongly associated with moves in the exchange rate. Indeed, our work suggests that swings in the Real translate into changes in market consensus for year-ahead inflation expectations, with a time lag of about two months. The exchange rate pass-through is alive and kicking. Some observers have argued that the pass-through from the currency into inflation tends to decline over time. Indeed, our work suggests that the relationship is not linear: the impact from the currency decreases as inflation has declined in recent years. But that is different from saying that there is no relationship. Recent currency appreciation has yet to translate into lower inflation expectations in coming months. In fact, our econometric exercise suggests that if the Real consolidates at levels stronger than 1.90 R$/US$, for instance, then market consensus inflation expectations would eventually move closer to the 3.0% mark than to the 4.0% level. External accounts are not a binding constraint at the moment. Some analysts have argued that the reliance on rising imports to help meet rising domestic demand will eventually erode the current account surplus, and could thus remove a key support for the currency. However, we would offer two considerations here. First, starting points matter: Brazil is running a current account surplus above 1% of GDP. That is remarkable, in light of currency appreciation in recent years and fast domestic demand growth. Favorable trade performance is due to strong exports, on the back of robust global demand and high international commodity prices. If anything, a savings-hungry emerging economy like Brazil should probably move towards a modest current account deficit. But that will likely still take a couple of years. Second, what matters for the currency is the overall balance of payments, rather than just the current account alone. And the capital account has proved remarkably solid, with strong capital inflows across the board. Bottom line
Currency appreciation is an important driver for inflation expectations and for the inflation outlook, supporting the ongoing monetary policy easing cycle. In the local yield curve, the January 2009 contract has already recovered from recent weakness. If the positive environment persists, the next step will likely be a flattening of the local yield curve, with rates for longer tenors moving lower as well. In turn, a flatter local yield curve could have positive spillover for sovereign debt and local equity markets as well.
[1]See for instance: BIS Working Paper 227, “Globalization and inflation: new cross-country evidence on the global determinants of domestic inflation”.
Important Disclosure Information at the end of this Forum
Disclosure Statement
The information and opinions in Morgan Stanley research were prepared or are disseminated by Morgan Stanley & Co. Incorporated and/or Morgan Stanley C.T.V.M. S.A. and/or Morgan Stanley & Co. International plc and/or Morgan Stanley Japan Securities Co., Ltd. and/or Morgan Stanley Asia Limited and/or Morgan Stanley Asia (Singapore) Pte. (Registration number 199206298Z) and/or Morgan Stanley Asia (Singapore) Securities Pte Ltd (Registration number 200008434H) and/or Morgan Stanley Taiwan Limited and/or Morgan Stanley & Co International plc, Seoul Branch, and/or Morgan Stanley Australia Limited (A.B.N. 67 003 734 576, holder of Australian financial services licence No. 233742, which accepts responsibility for its contents), and/or Morgan Stanley India Company Private Limited and their affiliates (collectively, "Morgan Stanley"). As used in this disclosure section, Morgan Stanley includes RMB Morgan Stanley (Proprietary) Limited, Morgan Stanley & Co International plc and its affiliates.
Global Research
Conflict Management Policy
Morgan Stanley Research observes our conflict management policy, available at www.morganstanley.com/institutional/research/conflictpolicies.
Important Disclosures
Morgan Stanley Research does not provide individually tailored investment advice. It has been prepared without regard to the circumstances and objectives of those who receive it. Morgan Stanley recommends that investors independently evaluate particular investments and strategies, and encourages them to seek a financial adviser's advice. The appropriateness of an investment or strategy will depend on an investor's circumstances and objectives. Morgan Stanley Research is not an offer to buy or sell any security or to participate in any trading strategy. The value of and income from your investments may vary because of changes in interest rates or foreign exchange rates, securities prices or market indexes, operational or financial conditions of companies or other factors. Past performance is not necessarily a guide to future performance. Estimates of future performance are based on assumptions that may not be realized.
With the exception of information regarding Morgan Stanley, research prepared by Morgan Stanley Research personnel is based on public information. Morgan Stanley makes every effort to use reliable, comprehensive information, but we do not represent that it is accurate or complete. We have no obligation to tell you when opinions or information in Morgan Stanley Research change apart from when we intend to discontinue research coverage of a company. Facts and views in Morgan Stanley Research have not been reviewed by, and may not reflect information known to, professionals in other Morgan Stanley business areas, including investment banking personnel.
To our readers in Taiwan: Morgan Stanley Research is distributed by Morgan Stanley Taiwan Limited; it may not be distributed to or quoted or used by the public media without the express written consent of Morgan Stanley. To our readers in Hong Kong: Information is distributed in Hong Kong by and on behalf of, and is attributable to, Morgan Stanley Asia Limited as part of its regulated activities in Hong Kong; if you have any queries concerning it, contact our Hong Kong sales representatives.
Morgan Stanley Research is disseminated in Japan by Morgan Stanley Japan Securities Co., Ltd.; in Canada by Morgan Stanley Canada Limited, which has approved of and takes responsibility for its contents in Canada; in Germany by Morgan Stanley Bank AG, Frankfurt am Main, regulated by Bundesanstalt fuer Finanzdienstleistungsaufsicht (BaFin);in Spain by Morgan Stanley, S.V., S.A., a Morgan Stanley group company, supervised by the Spanish Securities Markets Commission(CNMV), which states that it is written and distributed in accordance with rules of conduct for financial research under Spanish regulations; in the US by Morgan Stanley & Co. Incorporated, which accepts responsibility for its contents. Morgan Stanley & Co. International plc, authorized and regulated by Financial Services Authority, disseminates in the UK research it has prepared, and approves solely for purposes of section 21 of the Financial Services and Markets Act 2000, research prepared by any affiliates. Private UK investors should obtain the advice of their Morgan Stanley & Co. International plc representative about the investments concerned. In Australia, Morgan Stanley Research and any access to it is intended only for "wholesale clients" within the meaning of the Australian Corporations Act. RMB Morgan Stanley (Proprietary) Limited is a member of the JSE Limited and regulated by the Financial Services Board in South Africa. RMB Morgan Stanley (Proprietary) Limited is a joint venture owned equally by Morgan Stanley International Holdings Inc. and RMB Investment Advisory (Proprietary) Limited, which is wholly owned by FirstRand Limited.
Trademarks and service marks in Morgan Stanley Research are their owners' property. Third-party data providers make no warranties or representations of the accuracy, completeness, or timeliness of their data and shall not have liability for any damages relating to such data. The Global Industry Classification Standard (GICS) was developed by and is the exclusive property of MSCI and S&P. Morgan Stanley bases projections, opinions, forecasts and trading strategies regarding the MSCI Country Index Series solely on public information. MSCI has not reviewed, approved or endorsed these projections, opinions, forecasts and trading strategies. Morgan Stanley has no influence on or control over MSCI's index compilation decisions. Morgan Stanley Research or portions of it may not be reprinted, sold or redistributed without the written consent of Morgan Stanley. Morgan Stanley research is disseminated and available primarily electronically, and, in some cases, in printed form. Additional information on recommended securities/instruments is available on request.
The information in Morgan Stanley Research is being communicated by Morgan Stanley & Co. International plc (DIFC Branch), regulated by the Dubai Financial Services Authority (the DFSA), and is directed at wholesale customers only, as defined by the DFSA. This research will only be made available to a wholesale customer who we are satisfied meets the regulatory criteria to be a client.
The information in Morgan Stanley Research is being communicated by Morgan Stanley & Co. International plc (QFC Branch), regulated by the Qatar Financial Centre Regulatory Authority (the QFCRA), and is directed at business customers and market counterparties only and is not intended for Retail Customers as defined by the QFCRA.
As required by the Capital Markets Board of Turkey, investment information, comments and recommendations stated here, are not within the scope of investment advisory activity. Investment advisory service is provided in accordance with a contract of engagement on investment advisory concluded between brokerage houses, portfolio management companies, non-deposit banks and clients. Comments and recommendations stated here rely on the individual opinions of the ones providing these comments and recommendations. These opinions may not fit to your financial status, risk and return preferences. For this reason, to make an investment decision by relying solely to this information stated here may not bring about outcomes that fit your expectations.
|
![](/img/clear.gif"){kind=spacer}