The Message from Jackson Hole
September 04, 2007
By Richard Berner | New York
Even the Grand Tetons’ majestic beauty could not temper concerns about the state of the US economy and financial markets at the Kansas City Federal Reserve’s annual Monetary Policy Symposium this weekend in Jackson Hole, Wyoming. This venue has unfailingly provided a relaxed backdrop in which to debate and reflect on sweeping issues with the best of the best. This time, however, the atmosphere was stressed, echoing market conditions. Concerns that the one-two punch of a budding liquidity crunch on top of the ongoing housing downturn could trigger a US recession, with broader implications for the global economy and markets, hung heavily over the discussions.
Fed Chairman Bernanke wasted no time in explicitly cataloguing the downside risks to economic activity from both sources, underscoring the rapidly evolving shift in the FOMC’s policy bias. Just as in the FOMC’s August 17 risk assessment, the Chairman’s key point is that tighter financial conditions have gone well beyond mortgage lending. As he described it, an ongoing repricing of risk has abruptly morphed into a broad-based liquidity squeeze that is both scaling back the availability of credit and increasing its price, threatening significant collateral damage to the economy.
To be sure, not all FOMC members share that sense of risk. They hope that aggressive actions to provide liquidity at the Fed’s discount window will soon restore liquidity and ease the recent abrupt tightening in financial conditions. Indeed, markets remained open to high-grade issuers through August’s turbulence. And they correctly noted that available economic data prior to August’s liquidity shock were solid.
But if anything, the dislocations in money markets continue to intensify, and Chairman Bernanke himself argued that past data wouldn’t be useful in assessing the future fallout from those dislocations. Moreover, the more perceptions of a liquidity crunch persist, the greater probability that markets will price in aggressive central bank easing, putting more pressure on the Fed. Given the risks, and barring a rapid easing in financial conditions, the FOMC likely will take a first, 25 bp step towards ease at their meeting in two weeks. Additional money-market dislocations could promote using unconventional tools or a more aggressive response.
Fed officials at Jackson Hole were on the defensive on three counts. The first two relate to the causes of today’s mortgage lending mess: Directly and indirectly, officials were accused both of regulatory laxity and of keeping monetary policy too easy in 2002-2004, and thus were criticized about their role in creating a housing bubble and the subsequent subprime mortgage meltdown. Officials pushed back. On the first count, some argued that having jurisdiction over banks alone left them powerless to oversee the capital markets, including securitized subprime mortgages, SIVs and conduits. And on the second count, Fed Governor Mishkin passionately affirmed the Fed’s view that policymakers can’t identify bubbles, so they shouldn’t try to prick them; instead, conventional wisdom argues for an aggressive response to mop up the damage when the bubble bursts.
Importantly, their responses lacked the conviction of the past, and as I see it, that’s no bad thing; appropriately, these strands of criticism are triggering a rethinking of both regulation and how monetary policy should deal with suspected asset price bubbles. Former Fed Governor Gramlich’s list of remedies is a good place to start on regulatory reform. In a paper delivered for him at Jackson Hole, he applauds the Fed’s new joint program under which the Board and the Office of Thrift Supervision will cooperate with state bank supervisors to begin supervising all subprime lenders (for details, see http://www.federalreserve.gov/BoardDocs/press/bcreg/2007/20070717/default.htm). The Fed’s new guidelines for rate resets from teaser levels are helpful; they require that prepayment penalties expire 60 days before rates reset. But Gramlich would go further by cutting the threshold to classify a loan as high cost under the Home Ownership and Equity Protection Act (HOEPA) to 500 bp above Treasury rates from 800 bp. He suggests that community groups buy foreclosed properties and turn them into rental housing. And so on. The flame of his passion for making people’s lives better still burns brightly.
Notwithstanding Governor Mishkin’s erudite defense of the standard view of the role of asset prices in the conduct of monetary policy, other central bankers are moving away from that orthodoxy. At Jackson Hole, the new debate began in earnest. I’m especially sympathetic to new thinking on this issue, because it’s clear that the old tenet ironically risks financial instability and moral hazard in policy, especially at low rates of inflation (see “A Higher Inflation Objective?Global Economic Forum, August 11, 2006).
The new logic is pragmatic, perhaps best expressed at Jackson Hole by the Governor of the Swedish Riksbank, Stefan Ingves. In effect, he said that our models don’t adequately capture the influence of asset prices on growth and inflation. But our experience tells us that they nonetheless matter for economic behavior, and policy should consider them in a forward-looking way. And it’s critical to do that when asset prices rise, not just when they decline. “In my view it is well worth keeping an eye on house prices and other asset prices and passing judgment on the risks that their developments may give rise to. If the probability of very negative outcomes can be reduced ex ante, I believe this to be a good thing and a better solution compared to picking up the pieces ex post.” Not only does that sound right to me, but I also think that’s just what other central bankers will do. It simply requires good pedagogy; in Governor Ingves’ words: “We must explain that we do not target house prices but that we do not ignore risks associated with them.”
The last line of criticism at Jackson Hole was leveled at the Fed’s response to current market conditions. Many market participants think that the Fed’s discount-window strategy is not working, and are pressing officials to do more to avoid a credit crunch and a recession. However, Fed officials generally don’t see undue market stress and want to give what they have done time to work. Many believe that their discount window strategy should be viewed as a backstop for markets, so that market conditions rather than the volume of borrowing should be the metric for judging its success or failure.
If so, there was no sign of improvement while officials were at Jackson Hole. Money-market turmoil persists, manifest most prominently in interbank lending and asset-backed commercial paper rates. Over the past week, three-month LIBOR rates jumped by 10 bp to 5.62%, one-month rates surged by 22 bp to 5.72%, and 30-day AA ABCP rates rose by 15 bp to 6.20%, bringing the spread over AA financial company paper to 96 bp — 90 bp higher than at the end of July.
At work is a forced re-intermediation of the banking system, as issuers unable to roll over maturing ABCP are calling on their bank sponsors to absorb the commitments they made to back up CP in just such circumstances. Inherently, that reduces leverage in the financial system, as lenders shift from a funding source that requires no capital to one that does, and tightens credit. While my colleague Betsy Graseck believes that US banks can accommodate 92% of their “at-risk” non-card commitments before pushing the median Tier I capital ratio below the 6% “well-capitalized” level, banks still want to be paid at the margin for renting out their balance sheets as liquidity grows scarce (see “Bank Capital: Sufficient Capacity to Absorb Commitments”, August 30, 2007). So they will honor existing commitments, but funding new ones involves tapping the markets — markets that are still in varying degrees dislocated. And that means tightening financial conditions, with collateral implications for economic activity.
The ever-changeable weather in the Tetons is often the proverbial pathetic fallacy, a metaphor for the conference: Last year’s weather was unsettled, alternating between cold, gloomy and sometimes rainy conditions and periods of warmth, sun and bright fluffy clouds, only to revert back to chill. Likewise, the participants’ outlook seemed to vacillate between hopes for a continued benign economic climate and fears of an imminent popping of the housing bubble.
That was then. After a day of clouds and sprinkles, this year’s weather was nothing short of spectacular, with the temperature ideal and hardly a cloud marring the intensely blue sky by day or the starry firmament at night. But the tone of the conference went in the opposite direction. Discussions over meals, in the halls, and on the mountains centered on the threat to housing wealth, to housing activity and to consumer spending from even moderate home price declines. Most fundamentally, of course, observers are concerned that the economic fallout from these developments will be greater than what the Fed anticipates, and that the time for action has come. Martin Feldstein’s clarion call at the end of the conference for a 100 bp decline in the funds rate to mitigate the risks was only one of many.
To some extent, that explains the dichotomous performance of money and equity markets. Equity investors are celebrating the promise of Fed policy action and the Administration’s new plan to help pressured borrowers. But equities in my view are vulnerable to rising volatility and downside risks to earnings. Indeed, while much of the risks described above are in the price, heightened uncertainty in money markets and deteriorating economic news promise still steeper yield curves and elevated volatility.
Tighter financial conditions are multiplying the downside risks to the economy, which could show up sooner than expected. But for risky asset markets, ironically, the near-term risk is that investors try to look through that weakness to the eventual recovery and continue to rally.
2Q07 GDP Beats Expectations
September 04, 2007
By Chetan Ahya and Deyi Tan and Shweta Singh | Singapore, Singapore, Mumbai
GDP Growth Higher Than Expected In 2Q07, GDP rose 4.4% YoY versus 4.2% YoY for 1Q07. This is above our and market expectations of 4.0% and 4.1%, respectively, and brings 1H07 growth to 4.3% YoY. Upside Surprise from Inventories and Government Spending Domestic demand showed initial signs of recovery, moving into positive territory of 2.1% YoY, versus -0.3% YoY in 1Q07. This was primarily driven by a decrease in inventory destocking, which contributed 0.7ppt to headline growth, versus -1.5ppt in 1Q07, as well as government disbursements. Fixed capex rose a marginal 0.2% YoY versus -1.5% YoY in 1Q07, as the government increased investment 3.1% YoY. Public consumption also stayed healthy, at 7.4% YoY versus 11.1% YoY in 1Q07. However, private consumption moderated further to 0.9% YoY, versus 1.3% YoY in 1Q07. On the external front, exports moderated mildly to 6.7% YoY, versus 6.9% YoY in 1Q07, while imports accelerated to 3.7% YoY, versus 0.2% YoY in 1Q07. As a result, growth contribution from the external sector declined to 2.5ppt, versus 4.4ppt in 1Q07. Agriculture Registered Strong Growth On the supply side, the agricultural sector accounted for the bulk of the growth acceleration, expanding 9.7% YoY, versus 3.3% YoY in 1Q07, as crops and fishing production increased to 12.4% YoY and 6.4% YoY, respectively. The industry sector also improved to 4.4% YoY, versus 4.2% YoY in 1Q07, on the back of strong construction numbers (3.7% YoY versus 0.4% YoY in 1Q07). However, manufacturing growth continued to moderate, to 4.4% YoY (versus 4.6% YoY in 1Q07) – the lowest since 1Q05. The services sector decelerated to 3.6% YoY versus 4.3% YoY in 1Q07, contributing 1.6ppt (versus 1.9ppt in 1Q07) to the headline numbers. Expect Domestic Demand Recovery We are raising our 2007 GDP forecast to 4.5% YoY from 4.0% YoY to take into account the stronger-than-expected 2Q07 data, as well as expectations of a domestic demand recovery in the remainder of the year. Indeed, Thailand’s domestic demand had weakened since the political instability following the 2005 general elections. However, as we highlighted in our July 12 note on Thailand, ‘Politics: Moving in the Right Direction?’, we believe domestic demand is likely to recover from here. A stable political environment is critical to ensuring a sustained meaningful recovery in domestic demand. In this context, the recent political developments raise hopes of a potential revival in domestic demand over the course of the year. Specifically, Thailand politics seems to be getting back to democracy, with the success of the referendum and the announcement of December 23 as the election day. In addition, the lagged impact of a sharp reduction in policy interest rates and recent government efforts to accelerate spending will help support the economy.
The Decoupling Debate
September 04, 2007
By Chetan Ahya and Qing Wang | Singapore, Hong Kong
The Real Test of Decoupling Is Coming Increased global integration has meant that the real economy and financial market cycles of the US and Asia Ex-Japan (AXJ) have tended to move in synch, particularly post Asian crisis. However, the last few quarters of GDP growth trend for AXJ indicates that AXJ may already be decoupling from the US. However, in our view, the real test for decoupling is yet to come. One of the key reasons for this decoupling appears to be the fact that US GDP growth slowdown so far has been largely driven by a sharp deceleration in residential investments (and to some extent business investments), while consumption growth has been relatively stable. Over the last few weeks, the risk of sub-prime problem attacking the heart of the US growth — household consumption — has increased significantly. The US Fed, while announcing a cut in the discount rate on August 17, highlighted that “downside risks to growth have increased appreciably”. In the event of a sharp deceleration in US consumption growth, AXJ economies will face the critical decoupling test.
Hard or Soft Decoupling? We believe that a ‘hard’ decoupling — implying continued stable to strong growth in AXJ region while US witnesses significant slowdown — is a low probability outcome. The focus of this note is to assess the possibility of ‘soft’ decoupling implying that AXJ will decelerate following the US but less than proportionately. We believe that there is a high probability of AXJ economies witnessing ‘soft’ decoupling if the US economy soft lands. Our bottom-up country forecasts indicate that if US growth slows by 1%, AXJ GDP growth will decelerate by 1% to 7.2% in 2008. Note we are assuming that the financial markets in the US and in AXJ do not witness any further major turbulence. Hence, the key risk to our sensitivity estimates is the possibility of significant turbulence in the US and Asian financial markets. Whilst in the past the decoupling analysis would be focused primarily on spillover to AXJ’s real economy through foreign trade linkages, we believe that increased globalization of financial markets means that the risks of growth shock spreading through this route are probably much higher in the current cycle.
The Case for ‘Soft’ Decoupling Major strengthening of AXJ’s balance sheet over the last few years has increased expectations of a decoupling from the US economy. AXJ’s balance sheet is now in very different shape compared with that in 1997-1998 as evident in the trend on FX reserves vs External debt. While external debt to GDP has declined to 19.8% as of 4Q06 from 33.7% in 1Q99, foreign exchange reserves to GDP has increased to 41% as of June 2007 (US$2.6 trillion) from 22% in March 1999. As a result, AXJ’s surplus liquidity stock (stock of liquidity sterilized through issuance of bonds and cash reserve ratio hikes) has increased to about US$1,300 billion (23.2% of GDP) as of June 2007 from US$566 billion (14.3% of GDP) in June 2004. This excess liquidity is a mere reflection of relatively weak credit cycle also implying that the financial leveraging in the real economy is also manageable in this cycle. Except for India, most of the countries in the region have seen a steady decline in their credit-deposit ratio to 73.6% as of June 2007 compared with 85.5% in June 1999.
Although, trailing 12 months rise in foreign exchange reserves as a proportion of GDP has reached the peak it hit during the mid-nineties, most of the rise in the present cycle has been driven by current account surpluses instead of capital inflows. For instance, over the 12 months ended December 2006 the current account was in surplus of US$360 billion (6.3% of GDP) and indeed there have been capital outflows (US$6.9 billion) due to some of the more developed economies in the region making investments abroad. Over the past five years, the current account balance has accounted for US$1.06 trillion of the total balance of payments surplus of US$1.3 trillion. Compare this with 1996 (right before the Asian crisis) when the current account was in deficit of US$28 billion (0.9% of GDP) and capital surplus was US$109 billion (3.7% of GDP). Moreover, a large part of the capital surplus during the mid-nineties was due to debt inflows unlike the recent period where a large part of capital inflows has been non-debt creating.
However, a stronger balance sheet alone will not be good enough for soft decoupling. We believe the AXJ real economy decoupling will depend on two key factors (a) its ability to generate stronger domestic demand (i.e., reducing dependence on external demand); and/or (b) strength of support from external demand from its trade partners other than US (i.e., Europe).
Assessing the Ability to Stimulate Domestic Demand Domestic demand depends on three components: (a) investments; (b) private consumption; and (c) government spending. AXJ (excluding India)’s fixed investments are made with an eye on potential future global demand rather than domestic consumption. Hence, the fixed investment trend has tended to follow the region’s export and global growth cycle. The structural dynamics of private consumption are also not very strong. The private consumption trend in the region having recovered to moderate level is likely to sustain at the current levels but acceleration at the time when external demand could slow will be difficult barring a sharp cut in interest rates. We believe that governments could provide domestic demand support to some extent by pursuing expansionary fiscal policy. The combined fiscal deficit of AXJ has declined to 1.6% of GDP in 2006 from the peak of 3.2% in 2001. On balance, we believe that AXJ should be able to generate a weak though mildly positive support from domestic demand to offset the external demand slowdown. Diversifying into Non-US Destinations for Export Demand
The stable and/or stronger external demand from trade partners other than the US can be another source supporting decoupling. Indeed, over the last few years, AXJ’s trade dependence on the United States has been gradually reducing. This is evidenced by the fact that the United States’ share of AXJ’s exports decreased to 16% in 2007 (year-to-date) from 20% in 2002. In this period share of Europe has increased to 16% (year-to-date) from 14% in 2002. However, so far in the past we have observed that Europe's business cycle has followed that of the US at times with lag. As a result, AXJ's total exports have closely followed the US ISM trend. Hence, in this context decoupling in Europe’s growth cycle from that in the US would be important.
Our European team’s tentative general assessment for the euro area as a whole is that the region may partially decouple from the US, thanks to three factors: Credit risks are intrinsically lower in the euro area than in the US, since there does not seem to be an equivalent for the US sub-prime housing market in the euro area, The euro area capex cycle is still in an early stage, fuelled both by robust demand expectations and profits, Demand for capital goods, especially those linked to infrastructures, from Asia and oil producers is secular, not cyclical. The team argues that while European countries have mountains of cash, a 'hard decoupling' is unlikely. If the US economy were to go through a mild recession (not our main case scenario, but risks of such an outcome have increased), Euroland economies would experience a significant slowdown, although probably not a recession. Historical evidence, based on the last three recessions in the US, as reported by the National Bureau of Economic Research (3Q 1981; 3Q 1990, 2Q 2001) indicates that GDP growth only slowed in Europe, following a US recession. Hence, if US economic growth decelerates, AXJ’s export growth will inevitably decelerate but in a less than proportionate manner due to partial decoupling of the European economy.
Don’t Ignore the Risks of Financial Markets Linkages Key to our soft decoupling outlook is potential turbulence in US financial markets. In the last few years, globalization of financial markets has meant that we cannot ignore the possible transmission of growth shocks through financial market linkages. This point has been well enunciated in the IMF’s World Economic Outlook Report, April 2007. The report highlights that since the 1970s, cross-border financial linkages have increased significantly, with gross external assets of industrial countries rising from 28% of GDP in 1970 to 155% in 2004. Over the same period, gross external assets of emerging market countries increased from 16% of emerging market countries’ GDP to 57%. Not surprisingly, Asian financial markets have remained coupled with the US financial markets so far. During 2000-2006, the average correlation between MSCI Asia Pacific Ex-Japan and MSCI US was 72.6%. Similarly, price volatility is also highly correlated across countries. Moreover, as the IMF report highlights, financial integration has also led to increased co-movement in risk premia across markets, in part because an investor in one market is likely to be exposed to other markets.
Hence, the outlook for US financial markets will be critical to AXJ financial markets. While the three soft landings (significant growth deceleration but no recession) in the 1960s and 1970s led to bear markets, in the past two soft landings, the US financial markets did not suffer (see my colleague Gerard Minack’s note titled, Will Soft landing Be Good Enough?). Hence, for Asian financial markets it appears that not only the outlook of the US real economy in terms of soft landing or recession is important but also the reaction of its financial markets to the soft landing in the real economy.
Bottom line: We believe hard decoupling of the real economies (implying AXJ GDP remaining steady or accelerating) is a low probability outcome. We believe that if the US economy goes through soft landing (i.e., GDP growth decelerates to 1.5-2% YoY for 3-4 consecutive quarters) there is a high probability that we see soft decoupling (i.e., GDP growth decelerates but in less than proportionate manner). The key risk to this outlook is the potential significant turbulence in the US financial markets transmitting to Asian financial markets.
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