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Where Is Neutrality for the Fed and the ECB?
September 26, 2007

By Joachim Fels and Manoj Pradhan | London

Restrictive Fed and ECB. In spite of the FOMC’s rate cut to 4.75%, the Fed’s monetary policy stance continues to be restrictive.  More controversially, in the euro area, where the ECB’s refi rate stands at 75bp below the current fed funds rate, monetary policy is also on the restrictive side, though only slightly so.  These assessments are based on our updated estimates of the time-varying natural, or neutral, rate of interest in the US and the euro area, which we discuss in this note. 

The neutral rate fluctuates over time. The neutral, or natural, rate of interest is the level of the fed funds rate that would keep actual output at potential output and inflation stable over the medium term.  This natural rate fluctuates over time in response to changes in productivity and population growth, as well as the propensity to save and invest.   As it cannot be observed, the natural rate has to be estimated.  In our previous work, we presented a model and estimates of such a time-varying Wicksellian natural rate of interest (J. Fels & M. Pradhan, In Search of the Natural Rate of Interest, February 10, 2006).  Back then, our model suggested a level of 4.15% for the natural rate, consisting of a real natural rate of 2.25%, plus an inflation rate of 1.9% (as measured by the core PCE deflator).  We concluded that US monetary policy was slightly restrictive – the fed funds rate stood at 4.5% at that time – and that further rate hikes would slow both the economy and inflation over time.  That assessment has been largely confirmed by developments over the last 18 months: the Fed hiked rates to 5.25%, US GDP growth slowed to a below-trend pace, starting from 2Q06, and inflation, which initially kept rising, has eased somewhat in recent months.

Updated model suggests that the neutral rate has declined to 4%. With a year-and-a-half of additional data on GDP and inflation under our belts, we have re-estimated the model and find that the real natural rate for the US has come down by about a quarter of a percent to 2.0%.  This is consistent with the notion that the pace of trend productivity growth, and thus potential output growth, has declined in the past couple of years (note that in our model the natural rate and potential output growth are linked, but do not have to be identical).  With core PCE inflation running at close to 2%Y, the nominal neutral rate of interest is thus currently around 4%. 

Thus, the Fed’s stance is still restrictive at 4.75%. Based on our estimate of the neutral rate, current US monetary policy continues to be restrictive, despite the 50bp rate cut.  To get back to neutral, the fed funds rate would have to be reduced by about 75bp from here, which incidentally is in line with what markets are currently pricing in by the end of the 1Q08.  In other words, at this stage, the Fed is not at risk of over-stimulating the US economy.  If anything, monetary policy is still a drag on growth, and cutting rates down to 4% would merely serve to remove this drag and allow GDP growth to return to potential over time.

But neutral Fed may be too easy for dollar peggers. The Fed sets interest rates based on the outlook for US growth and inflation.  But with many countries in Asia and the Middle East (more or less rigidly) pegging their currencies to the dollar, the Fed implicitly also influences the monetary policy stance in these countries.  The correct monetary policy stance for the US economy may thus not be the right stance for the wider dollar bloc.  Arguably, with many countries in the dollar bloc, such as China and other emerging markets, growing more strongly than the US, a fed funds rate of 4%, while neutral for the US, would imply a very expansionary monetary policy there.  This could (over-) stimulate growth and raise inflation pressures in these countries, unless they accept an appreciation against the dollar or use capital controls to drive a wedge between US and domestic interest rates. 

ECB no longer ‘on the accommodative side’. We have also updated our natural rate model for the euro area.  In contrast to our results for the US, our estimate of the natural rate of interest in the euro has increased since then, reflecting a likely pick-up in potential GDP growth in recent years.  Our estimates suggest that the real natural rate has picked up to slightly less than 2%.  With core HICP inflation at around 2%Y and headline inflation likely to rise to about that level this month (from 1.7%Y in August), the nominal neutral rate of interest is thus currently at around 4%, exactly in line with the ECB refi rate.  However, taking into account that 3-month Euribor rates are trading significantly above the refi rate due to the confidence crisis in the banking system, monetary policy in the euro area is currently restrictive.  This contrasts with the ECB’s own assessment that monetary policy remains ‘on the accommodative side’, which is based on the ECB’s analysis of money and credit dynamics.  Yet, with the financial crisis and the slowdown in the US likely to dampen money and credit growth as well as economic growth in the euro area, we expect the ECB’s assessment of what constitutes ‘neutral’ to change in coming months.

Bottom line
Based on our natural rate models, the 75bp of additional Fed rate cuts priced into markets would suffice to restore a roughly neutral monetary policy stance for the US.  However, this level of the fed funds rate would probably be too low for other members of the dollar bloc such as China and other EM countries whose currencies are pegged to the dollar, stimulating growth there and stoking global inflation pressures.  In the euro area, monetary policy is now slightly restrictive, on our estimates, suggesting that the ECB’s bias might swing from hiking rates further to easing policy later this year or early next year.


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What Credit Crunch?
September 26, 2007

By Luis Arcentales | New York

In its most recent monetary policy communiqué, Banco de Mexico acknowledged an “insipient” pick-up in the pace of economic activity in recent months. While the statement simply confirmed the recent acceleration in manufacturing output and the mild improvement in consumer outlays, it also contained a clear warning about the downside growth risks posed by the ongoing turmoil in US housing and credit markets (see “Downside Growth Risks Become Reality”, GEF, September 9, 2007).  Indeed, while the debate on whether the world can decouple from the US rages on, no one is calling into question Mexico’s vulnerability to a US slowdown.

Whereas Mexico’s link to the US on the manufacturing front is very much alive, concerns that tighter financial conditions in the US are about to squeeze Mexico’s consumer and mortgage credit markets appear overblown.  Improved credit affordability, combined with significant pent-up demand, suggests that Mexico’s credit expansion can carry on largely independent of the US credit cycle.  Moreover, as our homebuilding analyst Jorge Kuri argues, the turmoil in markets for asset-backed securities and a slowdown in Mexican growth and remittances are unlikely to dent Mexico’s secular homebuilding and mortgage lending stories (see Mexican Real Estate: Securitization, Remittances and Other Concerns, September 17, 2007).  We are not arguing that in the event of a US recession Mexico’s domestic demand and credit story will prevent the Mexican economy from stalling – credit penetration is simply too low by most measures.  However, with the potential impact of a US slowdown dominating most headlines, Mexico watchers may be missing some very good domestic news, ranging from the likely resilience of the housing sector to the positive momentum on the reform front (see “Mexico: Boosting Fiscal Fitness”, GEF, September 5, 2007). 

What mortgage link?
Construction has been an important growth engine in the Mexican economy. 
Jobs in the sector grew 11% in the 12 months ending July 2007, accounting for 15% of total jobs created in the formal economy – far in excess of its 9% share in the formal jobs market.  Indeed, construction jobs expanded at the second-fastest pace of all major economic sectors, lagging only mining.  To be fair, annual construction activity growth in the first half of the year has been modest at just 1.6%, but a difficult base has played a role – campaign spending pushed construction up 7.1% in 1H06, the best two-quarter jump since the post Tequila-crisis recovery. 

But recently several factors – which we consider to be overblown – have called into question the resilience of the construction sector.  Our homebuilding analyst Jorge Kuri singles out three specific areas of investor concern regarding the ability of Infonavit and Fovissste – which jointly accounted for 68% of mortgages in 2006 – to continue granting credit: remittances, US credit woes and a sharp slowdown in job creation.  On all counts, we agree with Jorge that homebuilding and mortgage lending will remain resilient, given significant pent-up demand – the country’s housing deficit likely exceeds four million units – and the limited risk that the aforementioned factors pose to issuance plans of Infonavit and Fovissste. 

Growth in remittances has slowed to just 1.6% in the first seven months of the year from 15.1% in 2006 (see “Mexico: The End of Abundant Remittances?” GEF, April 17, 2007).  Still, not only do surveys show that remittances are not an important source of funds for housing-related outlays, but they play no role in funding the budgets of Infonavit and Fovissste.  In addition, it is worth pointing out that while the explosive growth in remittances has slowed, they have not dried up and still represent a significant source of funds, running at an annualized pace close to US$23.5 billion.

The sustained appetite for duration from local investors – even in the midst of the recent turmoil in US credit markets – suggests that demand for long-dated paper in Mexico remains solid.  Thus, and given the relatively small size of Infonavit’s 2008 securitization plan (M$10 billion in mortgage-backed securities or 8.6% of its total budget), we agree with Jorge’s view that Infonavit’s budget does not appear to be at risk.

Lastly, a slowdown in formal job growth below the 2.2% threshold contained in Infonavit’s budget could spell trouble for its mortgage origination plans.  To put this year’s issuance plan at risk, Mexico would have to shed jobs at an annualized pace in excess of 930,000 positions in the September-December period  – nearly three times the pace seen during the 2001 recession. While formal job growth has slowed to 5.7% in August from a cycle high of 6.9% in August 2006, our below-consensus expectations of GDP growth to average 3.2% over the next six quarters is still consistent with jobs expanding well above the conservative 2.2% Infonavit assumption.     

Beyond homebuilding, the prospects for construction are positive in light of the recently approved fiscal reform.  The reform is expected to generate additional revenues to the tune of 1.1% of GDP in 2008, of which 0.8% of GDP will go to the federal government (see “Mexico: Fiscal Reform – One Last Step”, GEF, September 15, 2007).  Consistent with the administration’s commitment to boost infrastructure outlays, over 70% of the federal funds are earmarked for various forms of infrastructure such as energy, transportation and hospital facilities.  While the amount is modest at 0.6% of GDP, it should nevertheless support construction activity. 

Has the credit boom run its course?  
At first sight, the trends on the consumer credit front do not seem encouraging. 
Real growth in consumer credit – which has averaged 40% in the past five years – dipped below the 30% mark in June for the first time since mid-2002.  Moreover, the ratio of non-performing loans to the consumer is on the rise.  And these two concerns come at a time when US credit conditions are tightening. 

However, results from our proprietary survey point to still significant pent-up demand for credit at a time when credit affordability is at historical levels thanks to lower interest rates (see Lore Serra’s and Jorge Kuri’s Mexico Consumer: Retailer Financial Services – Big Opportunity, but Should Take Time, September 9, 2007).  Moreover, with the banking systems’ overall profitability and capitalization ratios at high levels, the recent uptick in loan loss provisions and the ratio of past-due loans seems to reflect a change in the banks’ credit mix, particularly the explosive growth in credit card issuance, rather than a meaningful underlying deterioration in asset quality, according to our banks team. 

Our survey shows that credit penetration in Mexico is low across the income spectrum, with fully 42% of the participants carrying no debt compared to 26% in Brazil and 24% in the US.  Interestingly, most debt-free respondents (72% of the total) answered that the key reason for it is that they do not like having debt, rather than lack of access, with only 3% of this group having applied for credit only to be rejected.  Indeed, for a country with healthy banks, low inflation and an investment grade rating, the level of penetration of core banking products, the 4% ratio of consumer credit to GDP and overall credit penetration are shockingly low. 

Another important conclusion from our survey is that consumers are showing few signs of being overextended.  Only 13% of the participants holding debt claimed that they are “very uncomfortable” with their debt level.  These results appear consistent with Banco de Mexico’s estimate that consumer debt service as a share of disposable income is just over 5%.  At a time when questions about the leverage of US consumers are high on investors’ concerns, we estimate that once adjusted for the relative level of credit penetration, the Mexican household debt service ratio is about a third that of the US.  Based on these results, Jorge Kuri believes that Mexico’s consumer credit dynamics are likely to show limited correlation with the overall business cycle.

While consumers appear to be in good shape, indebtedness appears to have affected spending to some extent, with 36% of consumers with debt telling us that they’ve had to cut back on spending because of debt payments.  While this figure might seem alarming, the results from a similar survey in Brazil spearheaded by our retail analyst Lore Serra earlier in the year put this figure at 79%. If anything, retail sales in Brazil have boomed, up 9.8% in the first half of the year – compared with 6.2% for all of 2006 – with particular strength in credit-sensitive areas like furniture and appliances (+16.4%). 

One additional observation is that more than half of our sample (53%) is open to the prospect of obtaining financial services from retailers.  Last year, Mexico’s Ministry of Finance awarded 12 banking licenses, including one to Mexico’s largest retailer Wal-Mart.  Given consumers’ favorable attitude towards credit from retailers – particularly among low-income segments relative to their use of banking services – this represents a potential tailwind in Mexico’s credit story.  

Bottom line
Given the uncertainty over the outlook for US economic activity, it may seem difficult to be constructive on Mexico.  After all, the link between the US and Mexican economies is very much alive and cuts both ways.  But by focusing solely on Mexico’s limited ability to insulate itself from a downturn in the US, Mexico watchers may be missing some positive domestic news ranging from Mexico’s favorable credit story and the likely resilience of housing and mortgage origination to the encouraging momentum on the reform front, underscored by the recent approval of the fiscal reform package.


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