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Japan
Game is About to Start Again – Outlook report Preview October 18, 2007 By Takehiro Sato | Tokyo Outlook Report could herald resumption of groundwork for the next hike Following the upheavals of mid-summer, an element of risk-taking is returning to certain areas of the markets, with US and Asian stocks, for example, posting new highs. Meanwhile Japanese stocks remain slow to recover, and domestically, while consumer spending and capex are picking up from the summer slump, the drive towards recovery is by no means universal, as witnessed by the sharp fall in housing investment. Nevertheless, we expect the BoJ in its October Outlook Report (due on October 31) to reiterate its basic scenario that ‘the economy is likely to continue its sustained expansion’, and we think the report will herald the start of gradual ground-leveling towards a rate hike. Below we run through the main areas we will be watching in the Outlook Report. Economic and price outlook: Cautious on the economy at present, upbeat on the outlook; price outlook likely to be revised down again While we expect the BoJ to revise down its outlook for real GDP in F3/08, we think it will look for a return to 2% growth in F3/09 – which would be in line with our upbeat scenario. For personal consumption, which as in F3/07 has languished in the summer of F3/08, we expect a general move towards normalization in F3/09 with support from further tightening in the labor market. For capex, we expect a slowdown in F3/08, followed by re-acceleration, especially in non-manufacturing, in F3/09. And for residential investment, whereas we foresee a temporary, steep decline in F3/08 under the influence of the revised Building Standards Law, we anticipate a bounce back in F3/09. Because of this, we think the BoJ is likely to modulate its economic outlook between a subdued F3/08 and a generally positive F3/09. On the outlook for prices, we expect the Bank to revise down for F3/09 as well, having already done so (more sharply than we expected) for F3/08 in the April Outlook Report. Moreover, our forecasts are more conservative than the Bank’s, due to the latter’s assumption of a rather steeper Phillips curve. In other words, whereas the BoJ is more convinced of the ripple effect on prices from positive expansion of the output gap, we remain doubtful about the ripple effect on prices owing to globalization.
Upside or downside factors that could sway the basic scenario The BoJ is likely to stand by its standard scenario right up to the line. In other words, on economic growth we expect the Bank to generally adhere to its basic view that ‘the economy is likely to continue its sustained expansion with a virtuous circle of production, income, and spending in place’. While uncertainties about the overseas economies and credit markets will likely remain for the time being, the BoJ secretariat has been reassured about the real economy by the strengthening tone of production increases at manufacturers reflecting brisk demand in
Against this backdrop, the following are upside and downside risk factors to its basic scenario that we expect the BoJ to examine in the Outlook Report.
1) The BoJ is likely to continue regarding overseas economies as the foremost risk factor, both on the upside and the downside, though this time, because of concerns of collapse in the US housing market and events in the credit market, we expect it to revise a little more to the downside on this point. As an upside risk factor, on the other hand, we expect it to refer to a sense of overheating in Asian and emerging economies, reflecting growth in resource and energy prices.
2) On supply and demand conditions for IT-related goods, we anticipate a greater degree of tightness in supply/demand going forward, due to special demand relating to the Olympics among other factors. Moreover, while inventory of IT-related goods is at a high level according to the statistics, even in the September Tankan the sense of corporate inventory overheating had not strengthened all that much, so we expect the BoJ to remove this from the list of downside risks in the Outlook Report. At the same time, looking at the trend in business sentiment and capex plans in the September Tankan, it is possible that widening gaps for business conditions and management performance between large and small/mid-sized companies can be added as a new risk factor. 3) On risk factors relating to the ‘second pillar’ policy perspective – ‘possible larger swings in financial and economic activity based on optimistic assumptions regarding, for example, financial conditions’ – we expect the BoJ to maintain the basic tone it has taken up to now, while becoming more restrained in statements regarding upside risk.
Policy implications Considering the base scenario above and assessing the risks, we look for the next rate hike to arrive in December, earlier than the consensus envisions. Several factors underpin our view. (1) It now seems possible that buoyant external demand will allow GDP upside for the July-September quarter (to be announced in mid-November) to annualized growth of nearly 2%. (2) The December Tankan (due out on December 14) is likely to show a pick-up in the headline numbers, backed by the strong performance of manufacturing, and revised corporate plans after healthy interim results should continue to indicate solid profits and capex. (3) For prices, regardless of October data the likelihood is rising that the nationwide core CPI for November will be back in positive territory YoY.
These elements create opportune conditions for the BoJ to raise rates in December (otherwise in January), but if a hike is deferred till February there is the chance that October-December GDP data coming out in mid-February may show virtually no growth or negative growth, if only temporarily, as revision of the Building Standards Law brings a sharp drop in housing investment. There could also be a political vacuum at that time, if Diet deliberations are going nowhere or the assembly is dissolved, and these circumstances would make it difficult to raise rates again at that juncture. The core CPI is also likely to show the highest YoY growth in the January-March quarter of 2008, owing to the base effect of petroleum-related product prices mentioned earlier, and thereafter inflation could drop back near zero. As time passes, it may become harder to justify a rate hike from the price perspective too. The BoJ is therefore likely to earmark December (or January at the latest) as its window of opportunity, and step up its campaign to prepare for this event after the Outlook Report.
Possibility of the Governor and Deputy Governor posts standing empty Looking well down the road, we wonder how the policy board would react in the event that expiration of the terms of the Governor and Deputy Governors on March 19, 2008, coincides with dissolution of the Lower House for a snap election in the spring. We say this because four of the six non-secretariat policy board members appear to have hawkish leanings (Atsushi Mizuno, Miyako Suda, Hidetoshi Kamezaki, Tadao Noda), and in a political vacuum, the possibility of the hawks pushing through a rate hike under Miyako Suda (who would be the stand-in chairperson in the event of the executive posts standing empty) cannot be entirely discarded, though as a matter of common sense, there should not be a policy change under these circumstances. However, as the BoJ Governor and Deputy Governor terms last for five years, the DPJ seems most inclined to entrust these appointments to the next administration after the general election. As such, the possibility of the Governor and Deputy Governor posts remaining unoccupied for about 1-2 months is no laughing matter anymore.
Turkey
The Core of Disinflation October 18, 2007 By Serhan Cevik | New York Food prices are still rising, but ‘core’ indices show a steady disinflation. Food and non-alcoholic beverage prices (which account for 28.5% of the CPI basket in Currency appreciation is important, but not enough to account for the full extent of disinflation. The dollar’s weakness and the lira’s appreciation against the trade-weighted currency basket in real terms have certainly contributed to the disinflation process. Take, for example, the exchange rate pass-through effect on furniture and household goods prices. The year-on-year inflation rate in this category moved from the peak of 12.4% in May to 3.3% last month. Likewise, the entertainment and culture group (which includes personal electronics and foreign travelling) showed a sustained deceleration in the annual inflation rate from 10.5% in March to nil in September. Indeed, we can see similar movements, with varying intensity, in all the components of the CPI. As a result, the annual inflation rate in tradable goods prices excluding gold declined from 3.1% at the beginning of the year to -4% last month. In our view, this reflects a gradual response to the normalisation of distorted expectations, which resulted in price stickiness and thereby a disconnection between inflation and underlying economic conditions. Facing global volatility shocks and domestic political uncertainty, firms adopted a ‘just in case’ mark-up strategy, even though consumer spending kept declining over the past year. And now we are witnessing a correction in price-setting behaviour to reflect currency strength and economic weakness. That said, we should not exaggerate the pass-through effect, especially since it works in an asymmetric fashion with less intensity and longer lags on the downside. The correction in domestic demand is the real factor behind disinflation. So many exogenous factors can influence tradable goods prices, and that is why the best indicator of policy effectiveness and the quality of disinflation is the behaviour of non-tradable prices. The latest figures show that services price inflation — the main source of inflation inertia in the Turkish economy — declined from 12.2% at the beginning of this year to 8.4% last month. Furthermore, the stickiest component of the CPI — rental prices — eased from an annual inflation rate of 20.3% in January to 17.1% in September — an encouraging improvement in light of structural upward pressures in the housing market. Although the lira’s valuation affects services prices as well (mostly through contracts linked to the exchange rate), its influence has diminished a lot in the post-float period. Therefore, real economic fundamentals are the most important determinant of inflation dynamics in today’s economy, as tighter monetary conditions and higher risk aversion have led to a deep correction in domestic demand. For example, the annual growth rate of consumer spending dropped from 9.9% in the first half of last year to -0.3% in the second quarter of this year, largely because of a significant retrenchment in interest rate-sensitive demand for durable goods. No wonder tradable goods are now experiencing deflation and services price inflation is at the lowest level. Disinflation will accelerate, but macro risks are still on the inflation front. According to our estimates, disinflation will remain on track, even accelerating over the next nine months. The lira’s strength is an obvious contributing factor, thanks to the attractiveness of income and interest rate convergence. However, as argued above, disinflation is not just about the exchange rate pass-through effect; there are far more important fundamental factors influencing inflation dynamics. First, real wages (at least, in the private sector) are not growing as fast as productivity growth. This has implications for both cost-push and demand-driven inflation. Faster productivity growth and stagnant wages have led to a significant drop in unit labour costs and lowered the share of labour income from 30.7% of GDP in 1999 to 26.2% last year. Second, household debt grew from 7.5% of disposable income in 2003 to 25.4% last year, increasing the debt service burden from 2.2% to 4.2% of disposable income. Thus, we do not expect supply and demand conditions to deteriorate in an inflationary fashion in the near future. But that does not mean the state of the domestic economy will remain depressed forever. In our view, the slowdown was temporary and there are already clear signs of a gradual, but steady recovery in consumer spending. There is no reason to change our case of gradual monetary easing. The behaviour of inflation has become more encouraging in recent months and points toward a faster disinflation phase. Nonetheless, there are still risks (such as the volatility in food prices, much-delayed adjustment in electricity (and other utility) prices, and sudden shifts in international capital flows) that could upset the disinflation process. Furthermore, the pace of recovery in pent-up domestic demand may well accelerate faster than our expectations, thanks to strong capital inflows and improving credit conditions. This is indeed our main concern. The Turkish economy now has a higher potential growth rate, but it is no longer operating with an output gap that could accommodate the accumulated energy in domestic demand. Therefore, we do not see room for aggressive monetary easing, in spite of our below-consensus inflation projections for the next two years, and expect the Central Bank of
Mexico
No Hike, No Clarity October 18, 2007 By Gray Newman & Luis Arcentales | New York Rarely have Mexican watchers been more divided over the next move from Banco de Mexico. At the beginning of the month, just over half of those surveyed by a local bank expected a rate hike in either October or November. While the number of those calling for a rate hike might have come down a bit since the lower-than-expected September inflation reading last week (bringing annual inflation down to 3.79%), we suspect that market participants remain divided and indeed, confused, over how to read the central bank. For our part, we expect Banco de Mexico to be on hold for the remainder of the year. However, we admit, that it has been difficult to divine Banco de Mexico’s likely interest rate path based on its track record this year as well as based on its monthly communiqués. Accordingly, we hope that the central bank will improve its communication strategy. The quarterly inflation report, due out at the end of October, provides just such an opportunity. Nevertheless, we doubt that clarity is coming. The reason for our skepticism? We suspect that the debate among policy makers at the central bank remains heated. Points of Agreement First, most at the central bank agree that the growth path of the Second, there is consensus that the proximate cause of the unexpected upturn in headline inflation in Third, most forward-looking indicators of inflation have shown relative stability. Long-term expectations, while above the central bank’s 3% inflation target, have remained well anchored around 3.5%. Meanwhile, wage settlements have shown no upward trend despite the heavily politicized focus on inflation both in January of this year—when tortilla prices were the focus—and again in September when the focus turned to higher gasoline prices. Fourth and finally, there is general agreement that the media frenzy seen both at the beginning of the year and again more recently as Congress debated a new gasoline tax has exaggerated the risks of inflation getting out of control. Indeed, the central bank appears to be less concerned with the direct and indirect impact of the gasoline tax and more concerned with any damage to expectations. Further, we suspect that the central bank’s greatest concern is trying to determine how much of the new corporate flat tax (IETU) will be passed on by businesses to consumers during 2008. The areas of disagreement First, while wage and long-term expectations have not been contaminated, they do not appear to be showing clear signs of moving down to levels consistent with the central bank’s goal of 3% inflation. Some within the central bank have argued that the current state of affairs should mandate a further tightening. Second, while global supply shocks have been responsible for higher-than-expected inflation in Reaching a resolution We suspect that the communiqué will argue that the prospects of higher-than-expected headline inflation—despite its origins in soft commodity prices and energy—would normally justify a hike in interest rates. What then holds the central bank back? We suspect Banco de Mexico will argue that while a deterioration in headline inflation would warrant a move, the deterioration in the central bank’s confidence in the path of the US economy and hence the precise path of Mexican inflation warrants a central bank to be on hold. A higher point estimate when combined with a decline in the authorities’ confidence in their ability to forecast inflation is likely to keep interest rates unchanged. In many ways, we are back to our theme from earlier in the year of “no hike, but no comfort.” The central bank will likely continue to warn of the risks of a hike in the coming months without actually moving. Our concern is that the central bank’s decision to keep interest rates unchanged in October runs the risk of being misunderstood especially as all of the signs point to the central bank releasing higher inflation forecasts for 2008 than it has originally published (3% had been its expectation through August). In May, after months of debating how to respond to the supply shock from soft commodities, the central bank issued an ultimatum of reaching 3% by the end of 2008 and reiterated its focus on the balance of risks. A decision to keep interest rates unchanged in October and again in November even as inflation forecasts by the central bank are rising could damage confidence in the central bank’s commitment to 3%. Banco de Mexico will likely argue that external conditions—US growth uncertainty and hence the risks of a strong hit to Mexican domestic demand—require caution and represent a new factor that was not a major concern earlier this year. Still, if Banco de Mexico fails to convince market participants of its commitment to its 3% inflation target, it could see an uptrend in inflation expectations and wages at year-end and could ultimately force the central bank’s hand. Bottom Line But while |