The Currency Conundrum
February 13, 2008
By
Daniel Volberg | New York
With soft commodity prices near record levels and no signs of the Argentine consumer slowing spending, it is tempting to extrapolate forward from the past five years of strong growth. But we fear that the days of easy extrapolation are set to end soon. Indeed, we expect a reversal in key fundamental forces that have helped to reduce the costs of the unorthodox policies adopted by the Argentine policy-makers.
In particular, we are concerned that if the US dollar strengthens and the Brazilian real weakens, as we expect, the Argentine peso is set for a sharp appreciation on a real effective basis. That sharp appreciation, in turn, produces significant downside risks to growth, upside risks to inflation and increased likelihood of a sharp policy-driven depreciation in the nominal peso-dollar exchange rate.
While many Argentina watchers question the long-term sustainability of the current economic model, few are willing to argue that the model is set to unravel in the near term, as long as the twin balance of payments and fiscal surpluses remain. Most Argentine watchers acknowledge that the economy is facing multiple adverse shocks: inflation uncertainty, a host of distorted relative prices – from frozen energy tariffs (that have contributed to an energy crunch) to the negative real interest rate (that have helped fuel an inflationary credit boom) – and regulatory uncertainty are just a few examples. However, most Argentina watchers seem to believe that as long as the twin surpluses provide the authorities with the financial resources, these problems can continue to be managed successfully in the short run. We are sympathetic to this view. Indeed, we were avid believers in it last year. And we acknowledge that turning points are difficult to predict. However, while we expect the twin surpluses to remain and while we are not yet fully convinced that the turning point in Argentina’s robust growth dynamic comes this year, we suspect that 2H08 is set to be an increasingly difficult time for Argentina for two reasons:
Global economic slowdown
The key to the Argentine peso’s modest depreciation in real terms has been a dramatic appreciation in the currency of Argentina’s largest trading partner – Brazil. In the past five years, the Brazilian real has strengthened steadily from above 3.00 then to near 1.75 in mid-February. With nearly one-quarter of all Argentine trade destined to Brazil, the appreciating real (in nominal and real terms) has reduced the inflationary cost of Argentina’s weak peso import protection policy. We expect that this situation is set to be reversed this year – we expect the real to weaken from the current 1.75 level to 2.00 by year-end (see “Brazil: Trade Consensus – What Is Wrong with This Picture?” EM Economist, November 16, 2007). In fact, we would not be surprised to see the real weaken further if the decoupling thesis is called into question as weakness in the US, Europe and Japan begins to take its toll on Chinese import demand and ultimately commodity prices as well. The depreciation in the real along with our forecast of a modest dollar strengthening could provide a reversal to the benign currency environment which Argentina has enjoyed and produce the first significant appreciation in Argentina’s real effective exchange rate in five years.
We have built several scenarios to assess the potential for real exchange rate appreciation in Argentina this year. When examining the real effective exchange rate, one additional dimension that complicates the analysis is continued irregularities in the official inflation measurement. We build a total of eight scenarios based on extrapolating forward four different measures of Argentine inflation for each of our two scenarios for the real. The four inflation measures we use are: the official Indec measure, the Mendoza province inflation measure, the estimate produced by the Indec labor union and our own estimate of inflation based on price data collected in Buenos Aires. The two scenarios for the real are for a gradual weakening to 2.00 or a gradual weakening to 2.40 by year-end. The effects on the real effective exchange rate (REER) are dramatic.
Assuming the real at 2.00 by end-2008 and using our highest inflation scenario (Mendoza inflation – roughly 24%), Argentina’s peso would gain 18% in real terms in 2008 and 33% over 2007-08. Contrast this with substituting the official inflation print of 8.5% in 2007 and our forecast that in 2008 the number would be 10.5% into the scenario, and the REER appreciates just over 5% this year. The other two inflation estimates fall between these two extremes, but closer to the high inflation scenario. Of course, in the scenario where the real weakens to 2.40, the real appreciation of the peso in 2008 is greater – over 25% if we extrapolate forward Mendoza’s high inflation and just over 12.5% for the official inflation forecast. Once again, the other two inflation measures fall between the two extremes, but closer to the high inflation scenario.
Indeed, even with the official inflation – which according to our calculations underestimates actual inflation – our forecasted weakness in the real translates into significant real exchange rate appreciation for the peso. Given that a weak currency, on a real effective exchange rate basis, is central to providing import protection to large sectors of the Argentine economy – fuelling strong employment and consumption growth that are some of the key drivers of the strong GDP growth dynamic over the past five years – the real appreciation would come as an adverse shock in 2H08. One potential consequence is a direct negative impact on economic indicators such as inflation, GDP growth and employment.
Policy response
Second, economic conditions in late 2008 could become more challenging if the real effective exchange rate appreciation provokes a policy-induced weakening of the nominal peso-dollar exchange rate. While we expect the authorities not to weaken the exchange rate, and instead more likely rely on subsidized credit as a policy response, there is significant risk – given low credit penetration in Argentina – that their preferred policy response could be ineffective. Should the authorities be forced to resort to weakening the nominal exchange rate – in an attempt to regain some of the lost competitiveness from higher inflation and a weakening real – the magnitude of the necessary adjustment would need to be unusually large.
We estimate that, given our eight scenarios, in order to offset the REER appreciation, the authorities would need to weaken the peso to anywhere between 3.35 and 4.00 from the current 3.15. In particular, in order to offset the REER appreciation in a scenario where the real weakens to 2.00 and inflation is 24%, the nominal peso-dollar exchange rate would need to weaken from 3.15 to 3.80 by year-end. And if the real were to weaken to 2.40, the peso would need to weaken to 4.00 simply to maintain the same level of real weakness that it currently enjoys. The most benign scenario – where inflation is near 10% and the real weakens to 2.00 –would still require the peso to weaken to 3.35 in order to offset the loss of import protection afforded by the currently weak exchange rate. We are concerned that a weakening nominal exchange rate could have wider implications for the Argentine economy.
We are concerned that if the authorities carry out a policy-induced weakening in the peso, the consequence could be a significant deterioration on the inflation front. Given doubts over the official inflation figures and the acceleration in alternative inflation measures, we suspect that short-term inflation expectations are largely anchored by the nominal exchange rate.
Thus, we suspect that a decision by the authorities to weaken the nominal exchange rate in response to real appreciation would be associated with a significant deterioration in inflation expectations. Given that organized labor has already demanded and received extra wage increases at the end of 2007 to compensate for the accelerating inflation, a further deterioration in inflation expectations from a weakened nominal exchange rate would likely lead to another round of inflationary wage increases. Given that alternative inflation indicators are pointing to inflation near 20% and given that we expect the labor cost-push shock to drive alternative measures of inflation above 25% in 2008, a second round of wage increases could see Argentina with the highest inflation in the region at near 30%. We suspect that inflation at such high levels could result in a sharp correction in both supply and consumer demand in 2H08 and into 2009 (see “Argentina: Toward a Wage-inflation Spiral?” EM Economist, July 13, 2007).
Bottom line
We suspect that Argentina is ill prepared to deal with the impact of a slowing global economy later this year. A key factor in the impressive growth dynamic over the past five years has been a weak currency policy that has provided import protection for large, employment-intensive sectors. The cost of pursuing such a policy mix has been rising inflation. The appreciation of the real has helped Argentine policy-makers to avoid paying the full inflationary cost of their policy mix. If, as we expect, the real depreciates this year and the US dollar gains some ground, Argentina may find a reversal of the benign conditions which permitted higher and higher inflation with only a limited loss in competitiveness. While the year has gotten off to a strong start, we fear that the policy response necessary to maintain the current economic model in the face of the deteriorating external environment – significant weakening in the peso – could have adverse inflation and growth effects later this year.
ECB Rate Cuts – Now and Then
February 13, 2008
By
Elga Bartsch | London
A look back to better anticipate the future
In gauging the likelihood and the timing of an ECB interest rate cut at the current juncture, it makes sense to travel back in time and study past turning points in the euro area interest rate cycle. Due to the relative short time-span that the ECB has been in charge, there is only one such turning point: spring 2001. Back then the ECB decided to cut the refi rate by 25bp at its May meeting, five months and 200bp after the Federal Reserve began cutting rates. This was the start signal for an easing campaign that eventually took interest rates from 4.75% down to 2% by June 2003. When the ECB finally decided to pull the trigger on the refi rate in 2001, the Governing Council was facing a somewhat different macroeconomic data set than the one presenting itself today.
Some similarities in inflation and bank lending…
One of the striking parallels between now and then is that, at 3.1%Y, HICP inflation was also way above the ECB’s price stability ceiling in the spring of 2001. Lending growth also printed double-digits in 2001. But contrary to today, the euro area business climate was about to fall below its long-term average in a somewhat steeper correction. At the moment, we are still printing business confidence a good 0.7 standard deviations above its long-term average. We do expect business confidence to come down in the coming months. But, so far, business morale has held up better than expected and some high-profile business leaders have recently rejected the idea of a US recession, which for most financial market participants seems to be a done deal. For those in the trenches on the trading floors, euro area business sentiment back down at the levels of 2001 would mean, for instance, a reading on the Ifo business climate of around 96 (currently 103.4).
…but big differences in money growth and business climate
In addition, monetary aggregates, which have been a key factor in changing the ECB’s assessment of the medium-term inflation outlook in the run-up to the rate cut, have shown very different dynamics in 1H01. Narrow M1 money supply growth had being easing to just about 2% and the rate of expansion in the broad M3 aggregate had been falling to 4% or so. The only other number, apart from the coincident inflation rate, that resembles the dynamics seen in 2001 is lending to the private sector, which also cruised at double-digit rates back then. Another important element of the data mix was probably the sharp drop in the break-even inflation rates in the spring of 2001.
Expecting further easing in business confidence, money and credit growth. True, the macroeconomic data set can and will likely change going forward. But we need to cover some distance before we get to anything that resembles the data set seen back in 2001. Of course, each easing cycle is different. Nonetheless, a trip down memory lane is useful (at least to me) to put events into perspective. This is in particularly true when assessing the take-away message from the ECB’s monthly press conferences. After the February press conference, markets and many observers concluded that the ECB had paved the way for a rate cut as soon as April. Our interpretation was a different one (see ECB Watch: The Hawks Tone it Down a Tad, February 7, 2008). Subsequent interventions by ECB officials at the G7 meeting and afterwards seemed to be an attempt to lean against market expectations for an early rate cut.
So, what signals are we looking for from the ECB? In my view, the key passage to watch in the introductory statement is the assessment of the risks to price stability. Currently, the ECB Council views the risks to price stability to be to the upside. In my book, this implies that the ECB still has a tightening bias The downside risks to growth that ECB President Trichet mentioned in the February press conference are relevant. But, importantly, it is in the face of these downside risks to growth that the ECB still sees upside risks to price stability. In the run-up to the May 2001 rate cut, the ECB started to signal a moderation in growth on the back of an unusually uncertain environment as early as its December 2000 meeting (see below for the extracts of the key passages from the monthly press conferences). Subsequently, the ECB started to view the risks to price stability as becoming more balanced than before in February and March 2001 and as late as April acknowledged that the risks had diminished, but not yet fully disappeared. Eventually, it seems to have been the monetary pillar of the ECB’s monetary policy analysis – at the time still called the first pillar – that swung the Council’s assessment around. We have long argued that, especially at the current juncture (where concerns about a credit crunch undermining economic growth are rife), the monetary analysis will be a key factor in the ECB’s assessment.
Bottom line
At the current juncture, the ECB is still further away from cutting euro area interest rates than the market, which is attributing an 80% probability to a refi rate cut of 25bp by April, expects. In terms of the language, I would see the tone of the February 2008 meeting on par with that of the December 2000 meeting. In the face of the equity market meltdown of 2000/01 and the US sliding into recession, the ECB took another five months from there onwards before it actually pulled the trigger. The March 2008 meeting will likely bring a marked downward revision in this year’s GDP growth projections. We would expect the ECB’s new projections to get much closer to our estimate of 1.6%, than its current 2.0% projection. In addition, there is also the possibility of a downward revision of the inflation projections. However, as the December projection, which showed a central projection of HICP inflation falling back below 2% next year, was openly disputed by the Governing Council, this is more of possibility than a probability, I think. If so, such a downshift in the inflation outlook would need to be reflected in a more balanced assessment of the risks to price stability. Then, but only then, it would be appropriate to argue that the ECB is paving the way for an interest rate reduction at one of its next meetings.
Key passages from ECB press conferences in the run-up to the May 2001 rate cut
November 2000
In order to maintain price stability over the medium term it is important that economic agents accurately perceive the nature of current price developments. In particular, it needs to be recognised that current upward pressures can be successfully overcome if economic agents see them for what they are – namely, one-off or temporary price increases resulting from external factors – and act accordingly. These factors must not give rise to second-round effects. If oil prices do not rise further, as the markets expect, the effects of past oil price increases will gradually drop out of the annual inflation rate…the Governing Council is committed to maintaining price stability in the medium term. It will continue to assess thoroughly the outlook for price stability in the euro area. Monetary policy will not accommodate inflationary tendencies in the euro area and in this way will make its best contribution to sustainable growth.
December 2000
Starting with the first pillar, it is fair to say that M3 growth rates have shown signs of moderation over the past few months. However, taking into account the protracted upward deviation of M3 growth from the reference value of 4 1/2% and the still robust growth of credit to the private sector, caution continues to be warranted with regard to the upside risks to price stability stemming from the monetary side. As for key indicators related to the second pillar, the assessment is currently complicated by increased uncertainty. In the first place, this applies to tendencies in the world economy. With regard to the evolution of real GDP growth currently foreseeable for the euro area, the underlying dynamism of growth continues to prevail, although subject to some moderation. … Turning to consumer price developments, recent developments have continued to reflect, above all, developments in oil prices, but also previous developments in the euro exchange rate. Over the medium term, the upward pressures from energy prices are expected to disappear gradually, while HICP rates of inflation will increasingly depend on domestic forces. On balance, the Governing Council judges the risks to price stability still to be on the upside.
February 2001
Notwithstanding the assessment that the risks to price stability are now more balanced, there are still factors posing upside risks which therefore require continued attention. These are mainly related to potential second-round effects on wages of the past increases in import prices, as well as to bottlenecks and shortages in labour markets. For the medium term, it remains paramount that wage developments remain moderate.
March 2001
Overall, for the medium-term outlook for price stability, risks appear to be more balanced than in late 2000. In particular, the indications from M3 growth over recent months point to a gradual decline in upward risks. However, some factors still argue for caution. In this respect, it is crucial that social partners …
April 2001
The Governing Council conducted its regular examination of monetary and economic developments and analysed their implications for the maintenance of price stability in the euro area. It decided to keep the key ECB interest rates unchanged. In order to explain today's monetary policy decisions in some more detail, let me share with you our assessment of the information provided under the two pillars of the monetary policy strategy of the ECB. As regards the first pillar, M3 growth has been on a gradual downward trend since spring 2000. The three-month average of the annual growth rates of M3 reached 4.8% in the period from December 2000 to February 2001. Growth in credit aggregates has also been less buoyant over the past few months. All in all, the information from the first pillar is signalling that upward risks to price stability have diminished over the past few months. As regards the second pillar, upward risks to price stability have also diminished somewhat over the past few months, but they have not disappeared
May 2001
The Governing Council conducted its regular examination of monetary and economic developments and analysed their implications for the maintenance of price stability in the euro area. It decided to lower the key ECB interest rates by 25 basis points. This reduction is to be seen as an adjustment of the level of interest rates to somewhat lower inflationary pressure over the medium term. On the basis of the information available, this is the appropriate level of interest rates to ensure that the euro area economy will be able to maintain price stability and thereby to contribute to sound economic growth over the coming years. In order to explain today's monetary policy decisions in some more detail, let me share with you our assessment of the information provided under the two pillars of the ECB's monetary policy strategy.
June 2001
On the basis of the information available at today's meeting, the Governing Council concluded that the current level of interest rates remains appropriate to ensure that the euro area economy will be able to maintain price stability in the medium term, and thus decided to keep the key ECB interest rates unchanged.… Looking forward, there is ongoing concern about the emergence of second-round effects, so that wage developments need to be monitored very closely. In this context, it appears particularly important that wage setters fully understand that current price developments are strongly affected upwards by factors which should only have a temporary impact on the inflation rate …. However, if no further unfavourable price shocks occur, this upward pressure should soon start to diminish, making it likely that annual HICP inflation will start to fall in the course of this year and be below 2% in 2002. Nevertheless, there is a need to remain vigilant as regards future developments affecting the balance of risks to price stability, although weaker economic growth than that currently expected might reduce inflationary pressures. Close attention needs to be paid to factors which might entail a resurfacing of upward risks to price stability, including, in particular, wage developments, energy prices and recent movements in the exchange rate, which is an important indicator to be taken into account under the second pillar.
Late June 2001
Overall, the latest information did not change our assessment of the outlook for price stability over the medium term. We continue to expect the currently high rates of inflation to remain a transitory phenomenon and, in the absence of further unfavourable price shocks, inflation rates should fall below 2% in 2002. These developments are expected to take place in an environment of weaker economic growth, which should, however, remain broadly in line with trend potential growth of the euro area. We will continue to remain vigilant as regards future developments affecting the balance of risks to price stability, including – in particular – monetary developments, real GDP growth, price setting behaviour and wage developments. At this juncture, at which price developments are affected mainly by transitory factors, it is crucial that the current upward movement of prices does not become more lasting, and it is therefore important that wage moderation is continued.
July 2001
It considers that the current monetary policy stance remains appropriate and should bring inflation back in line with price stability in the medium term. Maintaining a favourable perspective for price stability is the best contribution monetary policy can make to fostering economic growth over the long run. The main risk related to this outlook concerns second-round effects having an impact on wage negotiations this year and early next. As has been said on previous occasions, when looking back, the wage developments seen so far have been satisfactory, while, when looking to the future, there is ongoing concern. Overall, our current policy stance should ensure price stability in the medium term. Of course, we shall continue to monitor closely future developments affecting the balance of risks to price stability, including - in particular - monetary developments, real GDP growth, price-setting behaviour and wage developments.
August 2001
Following its regular examination of monetary and economic developments and analysis of their implications for the maintenance of price stability in the euro area, the Governing Council decided to lower the key ECB interest rates by 25 basis points. The Governing Council considers that the available evidence points to an improvement in the outlook for price developments. This is particularly apparent from the information under the second pillar of the ECB’s monetary policy strategy, while that related to the first pillar remains consistent with a favourable outlook for price stability in the medium term. … Regarding the second pillar, there are clear signals of lower inflationary pressures from the demand side… Overall, as several indicators are pointing to an abatement of inflationary pressures, the new level of interest rates is compatible with the maintenance of price stability over the medium term, which, in turn, is essential to create a favourable environment for sustainable economic growth
Source: ECB, bold-ins have been added by the author of this note.