Easing Into the Great Monetary Easing
March 14, 2008
By Joachim Fels | London
‘The Great Monetary Easing’ Revisited
At the start of this year, we argued that many central banks, led by an aggressive Fed, would shift towards an easier monetary policy stance in 2008, thus starting a new global liquidity cycle (see The Great Monetary Easing of 2008, January 3, 2008). While we anticipated global inflation pressures remaining high, we expected many central banks to eventually put concerns about economic growth and financial stability above inflation worries. Ten weeks later, Fed policy has in fact become significantly more expansionary as the economy has weakened and the credit crisis has deepened. However, with very few exceptions, most other central banks have either held rates steady or tightened policy further since the start of the year in response to mounting local and global inflation pressures. Against this backdrop, it’s time to revisit our ‘great monetary easing’ thesis by taking a closer look at the recent and prospective monetary policy paths around the globe. In a nutshell, we conclude that our thesis remains valid. Through their combined – though not always coordinated – actions, central banks are likely to start a new global liquidity cycle that should lift growth and asset prices in 2009. And the odds are that easy monetary policies will cement the new regime of higher global inflation that we described in last week’s The Global Monetary Analyst. The Fed opens the floodgates. The Fed is now about to enter Phase 3 of its current easing cycle, which involves taking the real rate of interest to, and eventually below, zero: - In Phase 1, which lasted from the summer to December of last year, policymakers returned the fed funds rate from a restrictive 5.25% to a broadly neutral level of 4.25%.
- In Phase 2, rates were reduced by a total of 125bp to the current level of 3% in two steps in January, which turned monetary policy expansionary.
- Phase 3, which we will likely enter next week, is about pushing the real policy rate to and below zero. With core PCE (CPI) inflation running at 2.2% (2.4%), a widely expected 75bp rate cut to 2.25% on March 18 would achieve just that. Looking beyond next week’s FOMC meeting, our US economists forecast a further 50bp rate reduction to 1.75% at the April 29 meeting and expect rates to be held at this level throughout the remainder of the year.
This time around, the Fed has been much faster in reducing the real funds rate to and below zero than in previous recessions, when real rates typically reached zero towards or only after the end of the recession. Thus, the Bernanke Fed is not only more proactive than other central banks at the current time – it is also more proactive than any of its predecessors including the Greenspan Fed have been in the past. Only a few others have cut rates this year. Apart from the Fed, only two other G10 central banks have cut interest rates since the start of the year. The Bank of Canada comes closest to emulating the Fed’s aggressive action with a reduction in rates by 75bp so far this year, while the Bank of England has reduced rates by a more cautious 25bp. Outside of the G10, only the central banks of Turkey and Israel have eased monetary policy recently. In all four countries, we expect further rate cuts in the course of this year, ranging from 25bp in the UK (with a good chance of more than that) to 50bp in Canada and 75bp in both Turkey and Israel. Bank of Japan to join the easing camp in 2Q. Another G10 central bank that, on our forecasts, will likely join the easing bandwagon this year is the Bank of Japan. Against consensus expectations for an unaltered policy stance, our BoJ watcher Takehiro Sato expects the bank to cut the overnight rate from an already very low 0.5% to 0.25% in the second quarter of this year, once the leadership succession issue is solved. Dollar peggers import easy Fed stance. Another important building bloc of our ‘Great Monetary Easing’ thesis is the impact of aggressive Fed easing on monetary conditions in countries that have tied their currencies rigidly or less rigidly to the US dollar. This group includes many countries in Asia, most prominently China, and in the Middle East. This group is facing rising inflation pressures, as illustrated by the surge in the Chinese CPI to 8.7% in February. This would normally require a tighter monetary policy stance. However, unless they restrict the free flow of capital or allow a significant appreciation of their exchange rate, the central banks of these countries will not be able to raise interest rates in an environment where the Fed is easing, and many will even be forced to follow the Fed on the way down. European bloc on hold for now. Meanwhile, persistent inflation pressures have kept inflation-targeting central banks in Europe such as the ECB, the Swiss National Bank and the Norges Bank on hold so far this year. In Sweden, the Riksbank even raised rates by 25bp recently, and there is a roughly even chance that the Norges Bank will do the same at its policy meeting this Thursday. Looking ahead, in our economists’ main scenarios, the ECB, SNB and the Norges Bank will keep rates unchanged this year, against market expectations for one or several cuts. However, a deepening US recession, further stress in the financial system and continuing downward pressure on the US dollar suggest that the risks to our main scenario of unchanged rates in these countries are skewed to the downside. More tightening in Central and Eastern Europe. Further east, most central banks are still in a tightening phase, with Russia, Ukraine, Poland, the Czech Republic and Romania all having raised rates recently. Our economists expect rates to rise further in all of these countries as inflation keeps exceeding central banks’ targets. The one notable exception is Hungary, where Pasquale Diana believes that the market is far too aggressive in pricing in NBH rate hikes in 2008. If anything, he sees some scope for rate cuts later this year. Latin America broadly on hold. The other region that is unlikely to join the Fed’s easing campaign anytime soon is Latin America, where our team sees unchanged rates throughout the year in Mexico and Columbia, and even some further tightening in Chile (near term) and Peru (later in the year). Brazil, the largest economy in Latin America, is the only country in the region where our economists anticipate lower rates – though only towards the end of the year. Overall: easing towards more global easing. Taken together, while the monetary policy outlook across the main regions is still fairly diverse, a few things stand out: - First, the Bernanke Fed is more aggressive in countering recession and financial sector stress than any of its predecessors, and real rates in the US will soon enter negative territory.
- Second, among the G10 central banks, we expect the Bank of Japan to join its American, British and Canadian brothers on the easing bandwagon soon. Others who might join in later include the Swedish Riksbank and, perhaps after one more hike, the Reserve Bank of Australia later this year. And, while it is not our main scenario, the ECB and the SNB may follow later.
- Third, while rising inflation pressures in many dollar peggers would call for higher interest rates, the Fed’s aggressive stance implies easier monetary conditions there, unless these countries allow their currencies to appreciate or reinstate capital controls.
Eyeballing across our global interest rate forecasts, our team expects less than one-fifth of the central banks we cover to hike rates by more than 25bp this year. By contrast, over a third are expected to cut interest rates. Note that this is despite the fact that almost 80% of these countries have current inflation running above target right now, and around half of the group will, on our forecasts, still have inflation above the norm in one year’s time. For many countries, we expect growth concerns to gain the upper hand eventually – in nine out of ten countries, we forecast lower growth this year than last year. Bottom Line Even though the picture is mixed across the various regions, we conclude that the ‘great monetary easing of 2008’ is on track, especially as the GDP-weighted global real interest rate is currently virtually zero. Led by a very aggressive Fed, central banks are likely to kick-start a new global liquidity cycle, which should eventually lift asset prices and economic growth in 2009. However, as we argued last week, the price to pay for such a policy response is persistent global inflation pressures, which may render current inflation targets obsolete.
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Higher Inflation for Longer
March 14, 2008
By Qing Wang | Hong Kong
CPI Inflation Reached 8.7% YoY in February As expected, headline YoY consumer inflation accelerated further in February, reaching 8.7% from 7.1% in January (4.8% in 2007), in the aftermath of snowstorms that damaged food supplies and paralyzed transport systems in several provinces. The jump was larger than our expectation (+7.8%), as food prices surged 23.3%, steeper than our projection of 20.5% and contributing 90% of the month’s inflation. Following the snowstorms, fresh vegetable prices jumped 46% YoY in February (+13.7% in January and +8.9% in 2007), while the supply of meat and poultry (+45.3% in February versus +41.2% in January and +31.5% in 2007) remained tight, especially that for pork (+63.4% in February versus +58.8% in January and +48.3% in 2007). In the non-food categories, there was a noticeable increase in utilities (+6.5% in February versus +5.5% in January and +3% in 2007), but other items showed stable trends. The Lunar New Year effect eased on items such as intercity transport (+4.2% in February versus +6% in January) and travel (+1.8% versus +5.1%) services, bringing overall service inflation to 2%, down from 2.6% in January. Revising Our CPI Inflation Forecasts We are taking this opportunity to reassess our inflation outlook. Specifically, we are lifting our CPI inflation forecast for this year (from 4.5% to 6.5%) for two key reasons: (a) the not-so-temporary supply shocks, and (b) the more accommodative monetary policy stance in the face of a weaker global economy. We elaborate on these below. The January-February record-high CPI readings reflected such temporary supply-side factors as the severe snowstorms that sharply drove up the prices of some food items (e.g., fresh vegetables). However, the impact appears to be lingering for longer than would normally be expected, keeping inflation up and exacerbating inflationary expectations. In the face of a weaker global economy, policymakers are striking a delicate balance between tackling inflation and avoiding policy overtightening with a view to managing the downside risks to the growth outlook. While Chinese Premier Wen struck a quite hawkish tone in discussing inflation in his recent government work report, he cautioned that “uncertainties in the international economic environment and potential risks have increased” and pointed out the need to “be fully prepared for changes in the international environment and become better able to defuse risks” and “maintain the appropriate pace, focus and intensity of macroeconomic management to sustain steady and fast economic development and avoid drastic fluctuations in the economy” (see China Economics: Key Statements by Premier Wen on Inflation and Housing Policy, March 5). This generally balanced approach should lower the probability of the authorities’ intensifying tightening measures in the near term despite the high CPI reading, in our view. In this context, the authorities have adopted a less ambitious inflation target of 4.8% for 2008. Moreover, according to the PBoC, the M2 supply growth target for 2008 is to be set at 16% and the loan growth target at below last year’s growth rate (i.e., 16.1%), as opposed to the 13-14% target that had been understood by market participants. Therefore, underlying monetary conditions are unlikely to be as tight as originally envisaged. In light of the latest developments, we are revising our CPI forecasts. We believe that headline CPI inflation peaked in February, but will hover above 7% in 1H08 before easing to below 5% in the latter part of the year, resulting in a year-average inflation rate of 6.5%. Specifically, we believe that the food price level should start to move down in the coming months. Year-on-year food inflation should ease primarily on the high base to around 7% by 4Q08, from the latest 23.3% in February, as the positive supply response (e.g., pork) is expected to show an impact by around mid-year. Averaging an estimated 14.5% for the year, food inflation is expected to account for three-quarters of total inflation this year. Non-food inflation, on the other hand, is expected to be on a very gradual upward trend, as continued robust consumer demand amid sustained household income growth and wealth accumulation enables producers – whose margins have been under pressure – to pass on higher input costs. However, the pass-through is unlikely to be complete, as deteriorating external demand weakens Chinese manufacturers’ pricing power. We therefore project non-food inflation to climb only gradually from 1.5% currently to 2% by year-end. Averaging an estimated 1.7% for the year, non-food inflation is expected to account for a quarter of China’s inflation this year. Looking to 2009, we envisage that non-food components will contribute an increasing portion of inflation in China. As food inflation eases, Chinese authorities will probably see scope for deregulating administered prices (e.g., for refined oil products, electricity power) with a view to improving energy conservation and efficiency. We forecast 3.5% CPI inflation in 2009. No Change in Our Policy Call: No Rate Hike On January 22, we changed our PBoC call from “two rate hikes in 1H08” to “no rate hike throughout 2008” in view of the rapidly deteriorating global market sentiment and the US Fed’s sharp rate cut by 75bp on January 22 (which was followed by another 50bp cut on January 30) (see China Economics: The Probability of Imported Soft Landing in 2008 Rising, January 22). Now that, subsequently, the snowstorms lifted the headline inflation rate to such high levels for January and February, market expectations of an immediate rate hike have gained considerable traction of late, especially when the authorities have reaffirmed their strong intention to bring inflation under control. A rate hike at this juncture would contribute to managing inflationary expectations. We, however, attach a less than 50% probability to a rate hike this month, but note that there are strong arguments in favor of a rise. We are standing by our no-rate-hike call for several reasons. First, our US economists, Richard Berner and David Greenlaw, expect the US Fed to deliver another 75bp interest rate cut at the March 18 FOMC meeting (see A Darker US Outlook, March 10, 2008), which, if it materializes, would further limit the scope for a PBoC rate hike. Second, the domestic stock market has been under heavy selling pressure in recent weeks and a rate hike at the current juncture would greatly exacerbate the negative market sentiment and likely cause a renewed sell-off, a situation that the authorities appear to want to avoid. In fact, past experience suggests that the PBoC tends to time its rate hikes so that they do not cause major ‘damage’ to the stock market. Third, the spike in headline inflation in January and February was largely due to the snowstorms, a supply factor that monetary policy is not best equipped to tackle. There are other measures at the authorities’ disposal to manage inflationary expectations and ease the negative impact on the population groups most affected by the high prices. Last but not least, even though the authorities have reiterated their determination to tackle inflation, they have also maintained that interest rate policy should be used “prudently”, in line with domestic and external economic and financial conditions, and that the policy stance will be “fine-tuned” as appropriate (see China Economics: Our Quick Reading of PBoC Monetary Policy Report, February 24). In our opinion, this suggests that the authorities will not resort to an interest rate hike unless it is considered absolutely necessary. Based on considerations discussed above, we do not think that this criterion has been met. Policy Responses on the Radar Screen Then what are the most likely policy responses? We expect the authorities to continue to use open-market operations and reserve requirement ratio (RRR) hikes to mop up liquidity from the balance of payments surplus. Meanwhile, we also expect the recent acceleration of renminbi appreciation against the US dollar to be sustained. We now see the renminbi reaching Rmb6.6/US$1 by end-2008. In his government work report delivered at the NPC annual meeting, Chinese Premier Wen put great emphasis on supply-side factors in containing inflationary pressures, including boosting agricultural production, restricting relevant exports and encouraging imports (see China Economics: Key Statements by Premier Wen on Inflation and Housing Policy, March 6). In this context, we also believe that the existing administrative controls over key prices (energy, utilities and certain food products) are unlikely to be lifted anytime soon and will likely be maintained throughout 1H08. Risks Given the ever-expanding host of factors contributing to inflation as China becomes increasingly integrated with the rest of the world through the process of globalization, macro forecasting is becoming ever more challenging. We highlight to investors the upside and downside risks to our new forecasts so that they can be well positioned if circumstances change. On the upside, if the much anticipated US recession and the attendant negative impact on China does not materialize, China’s balanced approach in coping with inflation and at the same time in preparing for a potential export slowdown could mean renewed risks of overheating in the economy. If the Chinese authorities realize (say, by mid-year) that they cannot really count on an “imported soft landing” to cool the economy and help achieve disinflation, they may reassess and even re-intensify their macro controls, which may raise concerns about excessive tightening and a potential policy-induced hard landing of the economy. On the downside, should the US economy dip into a sharper-than-expected recession, the associated slowdown in export demand may have a much larger disinflationary and even deflationary impact on China, as was the case in 1997-98 and 2001-02 global downturns.
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