Global
All Easy in EM
April 10, 2008

By Joachim Fels & Manoj Pradhan | London

Extending natural rates analysis to EM… Despite the ongoing severe liquidity and solvency problems in the financial sector and the accumulating evidence of a global economic slowdown, inflation continues to come in above consensus expectations in many countries.  We have long been inflation bulls, so we are not really surprised.  Rather, what puzzles us is that market-based measures of longer-term inflation expectations have generally remained relatively stable.  In our view, market participants and observers still underestimate the longer-term inflation risks emanating from what we think is a very expansionary global monetary stance.  To illustrate the latter point, we extend our natural interest rate analysis, which has so far been confined to the US and the euro area, to the four largest EM economies – China, India, Russia and Brazil. 

… to gauge monetary policy stances.  Recall that the natural, or neutral, rate of interest is usually defined as the level of short-term interest rates that – considering all other factors influencing the economy – would keep GDP growing at its trend rate and inflation stable.  In our past work (available on request – just email us), we have described in detail how we estimate, with the help of econometric tools, this time-varying natural rate for the US and the euro area.  Comparing actual short rates to these estimates of the natural rate tells us whether monetary policy is expansionary or restrictive.

Fed funds rate way below neutral.  In the US, the Fed’s 200bp of rate cuts in 1Q have taken the actual fed funds rate way below the natural rate.  Adjusted for core PCE inflation, the Fed’s favourite inflation indicator, the real fed funds rate is now at around zero, while our model puts the real natural rate at slightly below 2%.  Thus, US monetary policy is now firmly back in expansionary territory, as it was for most of this decade with the exception of 2000 and 2006-07. 

Natural rate and potential GDP should be related.  It is worth emphasising that our estimates of the natural rate of interest are consistently below estimates of the growth rate of potential GDP.  This contrasts with the popular rule-of-thumb that the natural rate should equal potential GDP growth.  Indeed, theory suggests that the two should be linked, and our model consequently assumes that both are driven by the same factors (such as technology and population growth).  However, theory also suggests that the neutral rate of interest should be somewhat lower than potential GDP growth, because the first is a (virtually) risk-free rate, while the latter can be seen as the return on a ‘risky asset’ called the economy.  We will make use of this relationship between the natural rate and potential GDP growth when estimating natural rates for the EM countries below.

High inflation means ECB is expansionary, too.  In the euro area, our estimates also suggest that monetary policy is expansionary, though only moderately so.  Three-month Euribor, which we use in our model instead of the ECB’s refi rate, currently trades at 4.75%, or 75bp above the refi rate.  However, with HICP inflation at 3.5% in March, the real three-month rate currently stands at 1.25%, lower than our estimate of the neutral real interest rate of slightly less than 2%.  Thus, apart from the short spike in 2H08 caused by the liquidity squeeze in the interbank market, euro area monetary policy has been expansionary on our measure for most of the past six years.  It should hardly come as a surprise then that inflation in the euro area is running significantly above the ECB’s comfort level.

A shortcut to estimate neutral rates for EM… It is difficult to apply the econometric methodology we use for the advanced economies to estimate the natural rate of interest in EM economies. Reliable data series spanning several decades are often not available and, more importantly, monetary policy regimes in these countries have changed more frequently and sometimes quite dramatically.  Hence, we use a shortcut by taking our cue from the relationship we estimate between potential GDP growth and the natural rate of interest in the US.  As a first step, we calculate potential GDP growth in the EM economies by running a statistical filter (the HP filter) on actual real GDP growth in these countries. 

… by linking the neutral rate to potential GDP growth.  In a second step, we multiply the resulting potential GDP growth series by 0.78 – the average ratio of our US natural interest rate to US potential GDP growth – to get our rough estimate of the natural rate of interest.  This is consistent with our reasoning above that while the natural rate of interest should be related to potential GDP growth, it should also be somewhat lower than the latter.  This simple measure of the natural real rate of interest in China has trended higher in recent years together with potential GDP growth, which is likely to have been boosted by massive investment spending and the related implementation of new technologies in recent years. 

All easy in EM, except for Brazil.  A comparison of our estimated natural, or neutral, interest rates with actual real short rates gives us a sense of the monetary policy stance in our large EM economies.  The results are startling.  In China and Russia, with current inflation exceeding the level of the key policy rate, real short rates are actually negative, against our rough estimates of neutral real rates of some 8% in China and around 5% in Russia.  In India, the discrepancy is not quite as large, but the real short rate is still far below the neutral estimate of around 6%.  Moreover, in all three countries, real rates have been in expansionary territory since about 2002.  The one exception here is Brazil, where the real short rate has consistently been above our crude estimate of the neutral rate.  This is probably a legacy of extreme monetary instability in earlier decades, which has forced the central bank to run a relatively tight ship in order to build up credibility.

No substitute for our country analyses.  Before jumping to conclusions, we want to emphasise again that these natural rate measures for the large EM countries are likely to be only very rough approximations.  Apart from moving short-term policy rates, the authorities in these countries employ exchange rate intervention and other measures such as changes in banks’ reserve requirements to influence the monetary policy stance.  Also, applying the ratio between the natural rate and potential GDP in the US to EM economies may not do justice to the institutional differences.  We thus urge our readers to refer to the much more sophisticated regular analyses by our country economists on monetary policy in China, India, Russia and Brazil.

Bottom line: global inflation pressures to persist.  With these important caveats in mind, we still conclude that monetary policy in the three largest EM economies (China, India and Russia – who on IMF/World Bank PPP weights collectively account for close to 20% of world GDP and thus only slightly less than the US and Europe, respectively) appears to be very expansionary at this stage.  Viewed in conjunction with the Fed’s super-aggressive rate cuts and the slightly accommodative stance in Europe, global monetary conditions are thus conducive to persistent global inflation pressures in the coming years.  Against this backdrop, we reiterate our long-held view that inflation expectations are too low and investors would be well advised to buy protection against higher inflation.

(For the charts that accompany this piece, please see The Global Monetary Analyst, April 9, 2008.)

 

Europe
Switzerland: Lower Growth, Higher Inflation
April 10, 2008

By Luca Bindelli | London

Summary and Conclusions

We now see more downside risks to growth and upside risks to inflation, due mainly to global factors. Our 2008 forecast is for growth to reach 1.6% (1.9% previously) and inflation 2.1% (1.9% previously). The SNB is not in a hurry to lower rates, and may eventually do so only once by year-end. The CHF will remain supported by the global economic uncertainty in 1H, we think.

Our Broad Thesis Remains Unchanged

In our piece last month (see Orderly Slowdown in 2008, March 6, 2008), we laid out the basis of our economic scenario for Switzerland. Since then, the downside risks we saw for financials and external growth have become more of a reality. However, we still expect domestic demand to remain the key support for growth going forward. Indeed, broad labour market conditions (employment growth, vacancy rates) are very good still, and real employee income growth (the SNB projects a 2.8% growth for 2008) should continue to support consumption. On the inflation front, we continue to think that inflation may prove rather sticky. With a bigger-than-expected surge in oil prices this quarter, we now anticipate inflation to stay above 2% in 1H, and possibly in 3Q.  The factors we highlighted previously in support of this view remain present – higher domestic capacity (output gap) in late 2007, persistence in food and energy price inflation, rent inflation and increasing pass-through from producer prices.  The major determinants for triggering a change in our call are as follows:

1) Lower global growth. Our US and European teams have revised their growth profiles lower.  In short, estimated US growth is down to 1.0% in 2008, and down to 2.0% in 2009. In Europe, my colleagues expect euro area growth to reach 1.5% in 2008 and 1.5% in 2009. A slowdown coming from the external sector was already expected, but these revised profiles pose additional downside risk for Switzerland. Having said this, the external degree of competitiveness of Switzerland remains good, especially when compared to that of the EU.  In February, the CHF appreciated by only 3%Y in real terms; this compares to 8%Y and -8%Y for the EUR and USD, respectively. In addition, goods exports to Asia have so far more than compensated for the fall in exports to the US, as the region is only slightly affected by the US slowdown so far. While we anticipate that the real exchange rate appreciation (which started last October) will continue, these elements should help to dampen the export slowdown a little in 1H08.

2) Increasing risks for financials. The price discovery process, and the ongoing global financial turmoil, could continue to expose Swiss banking sector profitability to greater risk in the coming quarters. As we highlighted in our piece last month, the financial sector could overturn growth in other sectors, as happened in 1995 and 2001. Our small-scale model suggests that Swiss financial sector performance is significantly affected by equity market performance (S&P, DAX) and a currency index.  Last month, we expected the financial sector to shave off 0.3%Y from growth in 1Q. However, based on the latest developments in financial markets, the June futures equity prices and the 2001 experience, we suspect that risks are growing to the downside for Swiss financials in the coming months.

3) Higher oil prices. Recent developments in the energy markets (oil) have propelled global inflation to higher levels. In Switzerland, despite the recent CHF appreciation, fuel oil surged 45%Y in 1Q. Our new forecast profile for CPI inflation reflects this ‘overshoot’. Having said this, we still expect inflation to recede below 2%, but only by year-end.  The global and domestic slowdown should dampen excess capacity and energy price inflation next year. In turn, domestic inflation should fall back, but from a higher level.

The SNB Can Still Afford to Wait

We suspect that several factors will still delay/prevent the SNB from large rate cuts:

First, as we highlighted in the past, the current Libor rate (2.75%) is slightly accommodative. Moreover, we think that this will buy the SNB more time to gauge the impact of the financial crisis on the domestic economy, and ultimately on the increased trade-off it currently faces between inflation and growth.

Second, and so far, the flexible nature of the policy strategy allowed the SNB to deal effectively with short-term funding pressures without changing its policy stance. The SNB has managed to maintain a low risk premium on the interbank market (Libor target spread) by quickly lowering the 1W repo rate and providing large amounts of liquidity since the end of February. In short, the current Libor target spread remains very contained (12bp) in comparison to other G10 economies, and suggests lower implicit tightening (this spread remained below 6bp since September last year, and went up only recently). The current financial turmoil did not affect corporate access to credit so far. Indeed, corporate lending was still growing at a healthy pace (14%Y in January 2008).   Arguably, a risk to this call is the renewed pressure on 3M Libor-3M OIS spreads (currently around 60bp). A sustained increase in risk premiums could lead to a significant tightening of credit conditions. If the problems encountered by the big banks were to widen further, this would increase the likelihood of reduced lending, thereby raising concerns at the SNB.

Lastly, the Fed’s aggressive easing could eventually lead to a quick reversal in rates. The Fed already suggested some discomfort with inflationary pressure. When the Fed reaches the bottom of its easing campaign, we think that risk appetite could recover globally in a more sustainable fashion. This should put CHF at risk. Our US team is now forecasting a trough in the Fed policy rate in 2Q08, with a reversal in 1Q09. In short, the CHF appreciation might not last long, and quickly turn back into a potential inflationary force for the SNB, we think. 

For all these reasons, we think that the SNB will be reluctant to ease too quickly.

Main Risks

The ongoing financial turmoil suggests increasing risks to the domestic financials’ growth prospects. The further the CHF appreciates and the deeper equities fall, the higher the risk for growth. As before, a more prolonged global growth slowdown would also add downside risks. In case global financial conditions were to translate into more material downside macroeconomic risks, the SNB would cut interest rates quicker.