Upside Risks to Inflation
April 22, 2008
By Richard Berner | in Basel
Former Fed Chairman Paul Volcker recently opined that “We’re at a point where we have to worry about inflation.” Small wonder: At least on the surface, the inflation environment is starting to feel a bit like the 1970s again, with commodity, food and energy prices rising, monetary policy turning accommodative, and the dollar continuing to decline. As a result, I’m getting more worried about inflation, and it’s critical to assess the sources of risk.
There’s some good news: Global inflation may be moderating somewhat, especially in Asia, as some food price hikes have plateaued. My colleague Qing Wang points out that Chinese food price hikes are moderating as the supply shock from severe winter snowstorms ebbs, reversing the jumps in vegetable and produce quotes. As a result, headline inflation may decline to about 8% in April from 8.7% in February. And my colleague Chetan Ahya notes that a similar pattern may be emerging in India, with recent data showing some ebbing in food quotes (see Food Price Inflation Monitor, April 20, 2008 and India Economics: Inflation Remains High, April 17, 2008). But relief may be short-lived. Soaring energy quotes and renewed increases in food prices in many parts of the global economy likely will continue to push global inflation higher again, although the effects will probably be uneven. For example, Qing Wang thinks that China’s self-sufficiency in grain will insulate that country from such pressures (see The Impact of High International Grain Prices: Let Data Speak for Itself, April 21, 2008). But tighter monetary policies and currency appreciation in several other Asian economies are not restraining inflation there, at least not yet. Moreover, food and energy price increases, combined with the dollar’s recent decline, add to US inflation risks. I now think US headline inflation may linger near 4% through September, and the risks that such increases will seep into core inflation are rising. Here’s why. Accelerating food prices are a global phenomenon; they are widespread, they have recently intensified, and the sources of the increases are global in scope (for an analysis of the fundamentals, and ways to play them, see Robert Feldman and Hussein Allidina, Land to Mouth: How to Profit from the Food Chain in Food, January 15, 2008, and Malcolm Wood, Ryan Tsai and Cory Ng, Playing the Food Theme, April 17, 2008). So the recent moderation in food inflation, especially in parts of Asia, is good news, and may help blunt the human suffering wrought by massive price hikes in emerging market economies where food makes up 25-55% of consumer budgets. But recent food prices declines have only reversed a fraction of the enormous runup just in the past year. For example, the S&P GSCI agricultural commodities nearby index has tumbled by -10.5% from its mid-March peak, but that index jumped by 82% over the previous 14 months. More important, the respite may be temporary because the factors that have pushed up food prices are still in play and likely will promote a rebound. Among them: strong global demand; rising living standards and associated demands for protein in the developing world; the relatively new substitutability between corn and oil and US policies that reinforce that association; and the rise in energy costs that drives up both fertilizer and transportation costs for food producers. A rebound may now be imminent as the food crisis deepens; with major food producers limiting exports, markets may well stay dislocated and volatile. Last week Kazakhstan, one of the world’s biggest wheat exporters, banned exports and Indonesia stopped farmers from selling rice abroad, spurring global rice prices to a record high of $1000/metric ton. In the US, the pace of domestic price hikes for food has cooled by 100 bp to 4.7% in the past three months, but the risk is now that it will rebound. No relief from surge in energy prices. In contrast to the slight moderation in food, there’s little sign of restraint in crude oil and refined products quotes, with West Texas crude at $117/bbl, US wholesale gasoline close to $3/gallon, and natural gas at $10.60/mm btu. The ongoing surge in energy prices reflects the strong demand and limited supply, courtesy in part of chronic underinvestment, that have kept the market tight for the last few years. These forces may well take prices higher than we and our energy team thought and keep them there (see Doug Terreson, Integrated Oil: Raising 2008 Oil to $95/bbl; Long Term Remains $85, March 14, 2008). A weaker dollar and speculative investment flows likely also contributed to the rise in prices. Gasoline pump prices are approaching the $3.50/gallon mark that we thought would represent the Memorial Day peak, and now it appears they could easily surpass that mark by another 25 cents. Rising gasoline prices won’t much affect official inflation statistics (seasonally adjusted) for the next couple of months, as the price increases reflect the seasonal pattern of spring price hikes. But they will eventually appear; if prices don’t recede in the summer when seasonal factors anticipate a decline in demand, the official adjusted data will show significant increases. And the energy price hikes will start to appear in airfares, packaging, and a variety of other costs. A rise in import prices apart from food and energy — the product of a weaker dollar and gains in non-dollar import prices — is a third global source of inflation pressure. Unlike in the 1970s, that secular influence is moderate because global companies now tend to “price to market,” absorbing the effects of currency or import price changes in margins; in other words, the “pass-through” from such cost increases has declined (see “Globalization and Inflation”, Global Economic Forum, June 19, 2006). But I’ve long thought that “pass-through” depends on the cyclical state of the economy, being weak in recessions and stronger in expansions (for example, see “Is a Weaker Dollar Inflationary?” Global Economic Forum, November 16, 2007). But there are lags between the time the economy weakens and the degree of pass-through declines, and slack hasn’t yet increased by enough to mute the impact of such price hikes by as much as I thought a few months ago. And import prices have also risen over the past few months by a bit more than I thought — not solely because of the weaker dollar but also because costs have escalated. And the link between oil and the dollar and the connection from energy to food prices suggest that a weak dollar may carry more inflation risk than I’ve assumed. The upshot: While pass-through has been incomplete, import price hikes have given a lift to US inflation. Domestic factors haven’t helped tame inflation much, although I expect that they eventually will. Inflation expectations, partly reflecting the global forces mentioned above, are moving higher. Measured by the University of Michigan’s consumer canvass, 5-10 year inflation expectations have edged up to 3.1% this month, and are at the high end of their recent range. But a weakening US economy will help cap inflation, as the housing bust promotes a deceleration in rents and as slack in the economy generally undermines pricing power. In my view, the time-honored forces of increased slack brought about by recession will cause inflation to slowly move lower. In that context, I expect that rising costs will soon have an impact on profit margins instead of prices, as companies are less able to pass them through to consumers. And both investors and Fed officials can take comfort from the fact that job opening rates — a measure of labor market slack — have declined about 40 bp from their peak and that wages are decelerating. Yet the relationship between slack in the economy and inflation seems to be looser — in other words, the so-called Phillips curve is flatter — than in the past, so barring a significant downturn, inflation will be sticky. Fed dilemma; more steepening. As was the case in March, Fed officials are acutely aware of the inflation risks associated with aggressively fighting recession, especially if they overstay their welcome. The compromise 75 bp ease at the March 18 meeting and dissents from two reserve bank presidents speak to the Fed’s delicate balancing act. Some might argue that food and energy price hikes are simply changes in relative prices, so investors should focus on core inflation as a measure of the underlying trend. That’s the same logic that Fed Chairman Arthur Burns used when he instructed Fed staffers to extract core inflation from the total by excluding food and energy during the 1970s. Meanwhile, the rise in inflation eroded discretionary spending power and thus consumer spending. By allowing the hikes in energy and food prices to affect inflation expectations and wage setting, the Fed contributed to an era of stagflation (see “The Curse of Arthur Burns”, Global Economic Forum, October 22, 2004). That was then. Ultimately, my belief that inflation won’t rise significantly further rests on the Fed’s resolve to cap inflation. For now, however, policymakers are committed to limit the damage to the economy from an ongoing credit crunch. And that means they risk allowing inflation expectations (especially longer-dated inflation expectations) to creep higher. A Fed in reflation mode and the risk of higher inflation remain a recipe for a bear steepening in the US yield curve. Against this backdrop, buying longer-dated inflation protection (via inflation-linked products) also makes sense. While 10-year TIPS spreads have rebounded from their March lows, at 250 bp they discount a benign inflation scenario.
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Review and Preview
April 22, 2008
By Ted Wieseman | New York
Treasuries were crushed over the past week, with yields at the front end hitting their highest level, and the curve is at its flattest level since late January/early February, as awful earnings results in the financial sector apparently weren’t as bad as investors feared, sending credit spreads much tighter and stocks higher and creating hopes that the worst of the financial sector crisis might be over. This hope, which also resulted in the market’s shifting to price in just one more 25bp rate cut at the end of the month and the first hike as early as December, arose despite increasingly severe dislocations in interbank funding markets, which sent the opposite message about strains in the banking and broader financial system than investors were taking away from earnings results. As term LIBOR spiked higher, both spot and forward LIBOR/expected fed funds spreads blew out dramatically, with the spot spread moving to a new high for the year and forwards over the next year moving way up to new highs. This chaos in LIBOR caused major turmoil in the swaps market, with a blowout in spreads through most of the week before significant moderation Thursday afternoon and Friday and a general meltdown in the eurodollar futures market contributing significantly to the pressure on Treasuries. The economic data calendar was fairly busy but mostly little noted by investors. Retail sales were a bit better than expected in March, but still pointed to minimal growth in real consumer spending in 1Q and a weak starting point for 2Q. Single-family housing starts remained in freefall, with the cumulative drop seen so far and likely further decline in the months ahead starting to bring into view a correction of the bloated new home inventory situation within a reasonable timeframe. Inflation results were mixed − CPI was relatively benign, thanks to seasonal factors that restrained a sharp rise in gasoline prices – but while core finished goods PPI was muted, the rest of the PPI report was ugly. Early indications for key upcoming April data were somewhat mixed but negative overall. Jobless claims continued to trend higher, pointing to another decline in non-farm payrolls. The early regional manufacturing surveys from the Philadelphia and New York Fed Districts were sharply divergent, but taken together suggested that the national ISM will remain below the 50 boom/bust line. For the week, benchmark Treasury yields jumped 22 to 44bp, and the curve flattened dramatically. The 2-year yield rose 44bp to 2.18%, the 5-year 38bp to 2.95%, the 10-year 27bp to 3.745%, and the 30-year 22bp to 4.52%. Considering the enormity of this sell-off in the nominal market, a series of record highs for oil prices, and a looming period of very positive carry (with the NSA March CPI up 0.9%), TIPS performed terribly, with the 5-year yield up 32bp to 0.57%, the 10-year 24bp to 1.40%, and the 20-year 22bp to 1.95%. Financial sector earnings looked uniformly abysmal to us, but apparently investors were fearing even worse results, as upside in financials helped lead good gains in credit and equity markets on the week that contributed significantly to the Treasury market bloodletting. In late trading Friday, the 5-year investment grade CDX index was 21bp tighter on the week at 108bp, which would be the best close since January after what had been a partial reversal of gains as it traded from the prior recent best close of 109bp on April 4 up to a high of 130bp on Monday. The high yield CDX index was 58bp tighter on the week at 609bp through Thursday’s close, and the index was surging another more than three-fourths of a point late Friday. The leveraged loan LCDX index was similarly 64bp tighter on the week at 346bp through midday Friday. Stocks also had a very good week, with the S&P 500 rising 4.3% on the week, wiping out almost half of the prior year-to-date losses and reaching its best close since February 1. The commercial mortgage CMBX market had a very strong week as well, with the AAA index tightening 38bp to 105bp, the AJ 129bp to 296bp, and AA 146bp to 643bp, all new tights since January. The subprime ABX market, on the other hand, continued to lag badly. The AAA index rose modestly to 57.23 from 56.15, but the BBB and BBB- indices sank to new all-time lows. Fed rate-cutting expectations in the futures markets were scaled way back, with the market now expecting only one more 25bp rate cut to 2% at the upcoming FOMC meeting and then a move back to 2.25% as early as the December meeting. The May fed funds contract lost 12bp to 2.005%, July 17.5bp to 1.95%, and low rate August 20.5bp to 1.945%. The January contract plunged 34bp to 2.135%, pricing a rate hike as early as the December 16 FOMC meeting. The turmoil in the interbank lending markets severely intensified over the past week. 3-month LIBOR spiked 20bp on the week to 2.91%, having now risen 37bp since the low hit on March 18, the day of the last FOMC meeting, unwinding a significant amount of any stimulative impact from the 75bp cut at that meeting. Much of the surge in LIBOR appeared to reflect a correction of previously understated readings. Following a Wall Street Journal report on behind-the-scenes complaints that some of the 16 panel members submitting rates to the British Bankers’ Association were not accurately reporting their actual borrowing costs, the BBA confirmed that an investigation was underway and that any of the banks found to be submitting false rates would be booted from the panel. The sharp rise in 3-month LIBOR that followed these reports brought it much closer into line with 3-month eurodollar deposit rates, which had suddenly blown out relative to the official LIBOR fixing since the last week in March. Note that the last TAF auction, which was awarded at 10bp over 1-month LIBOR, was not awarded above where 1-month eurodollar deposit rates were trading at the time, so we knew there was at least some significant tiering of lending rates in the interbank market going on between the biggest and strongest banks and others, but the revelation that the LIBOR settings themselves may have been pegged artificially low was a surprise. Still, not all of the 20bp surge in 3-month LIBOR on the week was just a more accurate reporting by the panel banks, since 3-month eurodollar deposit rates also rose about 10bp on the week and have risen 35-40bp since March 18, in line with the move in LIBOR now. So notwithstanding an apparent partial technical correction in LIBOR this week, underlying conditions have also certainly deteriorated badly in the past month. Even with the major scaling back of near-term Fed rate-cutting expectations over the past week, the spike in 3-month LIBOR sent the 3-month LIBOR/3-month OIS spread up 9bp to 89bp, a new high for the year that is approaching the peaks hit in December after a major deterioration from a 38bp spread at the end of January. More striking was the blow-out in forward spreads, as investors now see no prospect of any meaningful improvement in the foreseeable future. The Jun 08 eurodollar futures contract plunged 45bp on the week to 2.91% versus an 18bp rise in the average rate on the overlapping June, July and August fed funds contracts to 1.97% for a 95bp spread, up from 67bp a week earlier. The Sep 08 eurodollar contract lost 58.5bp to 2.835% versus a 27bp rise in the average rate on the September, October and November fed funds contracts to 2.01% for an 82.5bp spread, up from 51bp a week earlier. And the Dec 08 eurodollar contract lost 58.5bp to 2.915% versus a 34bp rise in the average rate on the December, January and February fed funds contracts to 2.16% for a 76bp spread, up from 52bp a week earlier. We view these LIBOR/fed funds spreads as the best real-time indicator we have of the strains on the banking system and unfolding credit crunch that has driven the economy into recession, and clearly the situation in these markets is deteriorating badly. The big blow-out in spot and forward LIBOR/OIS spreads caused turmoil in the swaps market, sending spreads sharply wider through early Thursday, though they came off a good bit the rest of the day Thursday and through Friday. On the week, the benchmark 2-year spread rose 8bp to 90.5bp after reaching as high as 102bp early Thursday, the 5-year spread rose 3bp to 85bp after trading as high as 99bp, and the 10-year spread rose 1bp to 65.5bp after reaching 76bp. Retail sales rose 0.2% in March, boosted by a small gain in motor vehicle sales that contrasted with the decline in unit sales (which are what matter for GDP purposes). Ex-auto sales gained 0.1%. Weakness continued in the direct housing-related components − furniture (-0.3%), building materials (-1.6%) and electronics and appliances (-0.4%). And, roughly in line with the soft chain store sales results, general merchandise (-0.6%), clothing (-0.5%) and drug stores (-0.1%) were all down, though the clothing drop was a good deal smaller than implied by the terrible chain store results, possibly as a result of seasonal adjustment issues with the unusually early Easter. Offsetting upside came from rebounds in gas stations (+1.1%) and food stores (+0.4%), and good gains by non-store retailers (+2.1%), a majority of which is internet-only stores, and sports, books and music (+1.4%). The key ‘retail control’ component that feeds into GDP gained 0.3%, better than the flat reading we had assumed. And translating the CPI results, we also lowered our estimate for overall core PCE inflation in March to +0.2% from +0.3%. The upside in retail control and lower inflation estimate boosted our 1Q consumption forecast slightly to +0.8% from +0.6%. A partial offset to this came from a lower-than-expected 0.1% rise in retail ex-auto inventories in February and a downward revision to January (+0.2%). Combining the slightly higher consumption estimate and a slightly lower forecast for the inventory contribution to 1Q growth (which we now see at +0.5pp), we boosted our 1Q GDP forecast marginally to -0.1% from -0.2%. Even with a late quarter boost from tax rebate checks, we see 2Q consumption on pace for a small decline. Housing starts plunged 11.7% in March to a new low of 947,000 units annualized. Single-family starts continued plummeting, falling another 5.7% to 680,000. And after plunging 40% to a 13-year low in December then rebounding a cumulative 62% in January and February, multi-family starts moved back down in March, falling 25% to 267,000. Single-family starts are now down 63% from the January 2006 peak, and we look for another 30% or so drop before a bottom is reached later this year. This should eventually lead to a correction in the bloated inventory of unsold new homes, but the pipeline of ongoing construction still needs to be cleared, with the number of single-family completions in March a huge 39% above the level of starts. Still, if we get the further 30% drop in single-family starts we expect through year-end and some stabilization in sales, currently extremely bloated inventories of unsold new homes should come down towards a more balanced level of six months’ supply by year-end. As far as sales, declining home prices and falling mortgage rates have already lifted housing affordability to the upper end of its historical range. The further 5-10% decline we expect in home prices through year-end would raise affordability to an all-time high and likely help set a bottom for sales. So, while the credit crunch rolls on with no end in sight, we see the housing market adjustment at least as well underway and believe that a bottom could be hit over the next year, though only after a lot of additional pain on the way there. Inflation results were mixed over the past week. Consumer prices weren’t nearly as benign as the surprising flat readings posted in February, but still relatively restrained thanks to tough seasonal factors this time of year. Meanwhile, the core finished goods producer price index was restrained, but otherwise the PPI report was a mess. The consumer price index rose 0.3% in March for a 4.0%Y increase, boosted by modest upside in energy, with seasonal factors offsetting a big rise in gasoline prices. Unadjusted gasoline prices were up 7%, but the seasonal factor converted this into only a 1% adjusted rise. A similar pattern should play out in April. Unadjusted gasoline prices have continued to surge to a series of record highs so far in April, but the seasonal factor knocks about eight percentage points off the actual change. Of course, this doesn’t matter for TIPS carry, which is based on the unadjusted CPI indices, which seasonally show their biggest upside in March and April. The core CPI rose 0.2% for a 2.4%Y gain, with mixed results across categories. On the negative side, hotels were down again, helping to restrain the key shelter component to only a 0.1% rise. Apparel posted its largest decline in a decade. New vehicles were down for a fourth-straight month. And medical care rose only 0.1% for a second-straight month. Offsetting this weakness were pick-ups in various categories, including recreation, communication and personal care, a surge in airfares and a slight pick-up in owners’ equivalent rent to +0.2% from the unusually low +0.1% in February. Meanwhile, the producer price index surged 1.1% in March for a 6.9%Y gain, boosted by major upside in both food (+1.2%) and energy (+2.4%) prices. The core was much more tame at +0.2% (+2.7%Y) after above-trend gains in January and February, as drug price gains moderated after surging the prior two months; motor vehicle prices declined slightly, and there was broad moderation in capital goods. News at earlier stages of production was ugly, with sharp gains in both headline and core intermediate and crude goods prices. The core intermediate index (+1.1%) posted one of its biggest gains since the early 1980s on big gains in chemicals, fertilizers and metals. The core crude (+3.5%) spiked again, boosted by sharp gains in various scrap metals. With global growth remaining resilient even as the US economy rolls over and exports consequently continuing to show strength, this has been and likely will continue to be an atypical recession in which the manufacturing holds up much better than it normally does in a recession. This was seen in both the March industrial production report and mixed results from the early regional surveys for April. Industrial production posted a modest 0.3% advance in March. The key manufacturing gauge was only up 0.1%, with a plunge in motor vehicle production as a result of strike disruptions a significant drag. Overall motor vehicle and parts output plunged 5.4%, with motor vehicle assemblies down 6.5% to their lowest level since the worst of the 1998 GM strike in July of that year and before that 1992. The American Axle strike has caused widespread shutdowns on GM plants and will likely have further significant negative impacts on factory output and jobs in April. Outside of motor vehicles, though, factory output gained a solid 0.4%. Looking to April, the often well correlated Empire State and Philly Fed surveys hugely diverged. On an ISM-comparable weighted average basis, the Empire survey improved to 51.0 from 49.6, but the Philly Fed fell to 44.0 from 45.6, a low since 2001. It’s hard to know what to make of this huge divergence, so we’ll be looking for more clarity from the other regional surveys to be released over the next week-and-a-half, but the Philly and Empire State results taken together suggest that the national ISM might have held modestly below the 50 boom/bust in April for a third-straight month and fourth month in the last five. There’s a light economic calendar in the coming week. The Fed is in its pre-FOMC meeting quiet period, so we shouldn’t hear anything substantive from it. Supply will be a big focus, with an US$8 billion 5-year TIPS being auctioned Tuesday and then a 2-year Wednesday and 5-year Thursday. Terms of the 2-year and 5-year auctions will be announced Monday. Sizes for these issues, which have already moved up substantially in recent months, will likely move up further in coming months, but April being a month of heavily negative net debt issuance as tax receipts pour in, we expect the sizes to be held at US$28 billion and US$18 billion this month. Data releases due out include existing home sales Tuesday and durable goods and new home sales Thursday: * The pullback in the pending home sales index to a new low in February below the prior trough hit in August suggests that existing home sales will reverse the surprising increase posted last month, so we look for a pullback to a 4.89 million unit annual rate in March. * We expect durable goods orders to fall 0.5% in March. Further weakness in motor vehicle orders, with activity significantly restrained by the American Axle strike, is likely to be the main contributor to a third-straight decline in orders. We look for a partial rebound in machinery after an extraordinarily large decline last month, however, to lead to a 1.2% gain in the key core gauge, non-defense capital goods ex-aircraft orders. * We forecast March new home sales of 584,000 units annualized. The homebuilders’ survey has remained at a very weak level but shown some improvement over the past few months, suggesting that new home sales might be approaching a bottom. So, we look for another relatively small (-1%) decline in March.
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Latin America: The Decoupling Paradox
April 22, 2008
By Gray Newman | New York
In the first months of 2008, Latin America’s economic performance is shaping up like a decoupler’s dream. It may turn out, as I contend, that we are simply living in the ‘land of the lags’ and that the year will end differently than it has begun, with the region’s growth story fraying on the edges. But so far, the data from the region are enough to make the ‘safe haven’ camp proud. Decoupling Dream Just last week Peru announced that monthly real GDP grew by 11.9% in February. And February’s reading does not appear to be a fluke. After a bit of a ‘breather’ during 3Q07, Boris Segura calculates that trend growth in Peru reaccelerated in October and is now running near 10%. In Brazil, industrial output was up 9.7% in February. In Argentina, February’s GDP proxy was up 8.8% in real terms. Even Chile’s industrial sector, which is facing serious energy problems, posted a better-than-expected 5.7% jump for the month. Indeed, nowhere is the contrast more telling perhaps than in Mexico. While Mexico is not enjoying the high single-digit growth seen in most of commodity-rich Latin America, this is not surprising. Other than oil (where production continues to plummet), Mexico exports few commodities. And unlike the rest of Latin America, Mexico’s link with the US dominates much of industrial activity and nearly all external trade. What is surprising is just how well Mexico is faring, given the downturn in the US. January’s GDP proxy was up 4.2% – well above the average for last year – and a host of indicators suggest that February should be strong as well in Mexico. From import demand (with or without gasoline imports) to investment spending to car sales, there are plenty of signs of strength in 1Q. That isn’t to say that there are no signs of softness. But our search mission in Mexico for the ‘slowdown smoking gun’ – evidence of a more pronounced downturn that breaks the trend seen in activity during last year – has come up empty handed (see “Mexico: Three Anomalies”, EM Economist, April 11, 2008 and “Mexico: In Search of the Slowdown”, EM Economist, March 14, 2008). Indeed, Mexico’s GDP in 1Q08 (once adjusted for Semana Santa) is likely to post a number close to the 3.8% seen in 4Q07. We are looking for GDP growth in 1Q at 3.5%. Mexico’s central bank admitted as much in its April 18 communiqué when it held interest rates unchanged and stated that the first data releases for 2008 suggested that the economy was reaccelerating. This stands in contrast to the previous communiqué, in which Banco de Mexico argued that the economy appeared to be continuing to slow as the year began. The region’s robustness in the first months of the year goes a long way towards explaining why central banks in Latin America continue to buck the Fed’s easing cycle. The Fed’s aggressive rate-cutting cycle has coincided with ten rate hikes in Chile, Peru, Colombia, Mexico and now Brazil since last September. Whatever the Fed is seeing on the growth front, it certainly isn’t driving Latin American policy makers in the same direction. Indeed, they are moving in the opposite direction. The latest example came from Brazil’s central bank, which hiked interest rates by more than investors were expecting on April 16. The hike in overnight rates by 50bp to 11.75% came even though inflation is within a rounding error of the central bank’s target and 12-month expectations remain below the target. The Brazilian central bank does not appear likely to stop with one 50bp move, and our team sees more rate hikes coming from central banks in Peru, Colombia and Chile. The rationale for the rate-hiking cycle in much of the region seems straightforward – growth in Latin America remains above trend and above almost any measure of potential output. While no central bank in the region will argue that its own monetary policy can revert the food price shock, almost all are concerned that the food price pressures can morph into broader inflationary pressures when economic growth is robust. ‘What If?’ Let’s imagine for a moment that the decoupling camp has it right – that strong demand from emerging economies will mean that the US downturn has little, if any, effect on growth in Latin America. I’ve been arguing since late last year why I’m skeptical of the decoupling thesis and I am not throwing in the towel (see “Emerging Markets: Emerging Questions”, EM Economist, August 31, 2007). But I think that ‘what if’ exercises are useful. The consequences of full-blown decoupling, I fear, are more disturbing than most think. I’d highlight three principal points of conflict: Decoupling Disease First, be on the lookout for a much more prolonged hiking cycle by central banks in the region if decoupling continues. The biggest surprise would likely be Mexico. When the Fed intensified its easing in January, many Mexico watchers thought that Banco de Mexico wouldn’t be far behind. This view has been discredited now, with the central bank admitting in its most recent communiqué that it had underestimated food price pressures and that it would be raising its inflation forecast at the end of April. Despite this, no one appears to be contemplating an additional hike. In a world in which decoupling holds, Mexican aggregate demand is likely to suffer little thanks to high oil prices boosting fiscal outlays and decent industrial production growth as non-US demand keeps US industrial production from rolling over. Recall that the price for Mexico’s oil is running at nearly twice the budgeted price, and most of it must be spent. Much to the chagrin of Mexico’s central bank, strong global demand could keep pressure on foodstuffs and energy and push Mexican inflation even farther from the 3% target for even longer. Mexico’s central bank is not the only one at risk of having to hike further. From Chile to Peru to Colombia, central banks appear to be counting on a slowdown in global demand to help out on the inflation front in 2008. There is no other way to read Chile’s decision in February to stop hiking interest rates and remove its tightening bias in April even though inflation is still running near its 12-year high. Indeed, both the Colombian and Peruvian central banks have gone on the record in their latest inflation reports that they expect slower global growth to help ease aggregate demand pressures at home as well as diminish imported inflation. If the decouplers are right, count on more hikes from Colombia and Peru, count on a resumption of hikes by Chile and prepare for Banco de Mexico’s next move to be a hike rather than a cut. My suspicion is that the central bank of Brazil’s move last week was also premised on the globe slowing later in the year. I suspect that the central bank expects a slowing global economy to do some of the work for it and hence reckons that the hiking cycle can be relatively short-lived. There may also be some concern at the central bank that weakness in global activity could produce a bout of currency weakness and that it wants to signal today that it will not tolerate broad contamination of prices if currency pass-through once again rears its head. Our Brazil economist, Marcelo Carvalho, expects a longer hiking cycle (200bp) than I do. But we both agree that it is hard to determine how much the central bank will have to do. After all, inflation is just slightly above the central bank’s midpoint of 4.5%, while 12-month and 2009 expectations at 4.4% remain below the central bank’s target. If the decouplers are right, I suspect that we will both find the central bank hiking much more than we expect. Second, a prolonged period of decoupling is likely to produce a significant deterioration in the region’s balance of payments while undermining the region’s manufacturing base as a handful of commodities reign. The upshot of higher interest rates is likely to be continued currency strength as widening interest rate differentials keep the carry trade alive and well. And given the limited degree of financial intermediation, I suspect that central bank policy will be less effective at slowing demand, especially as consumers find the purchasing power of their currencies enhanced. Of course, higher food prices hit the region’s consumers as well, but decoupling likely means a continuation of the rapid import demand that we are seeing around the region. Manufacturers are likely to continue to suffer from a form of Dutch Disease, which I will call ‘Decoupling Disease’, as a strengthening currency undermines their ability to hold their own with the commodity export sectors. You can debate whether the demise of the manufacturing sector in Latin America – where productivity should be high thanks to global competition – is a good thing or not, but it seems the likely consequence of prolonged decoupling. In a way, boosting domestic demand in the region and the return to current account deficits is precisely what ‘global rebalancing’ has always been about. However, the risk is that the burden of strong consumption in Latin America – where savings rates have long been low, and where public and private investment have long lagged Asia – may be to the detriment of the region’s long-term health. Third, be prepared as tensions heighten between policy makers in the region over how to respond to abundance in overdrive. We’ve already seen central banks engage in massive dollar-buying sprees in an attempt to limit the currency impact from higher interest rates. And in numerous cases, the moves have raised doubts about the central bank’s commitment to its inflation target, especially in countries where inflation has yet to reach the long-term target. Meanwhile, the authorities have also responded with a series of capital controls and taxes to limit portfolio inflows from taking advantage of widening interest rate differentials. Continued decoupling is likely to provide a further challenge to central bank autonomy, which remains largely untested in the region. Decoupling is almost certain to prompt more calls for capital controls, intervention in the currency markets and new taxes to limit inflows. Perhaps nowhere is the risk of a conflict greater than in Brazil, where over 30% of the public sector’s total (domestic and external) debt stock is linked to the overnight interest rates. Add in short-term debt (coming due in less than one year) and nearly 60% of Brazil’s total debt is vulnerable. Every 100bp of Selic hikes, all other things being equal, represents the equivalent of nearly 1% of the federal government’s budgeted primary spending. Bottom Line I continue to expect US weakness to spill over to other developed economies and to produce slower growth in Latin America and in other emerging economies as well. This is hardly reason for alarm. Indeed, the good news is that I expect Latin America’s largest economies to demonstrate how they can withstand a period of global weakness without falling vulnerable to the kind of financial accidents and crises of the past. In contrast, the greatest risk to the region is if the decoupling camp is right. I am afraid that prolonged decoupling will keep inflation risks higher, given the importance of food in the region’s consumption basket, and pit central banks against other policymakers and ultimately damage the autonomy and credibility of the region’s central banks. The consumption boom might be enjoyable at first and drown out concerns that export sectors are becoming narrower and more vulnerable. Indeed, many companies today are doing a booming business in countries in the region where the most strident heterodox policies limiting exports and capital flows have been introduced. But, ultimately, this is a worrisome path for the region. Decoupling has long been the dream of the safe haven camp. I would be careful what you wish for.
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Peru: An Inflation Dilemma
April 22, 2008
By Boris Segura | New York
We have been warning about the possibility of a broader inflationary bout in Peru after the inflation surprise early in the year and heavy currency intervention by the central bank since (see “Peru: Monetary Policy Dilemmas”, EM Economist, January 22, 2008). Inflation has moved up indeed, much higher and faster than expected by the monetary authorities. The move was initially driven by imported food inflation, but there are increasing signs that rapid growth of domestic demand, well above potential GDP growth, is putting pressure on inflation. This inflation dynamic is likely to have monetary policy as well as currency implications going forward. We’ll examine those consequences in this note. The Inflation Genie Is Out of the Bottle Earlier in the year, the Banco Central de Reserva del Peru expected inflation to peak at around 4.5%Y by May. The central bank’s diagnosis was that inflation was mostly food-driven and – given that world commodity prices were peaking – domestic inflation would likely peak as well. There is no doubt that food inflation is playing a role in pushing up Peru’s headline inflation. As food items in Peru represent the highest weight in the consumer price index of the region’s major economies, food inflation has had a disproportionate effect on Peru’s inflation. In fact, inflation excluding food is running at a 2.3%Y clip. But we are concerned that there is another major force behind the recent inflation burst – an overheating economy. After a brief deceleration in 3Q07, GDP closed the year on a roll, rising 9% for the full year. Early releases this year indicate that the economy has accelerated even more; February’s GDP was up 11.9%Y. We now project 2008 growth in economic activity at 8%, a revision upward from our previous forecast of 6.3%. This would make it the third year in a row of above-potential growth, estimated at somewhere between 6% and 7%. Keep in mind that the statistical drag alone from 2007 would set a floor of 5.2% for growth this year. Indeed, core inflation – which in Peru has some overlap with rising food prices but also provides some insight into the relative strength of domestic demand and domestic supply – has been steadily rising. Core inflation rose 3.11% in 2007, well above its 1.37% reading in 2006. In the first three months of the year, core inflation reached 3.59%Y through March. We expect inflation to rise to near 6%Y by April, breach that level later in the year and only converge to 5.5% by the end of this year, compared to our earlier forecast of inflation of 2.2%. 2008 would represent the second consecutive year when the central bank misses its inflation target, which remains at 2% with a tolerance of +- 1%. Producer price inflation represents inflationary pressures in the pipeline. Despite the appreciation of the Peruvian sol by 12% over the last year, producer prices grew to 8% from a flat reading a year ago. Within the context of strong domestic demand, producers might be more able to pass on increasing costs to prices paid by consumers. Monetary Policy Implications The Banco Central de Reserva del Peru began its tightening campaign back in July 2007. So far, it has hiked its reference interest rates four times, to 5.50%. It has also raised reserve requirements on bank deposits three times this year, the equivalent of an additional 125bp of tightening, according to central bank calculations. We are of the opinion that increases in reserve requirements are a complement to and not a substitute for higher reference rates. If done frequently, raising reserve requirements dilutes the monetary policy signal sent by the authorities, and is unlikely to have the same effect as outright rate hikes. In fact, bank credit is growing at a rapid pace, with consumer credit growing at rates above 50%. Available data to February do not suggest any let-up in the pace of credit growth. We suspect that higher rates and reserve requirements will begin to bite soon, but are doubtful of the timing and magnitude of the credit slowdown and its cooling effect on aggregate demand. We expect at least two more reference rate hikes in the remainder of the year to 6%, up from our previous forecast of 5.75%. As inflation releases are likely to deteriorate going forward, we suspect that the central bank will be forced to hike its reference rate at least twice. Currency Implications Given our expectation that inflation will remain a problem for longer and prompt the central bank to hike by more, we are revising our currency forecast. We now expect the Peruvian sol to end the year at 2.60, from our current forecast of 2.95. In addition to the central bank’s tightening cycle and favorable external conditions, we believe that de-dollarization (or reverse currency substitution) is also playing a major role in the trend appreciation of the Peruvian sol. Although de-dollarization in Peru has been steady over the decade, it has actually gathered speed since late last year. In this environment, domestic agents tend to raise both the demand for soles and the supply of dollars, bringing appreciation pressures on the sol. A major driver of this reverse currency substitution is a deliberate policy by Peru’s fiscal authorities to de-dollarize their debt, via skillful debt management. In particular, the sol-denominated portion of the public sector debt is projected to double at the end of this year to 40%, from just 20% in late 2006. The central bank has also done its part, by imposing higher reserve requirements on dollar bank deposits (and its non-remuneration) vis-à-vis local currency ones; this increases the rate of return attractiveness of both saving and borrowing in local currency. We suspect that there are balanced risks to our call. On the downside, a sharp fall in commodity prices is likely to bring about depreciation pressures on the Peruvian sol. This would be the case if the US malaise were exported to Europe and Asia, putting downward pressure on demand for commodities. But we are not certain of the timing of this event at this point. Another possible downside risk to our call is a sudden portfolio rebalancing by foreigners. The increase of international reserves since last November matches almost exactly the higher stock of certificates of deposits (and outright deposits) issued by the central bank. However, since early in the year, the central bank has all but eliminated the possibility of non-residents positioning themselves in short-term central bank CDs. Therefore, when existing CDs in the hands of foreigners begin to mature early next year, there is a chance that either they cannot position themselves in short-term instruments or that they are not willing to extend duration. In this case, we would get an exit of fixed income foreign investors from Peru, a policy objective in itself for the central bank. However, there is upside risk to our call as well. It would come in the case that S&P decides to award the investment grade rating to Peru’s foreign currency debt. We expect this to happen in 2H08. The differential between Peru’s reference rate and the US fed funds rate is also likely to keep the Peruvian sol well supported. The unsynchronized nature of the business cycles in the US and Peru is likely to keep attracting capital inflows into Peru. Bottom Line In order to fight off inflation, we believe that it is likely that the central bank tightens monetary policy more than expected and tolerates a stronger currency. With the inflation genie already out of the bottle, we suspect that more rate hikes will be needed to anchor inflation expectations going forward and reduce the risks to the monetary authorities’ hard-won credibility.
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