The Fed Moves Towards Balanced Risks
April 30, 2008
By Richard Berner & David Greenlaw | New York
We now think that the Fed will lower the federal funds rate by 25 bp to 2% at this week’s FOMC meeting, and that 2% will represent the trough in rates for this cycle. Previously, we thought that the trough would be at 1.75%. The difference is more than cosmetic; it reflects our and likely the Committee’s sense that upside risks to inflation are now nearly as important as the downside risks to growth.
Policymakers for some time have appeared to be following the market’s rate expectations, rather than leading the way. This time is unlikely to be different, with financial markets now repriced to a funds rate trough of 2%. However, officials themselves deliberately played a role in the recent reshaping of market expectations away from a 50 bp move. They have voiced inflation concerns, and articles in the press have indicated that the choice will be between no change and a cut of 25 bp, with the majority leaning toward the latter. Officials will not want to take any policy option off the table, given the uncertainties surrounding the outlook. But the statement issued at the conclusion of the meeting may well hint that the FOMC is prepared to move to the sidelines for a while. Indeed, the $115 billion of rebate checks that will be distributed starting this week would appear to give the Fed a perfect opportunity to pause. Looking ahead, we think the Fed will keep policy on hold for the balance of this year. That forecast reflects our view that downside risks to the economy will persist into early 2009. It gives the Fed options: If the economy weakens significantly again after the temporary impact of the fiscal stimulus fades away, the FOMC could certainly cut rates further. However, our base case is that the economy does not double dip, and therefore we continue to expect the Fed to remain on hold through the second half of the year. A renormalization of monetary policy (i.e., tightening) is likely to begin around mid-2009. Rising Inflation Risks The growth risks surrounding this outlook are all too familiar, but renewed upside risks to inflation are a relatively new development. Moreover they are complex, as it appears that for the first time since the 1970s, global forces likely will keep US inflation elevated and could push it higher. The ingredients: soaring energy, food and commodity quotes, a weaker dollar, and rising inflation expectations. As a result, we think US headline inflation will remain near 4% through September. A weakening US economy will eventually cap inflation, as the housing bust promotes a deceleration in rents and as slack in the economy undermines pricing power. But the relationship between slack and inflation has loosened in the past few years, so barring a significant downturn, underlying inflation will be sticky as sellers pass through some of those cost increases into retail prices (see “Upside Risks to Inflation”, Investment Perspectives, April 24, 2008). Such a mix of inflation sources complicates life for the Fed, because much of the recent rise in energy and food prices appears to be more the product of supply restrictions than of increases in demand. Monetary policy has no control over such supply shocks, and theory suggests that the Fed should tolerate at least a portion of these price increases, based on the idea that the shocks are temporary and that they may undermine growth as much as they push up inflation. Tolerating supply-induced price shocks may be easier for the Fed than it is for the ECB, because such shocks seem less likely to promote “second-round” wage increases in the US than in Europe. Nonetheless, the Fed must be alert to the possibility that the pass-through of energy, food and import prices will boost underlying inflation and inflation expectations. That the University of Michigan’s canvass of consumer 5-10 year ahead median inflation expectations in late April moved up to 3.2% is a warning flag. In the case of energy, the restraints on supply include a typical array of refinery fires, strikes in oil-producing countries, attacks on an oil pipeline and on Nigerian oil facilities, tensions in the Persian Gulf, and a strike at a Scottish refinery. More important, the press is full of stories about declines in Saudi crude output. The upshot is that market participants seem likely to hoard crude on the expectation of supply shortages. In addition, while food prices have been accelerating for two years, the recent jump appears to involve fears of supply shortages and the growing consensus that US first-generation biofuels policy has diverted corn from the food chain in a way that threatens to disrupt the food supply-demand balance. Downside Risks to Growth Meanwhile, the downside risks to growth have increased slightly since the last FOMC meeting, mostly because of the escalation in energy quotes. The main threats to economic activity continue to come from tight financial conditions, declining housing demand, falling home prices, and supply-induced hikes in energy prices. The good news is that, with the glaring exception of Libor money-market rates, financial conditions have eased somewhat since the last FOMC meeting in March. Credit spreads have narrowed and stock prices have risen by 10%. The pace of writedowns and capital-raising at banks and investment banks has intensified, and investors in many cases are welcoming the actions. Banks are readily selling blocks of troubled assets to private equity and hedge funds. The bad news is that while existing home sales may have steadied, new home sales continue to plummet and home prices continue to decline. And gasoline prices have jumped by about 25 cents/gallon. So the case for a mild recession is still intact, and it is now part of the Fed’s own forecast. Time for Fed to Pause Reflecting those risks, the Fed has eased aggressively over the past eight months; now it’s appropriate to pause and take stock. The economy has yet to contract; it appears that first-quarter growth may have been slightly positive as incoming data for consumer and capital spending and trade are somewhat firmer than we and likely the Fed have expected. As a result, slack in the economy likely has not increased by enough to give the Committee comfort that inflation will decline soon. To be sure, labor markets have softened, so that the unemployment rate has risen by 0.7 point; and the operating rate in manufacturing in March fell to 78.5 percent, a level 1.2 percentage points below its 1972-2007 average. However, it typically takes more significant increases in economic slack to promote a deceleration in inflation. Moreover, there are offsets to the economy’s downward momentum in the form of coming fiscal stimulus, the lagged effects of monetary ease, and ongoing support from healthy global growth. Still Expect a Bear Steepening For their part, investors seem uncertain about the outlook, although they agree that the Fed has greatly reduced systemic threats to financial markets and institutions. The markets’ recent rallies have apparently also revived hope that the mild recession, which was in the price in mid-March, will soon give way to a moderate and sustainable second-half recovery. Accordingly, financial markets have repriced to the 2% trough in Fed funds that we expect. That has entailed a significant bear flattening of the yield curve. In contrast, we agree with rates strategists Jim Caron and George Goncalves that bearish fixed-income investors should play the bear steepener. So long as downside economic risks balance off the upside risks to inflation, the Fed is unlikely to tighten monetary policy, and that will anchor short-term rates. But inflation or uncertainty about inflation will probably push the inflation component of yields − that is, breakevens − and the inflation component of bond term premiums higher. Moreover, from a technical perspective, a shift to longer-term debt issuance may magnify the steepener. As a result, we see longer-term yields rising past 4% by this summer. In contrast, two-year yields are likely to remain stable for now.
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No Hurry to Hike
April 30, 2008
By Gray Newman & Luis Arcentales | New York
Since the beginning of the year, the biggest question for watchers of Mexico’s central bank has been when would Banco de Mexico ease its monetary stance. That question is now morphing into a new one: will Banco de Mexico hike interest rates and if so, when? Our answer to the second question is the same as our answer to the first − not anytime soon. We maintain our view that the most likely outcome in 2008 is for Mexico’s central bank to keep its policy rate unchanged at 7.5%. The debate over monetary policy in Mexico is likely to heat up in the coming months. That doesn’t mean that those calling for a rate hike will be as adamant as those who until just a few weeks ago had called for an imminent rate cut. First, in many cases those calling for a rate hike are likely to be the same central bank watchers who had called for a cut. Being forced to reverse a call can often lower the level of conviction. Second, with the Fed still likely to cut interest rates once again and given concerns that Mexico’s economy will soon begin to show clearer signs of deceleration, I suspect it will be harder for the rate hiking camp to gain as many adherents. Nonetheless, while the new rate hiking camp may not be as adamant nor as numerous as was the rate cutting camp earlier this year, I suspect that the balance of inflation risks have shifted and that the monetary policy debate in Mexico will shift with it. Banco de Mexico is likely to shift the debate further when it hikes its quarterly inflation guidance this week. We expect that the central bank will raise its quarterly inflation guidance for each of the remaining three quarters of 2008 and likely increase the forecasts for 1Q09 and 2Q09 as well. While the central bank admitted as much in its April 18 communiqué when it stated that higher-than-expected food and commodity prices were likely to push inflation beyond the path in the coming months, I am concerned that the new forecast path could raise questions regarding the central bank’s commitment to its inflation goal. For the record, we do not believe that Mexico has an inflation problem. We largely agree with the central bank’s assessment repeated in its October quarterly report as well as again in its January quarterly report that most of the uptick in inflation has come from external shocks, mostly food but also from other commodities (energy and metals) which, as of yet, have not contaminated long-term expectations or wages. Indeed, we have been arguing for years that Mexico does not have an inflation problem (see “Mexico: What Inflation Problem?”, This Week in Latin America, November 15, 2004). While Mexico does not have an inflation problem, it does have an inflation target problem. My concern is that the central bank’s upcoming revisions to its inflation path may raise questions regarding the centrality of Banco de Mexico’s inflation target. A Path Is Just a Path After years of internal discussions, Banco de Mexico first released an explicit quarterly inflation path with a two-year horizon in October 2007. At the time, the central bank admitted that the external shock was so large that it would unlikely to reach its 3% target until 3Q08 − near the end of the two-year horizon when it saw inflation in the 3-3.5% range. Furthermore, the central bank admitted that during 1H08 inflation would likely range (4-4.5%) above the upper confidence interval of 4%. Recall that Banco de Mexico has a 3% target with a confidence interval of plus or minus 1%. There was some concern when the quarterly path was first released that any subsequent changes might raise questions regarding the central bank’s ability to forecast. Others were concerned that the path might be misunderstood by some observers as acquiescence by the central bank to a level of inflation above the target. Indeed, although the central bank did not explicitly state that the forecast quarterly ranges were acceptable levels, both its actions and the subsequent communiqués suggested as much. When headline and core inflation began to rise in the first months of 2008 and moved farther from the 3% target and above the 4% upper interval, Banco de Mexico did not tighten monetary policy. Instead, in each communiqué, the central bank highlighted the fact that while inflation was on the rise, it “remained within the range forecast by Banco de Mexico since last year”. And each communiqué the central bank emphasized the importance of inflation reaching the target “in the expected time”. The suggestion, while never explicit in the communiqués, was that if inflation moved outside of the forecast range or if it did not appear that it would return to the target within the forecast period, such a move could trigger a monetary response. And therein lies the difficulty facing Banco de Mexico today. By moving the range upward (we expect a new range to reach 4.75% or even 5% at mid-year without tightening interest rates), Banco de Mexico opens itself to the criticism that it is moving the goal posts after the game has begun. Banco de Mexico is likely to respond to this criticism highlighting four arguments in the quarterly inflation report. First, we expect Banco de Mexico to underscore that the bulk of the shock has come from external factors that have plagued inflation indices around the world. No central bank and no consumer inflation index the world over have been spared. Second, we expect Banco de Mexico to highlight that if there is any economy at risk from a US slowdown, it is Mexico, given the strong links from trade to remittances. The strong growth in 1Q notwithstanding, Banco de Mexico believes that the risks for Mexico’s growth in 2008 are for a slowdown and indeed is likely to cut its GDP forecast for 2008 from 2.75-3.25% to 2.5-3.0%. Third, we expect Banco de Mexico to indicate that the inflation forecast is simply a path, not a tool or a guideline that requires it to act if there is any deviation. Fourth and finally, Banco de Mexico is likely to reiterate that it has seen no contamination of other prices or of long-term expectations despite the external food and commodity shocks, as well as the pressure from the new corporate alternative minimum income tax. We agree that this is a favorable development. Look, for example, at core inflation during the past four years. Despite repeated shocks, the latest being processed food, aside from food items, we have seen no measurable impact on other core good prices nor has services inflation shown any meaningful upturn. Put simply, as we have long argued, Mexico does not have an inflation problem despite the temporary uptick in March and again in the first half of April that are producing some of the highest annual inflation prints in more than five years. There is, however, a problem with Banco de Mexico’s defense: it can just as easily be used to justify 5% inflation as it can 6% or even higher. This new path announced this week is expected for the first time to include inflation for 1Q10. What would happen if the central bank announced that it did not see inflation returning to its 3% goal until 1Q10? We don’t expect that to happen. We expect Banco de Mexico’s path will have inflation reaching the 3% goal by 3Q09 or 4Q09. But what if reaching the goal was postponed a quarter or two after the decision in mid-April not to hike interest rates? In that case, we fear that the central bank would be running a significant risk that market participants would begin to question the centrality of its target. We are afraid that the same would apply if the inflation variance at mid-year were significantly higher. As much as the central bank will argue that the path is just a path, significant variance from the path or a significant extension in the duration of the shock that does not produce a monetary response is likely to raise questions as to the primacy of the central bank’s 3% target. Balance of Risks Banco de Mexico appears to be in a dilemma seen among most central banks across the region: the uptick in inflation is coming largely from abroad, and while growth is currently gaining ground, it is likely to slow later in the year as the impact from the US downturn is felt. In Mexico’s case, despite the uptick in 1Q − look for the central bank to underscore that it sees the economy accelerating in 1Q relative to the pace in 4Q07 − Banco de Mexico will likely remind investors that the economy is not growing above potential. And Banco de Mexico believes that the risks to the downside for economic growth are likely to increase as the year progresses due to US weakness. With long-term expectations fairly well anchored and wages largely unchanged, Banco de Mexico appears to be in no hurry to hike. Our own concern is that at some point, Banco de Mexico may need to reintroduce the “balance of risks” discussion which contends that even if wages and long-term expectations are largely unchanged, the central bank could act if it sees the balance of risks increase that either event could take place. A more prolonged bout of food inflation or a sharper uptick could trigger deterioration in the balance of risks and prompt a rate hike. Bottom Line We largely agree with the central bank that despite a prolonged series of shocks from food, other commodities and tax changes, we have seen no change in price formation. There has been virtually no spillover from the goods or services directly involved to other items. That is good news and a testament to Banco de Mexico’s credibility. Furthermore, we expect (as does the central bank) that the economy will begin to show some signs of slowing in 2Q08 and 3Q08, taking off some pressure that aggregate demand could begin to kick in and create inflation pressures. But the risk to our view and the one held by Banco de Mexico is that “abundance in overdrive” could continue longer than we think (see “Latin America: The Decoupling Paradox”, EM Economist, April 25, 2008). Given those risks and the difficulty that Banco de Mexico still has it defining the centrality of its inflation target, we expect the central bank will have to adopt a more hawkish line in both the upcoming quarterly inflation report as well as in the communiqués in May and June. While we believe that the central bank is in no hurry to hike and will not need to hike, it needs to remind a market that has long been looking for an interest rate cut that a hike cannot be ruled out.
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