The Inflation Conundrum
May 02, 2008
By Joachim Fels & Manoj Pradhan | London
All talk, no action? Everybody talks about inflation, but market-based measures of inflation expectations have remained remarkably stable. We find this discrepancy between what investors talk about and what they seem to do puzzling. In this note, we discuss two possible explanations for this conundrum. One is that while inflation is currently a concern, most investors trust that central banks will ensure inflation stays in check over the longer term by taking appropriate action. Another is that market-based measures such as breakeven inflation rates may be distorted by crisis-induced buying of nominal bonds and thus do not reflect investors’ true inflation expectations. We present some evidence to suggest breakeven inflation rates are in fact distorted and true inflation expectations may thus be higher. However, we also think investors are still too confident in central banks’ ability and willingness to stem higher inflation in the coming years. Our bottom line: central banks are likely to keep missing their inflation targets in the coming years, and both true inflation expectations and breakeven inflation rates should rise over time.
The venom of Venice. That inflation is on many investors’ minds became very clear at Morgan Stanley’s 9th Global Credit Summit held in Venice last week. The assembled very senior group of clients represented a good cross-section of insurance companies, pension funds, asset managers, hedge funds, banks, private equity and sovereign wealth funds, with most participants coming from Europe and many being credit specialists. Asked about their main macro concerns, one-third of the crowd named inflation as their number one worry. And in the interactive polling, fully three-quarters of the clients expected US headline inflation to average 3% or higher over the next five years. Contrast this with the current five-year breakeven inflation rate from the US TIPS market, which stands at 2.2%! Remarkably, the group was at the same time very downbeat on the US economic outlook, and the majority did not believe in the decoupling theory, neither for Europe nor for China. So the big macro concern in the room was stagflation – the ‘venom of Venice’. Our credit strategist Neil McLeish, who organized the Summit, will publish a more comprehensive report on the conclusions from Venice shortly. The common view: central banks still in control. While these polling results on inflation from our Venice Summit are impressive (and close to our own views), we hesitate to say that they are representative of the view in the investment community at large. In general, we still get much pushback from clients against our view that global inflation will remain uncomfortably high in the next several years. The most frequent argument we hear is that central bankers are all inflation fighters these days and will do what is necessary to get inflation back to target, eventually. Will central banks hike rates this year? In fact, one possible reason why inflation expectations have remained low recently despite upside surprises to actual inflation around the globe is that markets assume central banks will react by cutting rates less aggressively or even hike interest rates later this year. Short rate expectations for many countries have been revised significantly upwards over the past month or two as inflation concerns have picked up. The Fed’s likely 25bp rate cut is now expected to be the last for this cycle, and markets are now almost fully priced for a first hike in 4Q08. The ECB is now expected to keep rates on hold this year − a sharp correction of expectations, which had called for more than three cuts earlier this year. Also, markets are pricing in a decent chance of a hike in Japan and in Switzerland before year-end, and look for only one or two more cuts from the Bank of England, against earlier expectations for up to four cuts. We doubt it. However, just as we thought market expectations for aggressive rate cuts earlier this year were exaggerated, we now think markets have corrected too far in the other direction. Our US economists think the fed funds rates will probably trough at 2% after the likely cut today (previously they expected a 1.75% trough), but think a rate hike this year is unlikely given their outlook for very weak growth following a temporary bounce in 3Q due to the tax rebates. In Japan, our BoJ watchers are no longer looking for a cut in 2Q in the wake of recent inflation surprises, but they think a hike this year is unlikely and there is still a good chance of a cut later this year. And in the euro area, our team is still looking for a rate cut in 4Q, once there are more signs of a significant economic slowdown. Hence, we expect growth concerns to dominate inflation concerns in the major economies. Targets tougher to achieve. Rate hikes or not later this year, the bigger question is whether central banks are still in control of inflation in their respective regions and, if so, whether small interest rate increases will suffice to bring inflation back to target. As we have explained in our earlier work, global factors have become much more important in determining national inflation rates over the past decade or so. These factors are no longer disinflationary but have turned inflationary, making it much more difficult for central banks to stick to their inflation targets, which typically date back to a time when globalization, deregulation and strong productivity growth, along with two decades of restrictive monetary policies, were still weighing down on inflation. That was then. Today, emerging market economies − through their very expansionary monetary policy stances and their hunger for food and energy − have become a source of global inflation. Also, the productivity boom has ebbed and governments are looking at re-regulating certain sectors, such as the financial industry. Last but not least, the global monetary policy stance has been very expansionary for most of this decade. All of this suggests to us that many central banks will have great difficulties meeting their inflation norms over the next several years. To be sure, in theory, they could still achieve their targets over the medium term. However, with the headwinds described above, this would require much higher interest rates and larger costs in terms of output than in the 1990s and early part of this decade. In today’s asset-dependent economies, we doubt many central banks will have the resolve to play it tough. Moving the goalposts? Against this backdrop, central banks face two equally unpleasant choices. First, maintain the targets but (very likely) continue to miss them in the next several years. Eventually, this would erode credibility and lead to a rise in inflation expectations. Second, acknowledge that the world has changed and adopt higher but more realistic targets. Of course this would invite criticism that central banks are moving the goalposts during the game. However, it is better to be open and transparent about the change, in our view, than to keep missing unrealistic targets year after year. In any case, we expect the debate about a possible change in inflation targets to heat up in the coming months and years. Breakeven rates distorted. Apart from many investors’ belief that central banks will do what’s necessary to keep inflation low eventually, we think there is another, more technical, reason why breakeven inflation rates are still so low. These breakeven rates are calculated as the difference between the yield on nominal government bonds and the real yield on inflation-linked government bonds of the same maturity. Due to the different relative size of the nominal and the inflation-linked markets, the former is much more liquid than the latter, introducing a liquidity premium in the so-called breakeven inflation rate. This liquidity premium varies over time and, importantly, is very likely to have increased significantly due to the ongoing credit crisis. With credit and equity markets under severe pressure during the crisis and high volatility, investors have been parking funds in government bonds as the perceived save and highly liquid haven. Moreover, as banks are struggling to get unsecured funding from other banks or money market funds, their demand for good collateral to secure collateralized lending has surged. Government bonds such as Treasuries and Bunds are the best collateral and thus trade at a premium. This is likely to have weighed down on nominal government bond yields and, as a side effect, also on breakeven inflation rates. MS FAYRE as a rough gauge of the distortion. Unfortunately, the size of this safe-haven and collateral premium is difficult to gauge. However, we can get a rough indication from comparing actual bond yields to MS FAYRE, as calculated from our fundamental fair value model for 10-year US Treasuries. In short, the model tells us where 10-year yields should be trading based on the empirical relationship between the real fed funds rate, survey-based inflation expectations and inflation volatility. Yields traded on average around fair value over a longer period. Since 2004, a period dubbed as the ‘bond yield conundrum’ by Alan Greenspan, bond yields were about 50bp lower than fair value. Since the start of the crisis, yields fell to, at one stage, 150bp below fair value. With the recent sell-off in bonds, the gap between fair value and actual yields has narrowed, but it still stands at around 100bp (fair value is currently around 4.75% while actual yields trade slightly below 3.8%). We attribute a large part of the widening gap between actual yields and fair value since the start of the credit crisis to safe-haven buying and the heightened demand for good collateral. If so, breakeven inflation rates are also depressed due to this factor, and true inflation expectations in the bond market are likely to be higher than this indicator suggests. Once the credit crisis abates and the exceptional demand for government subsides, breakeven rates should thus rise, revealing higher true inflation expectations. Bottom line. We think breakeven inflation rates are distorted downwards by safe haven buying and collateral concerns, and true inflation expectations in the bond market may thus be higher. However, even taking this factor into account, we think investors are still too confident in central banks’ ability and willingness to stem higher inflation in the coming years. Thus, central banks are likely to keep missing their inflation targets in the coming years, and both true inflation expectations and breakeven inflation rates should rise over time.
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BoJ Reverts to Neutral Policy Stance: April Outlook Report
May 02, 2008
By Takehiro Sato | Tokyo
Neutral Policy Stance Re-Assumed as Expected The direction of the BoJ’s April Outlook Report was as generally expected, with the forecast for the economy lowered and the price outlook raised in F3/09. Key areas of the Report offered no surprises, as a toned-down stance on policy normalization had also been anticipated. The downwardly-revised assessment of current condition in the bank’s April Monthly had foreshadowed these adjustments. The outlook for F3/10 is an optimistic case, envisioning the economy’s return to close to its growth potential and prices settling down. This too was in line with recent remarks by the governor. The bank was forced to tone down its policy stance in reaction to changing external circumstances, but is still somewhat upbeat on F3/10 and displays eagerness to resume policy normalization once the necessary conditions are in place. Upcoming data flow for the economy in Japan and overseas is likely to be encouraging, which has virtually killed off our scenario of a rate cut, and the markets are keenly anticipating the end of deflation as the CPI ticks up. We think the BoJ is likely to keep a low profile with a policy of entrenchment until core improvement in the domestic and overseas economies is evident, however. Clearly, this makes a proactive rate cut considerably more remote, but we think the chances of a proactive rate hike based on a so-called ‘second perspective (pillar)’ are even slimmer. Moderate Outlook on Growth Tag teaming by the Fed and US Treasury on March 16 averted a crisis in the financial markets, assuaging fears of a meltdown and allowing optimism to come to the fore. In such a climate, the BoJ has revised down its forecast for the economy in F3/09 to +1.5% (previously +2.1%), which is at the lower end of the upper 1% range it cites as the potential growth rate. The forecast for F3/10 outlined for the first time calls for the economy, at +1.7%, to revert to something close to its growth potential. With the real GDP growth rate in January-March likely to have reached about +3% annualized, the base effect for F3/09 would move up to about +1 point (from +0.4 point in our current forecast). That the BoJ would peg a real growth of 1.5% tops in F3/09 under such conditions is a cautious signal of a virtually flat growth within the fiscal year. Meanwhile, we think the F3/10 outlook is nothing more than a scenario given a myriad of uncertain factors. Cautious Outlook on Prices The BoJ has raised its forecast for the core CPI in F3/09 to +1.1Y (from +0.4%). The first indication on prices in F3/10 at +1.0% does not convey a particularly strong message, as the trend for primary product prices such as crude oil is murky, but the outlook calls for an increase comparable to that in F3/09, backed by food price inflation. Our price forecast, however, is imbued with more upside risk than the BoJ’s. This reflects the impact of another hike in the government’s resale price for imported wheat from April, and the reinstatement of provisional fuel tax surcharges on May 1. Another resale price hike for wheat is also coming in October. These elements make it possible that CPI inflation could settle in the upper 1% range going forward. Even so, we think the BoJ has offered up a cautious outlook on prices, heeding all conceivable upside factors. This tells us that the BoJ may be gingerly trying to avoid fanning expectations of a rate hike, and that is an important message. The point we are highlighting is that cost-push inflation of this type serves to lower real incomes. Larger trade losses due to worsening terms of trade will be coupled with a drag on real incomes from rising prices. Since these damage purchasing power in the economy overall, support for a policy rate hike will be lacking. Incidentally, given the high degree of uncertainty, the BoJ has decided to release, in addition to the Forecasts of the Majority of Policy Board Members, the aggregated probability distributions compiled from the distributions attributed by individual Policy Board members to the likelihood of divergence upward or downward from their forecasts (‘Risk Balance Charts’). According to this, the probability distribution for the real GDP growth in F3/09 is skewed to the left, which suggests that Policy Board members consider the downside risks to be greater than the upside risks, while the probability distribution for F3/10 is more or less evenly balanced, implying that Policy Board members attach similar probabilities to both upside and downside risks. Meanwhile, regarding the core CPI, the probability distributions for F3/09 and F3/10 are both somewhat skewed to the left. Such downward bias in the Risk Balance section of the bank’s price outlook is an intriguing foreteller of its future policy direction. As noted earlier too, this type of outlook on prices can also be taken as a message that the bank is in no rush to tighten. Upside and Downside Risks The Outlook Report cited the following upside and downside risks: (1) developments in overseas economies and global financial markets; (2) developments in energy and materials prices; (3) companies’ expectations of future growth; and (4) possible larger swings in financial and economic activity under continuing accommodative financial conditions. Note that in the previous October Outlook Report, the BoJ cited overseas economic developments and increasing volatility in financial and economic activity in the outlook for the economy, and uncertainty about the sensitivity of prices to the output gap and developments in the commodities market in the outlook for prices. Downside risks are more prevalent now than in the October Report. For instance, for risk (2), the bank mentioned that “…the outflow of income from Japan to abroad will increase”. Likewise, it cited possible downside risk to point (3) regarding companies’ expectations for future growth, “especially those concerning business fixed investment”. On risk (4), the bank also toned down its concerns about an overheated asset market, stating that “the recent economic slowdown seems to have reduced the risk that firms, households and financial institutions will overextend themselves”. Policy Implications There are stark contrasts between the bank’s October and April Outlook Reports, and they are as follows: October 2007: “The Bank will adjust the level of interest rates gradually in accordance with improvements in the economic and price situation”. April 2008: “Given the current situation where the outlook for economic activity and prices is highly uncertain, it is not appropriate to predetermine the direction of future monetary policy”. ”The Bank will implement its policies in a flexible manner”. The Bank also urged caution on downside risks in its so-called second perspective (second pillar) assessment, stating that “those that demand most attention are the downside risks to the economy stemming from uncertainties regarding future developments in overseas economies and global financial markets as well as the effects of high energy and materials prices”. The strong consensus of many market participants that Governor Shirakawa is a hawk should be largely dispelled by the conclusion section of the Report. We think he is a pragmatist on policy normalization, willing to adapt to changing circumstances, rather than dogmatic. The governor oversaw the BoJ’s external communications and compilation of the prevailing policy framework during his tenure as the executive director of the monetary affairs department, and as the recent April Monthly and this recent report show, he has the flexibility to reshape the economic assessment and strategy of the bank in accordance with changing external circumstances. The likelihood of a proactive rate cut has already receded significantly against the background below, however. First, the report is founded on the fair-weather understanding that the economy will not be battered by external shocks. Second, amid a string of downward revisions and guidance for plunging profits in F3/09 during the F3/08 results season, the stock market has swallowed that scenario and performed solidly, also supported by a succession of measures by overseas authorities to shore up the credit markets. Third, turmoil in both foreign exchange and credit markets has eased due to the prompt response to liquidity issues by the US fiscal and monetary authorities. The fact that Governor Shirakawa has presumably made no commitment to the prime minister’s office about the future direction of policy from its inception also militates against a possible rate hike. On the other hand, the new governor has stressed the need for flexible action as needs dictate if downside risks come to the fore. These remarks may be no more than lip service to a diplomatic protocol, however. Ultimately, we believe that the BoJ is likely to reserve the rate cut card for a response to crisis, and play it reactively rather than proactively. Conversely, the governor has not rushed to any conclusion regarding a rate hike, and is likely to bide his time in waiting for the right conditions to play that card. Upcoming Catalysts The next mini-catalysts are the April bank lending (May 12) and January-March GDP (May 16). The headline for lending is likely to be firm because of the demand for refinancing at local public authorities, and for GDP, we expect comparatively strong growth of about 3% annualized, spurred by external demand. This is likely to keep stock market expectations for the end of deflation stoked. Income tax cuts in the US have also been brought forward, with the rebate process beginning on April 28. The effect is meaningful, putting $1,200-1,800 back into the pockets of the average household, and there is a risk that US personal consumption could surprise on the upside in May and June despite the likelihood of a recession in 1H08. US housing starts are also poised to plumb the deepest trough since the 1970s in the coming 2-3 months, and should therefore bottom out before long. This creates the prospect of a supportive economic data flow both at home and abroad in the near term. The problem is how the economy fares from the October-December quarter after the US tax cut stimulus has faded, but with data set to pick up before then, the market is unlikely to be distracted by potential bad news in wait further out. Risks The decision has now been taken to restore provisional fuel tax surcharges. The increase in the government’s resale price of imported wheat will also have an effect, and we think prices could move above the BoJ’s forecast with inflation settling down in the upper 1% range. The consequences of this would in fact be deflationary, since it would restrict real income growth. Cost-push inflation in the early 1980s provides some pointers, when nominal wage growth consistently lagged price inflation in timing and magnitude, for conditions conducive to negative growth in real wages. Since nominal wage growth is stickier than prices, we would expect real wages to recover in the wake of prices if inflation cools, but this latter is the key condition. Yet the indications are that global food inflation will keep pushing up prices for an extended period, and this would make it hard for real wages to pull back the lost ground soon. The conclusion is that the path from price inflation to wage inflation will not be straightforward.
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