Naturally Below Neutral
May 08, 2008
By Joachim Fels | London
Constructive negativism at the Fed. Including last week’s unsurprising 25bp cut to 2%, the Fed has now lowered its key official interest rate by a total of 325bp since the start of the credit crisis last summer. While our US economics team believes that this level most likely represents the trough for the fed funds rate, it does not expect the central bank to raise interest rates before mid-2009, and thus later than markets are currently pricing in (see D. Berner & D. Greenlaw, Disconnect, May 5, 2008). With core inflation running above 2% and unlikely to fall much over the next year or so, US real short-term interest rates thus look set to remain in negative territory for an extended period of time.
But what about financial headwinds? Such a low short rate would seem to suggest that Fed policy has become very expansionary. Sceptics point out, however, that despite low short rates and a 7% trade-weighted depreciation of the US dollar since last August, overall financial conditions may not have eased that much. Notwithstanding the recent rally in risky assets, stock prices are still down from last summer’s levels, and credit spreads are wider. The cost of a 30-year mortgage is only marginally lower than last August, and banks have tightened their lending standards for private borrowers significantly, as was underlined by the Fed’s latest Senior Loan Officers survey released last week. Taking these headwinds into account, is US monetary policy really that expansionary? Back to nature. To help answer this question, we have dusted off our model and re-estimated the time-varying neutral, or natural, interest rate using the most recent data and our US economists’ latest forecasts. Recall that the natural rate of interest is the level of short-term interest rates that would keep the economy growing on trend and keep inflation stable over the medium term. The natural rate fluctuates over time in response to changes in productivity and population growth and the propensity to save and invest. But it is important to note that financial headwinds or tailwinds would also affect the natural, or neutral, rate. For example, if the availability of credit is impaired, the neutral short-term interest rate – that is, the level of rates that would keep the economy on an even keel – will likely be lower than in normal times. Ask Dr Kalman. The natural rate of interest cannot be observed – it has to be estimated. We do this by using a small model of the economy that links monetary policy, the output gap and inflation, and employing a statistical technique called the Kalman filter. Put simply, the procedure looks at the actual behaviour of short-term interest rates, real GDP and inflation to infer the time-varying level of the neutral rate. We will spare you the technical details here and focus on the results. A lower neutral rate. The results confirm our priors. Since our last update (J. Fels & M. Pradhan, Where Is Neutrality for the Fed and the ECB? September 19, 2007), our estimate of the neutral real rate of interest for the US has declined from around 2% then to 1.6% now. The inflation gauge used in our model is the core PCE price index, which is currently running at 2.1%Y. Thus, the nominal neutral rate has come down from slightly above 4% last summer to 3.7% right now. The decline in the neutral rate very likely reflects the headwinds facing the economy from wider credit spreads, lower home and equity prices and reduced credit availability. (For details of the underlying model and the estimation technique, see J. Fels & M. Pradhan, In Search of the Natural Rate of Interest, February 10, 2006.) Still, Fed way below neutral. Based on these results, the Fed would have had to lower the fed funds rate by about 40bp in order to compensate for the decline in the neutral interest rate and thus leave its previous monetary policy stance intact. In reality, the Fed slashed rates by 325bp from a restrictive 5.25% to 2%. Thus, the bulk of the Fed’s rate cuts represented a genuine easing of monetary conditions. With the fed funds rate now some 170bp below its neutral level, US monetary policy can still be labelled very expansionary. Time lags are important – it usually takes 6-12 months until monetary easing visibly affects the real economy – and so the Fed’s policy stance should contribute importantly to a healing of the economy by 2009. Economic healing, but not yet. Until that happens, however, the economic data are likely to deteriorate further, sowing seeds of doubt about the ability of monetary policy to stimulate the economy. Our US economists expect GDP to shrink at an annualised 2% pace in the current quarter and to broadly stagnate in 4Q08 and 1Q09, following a fiscal stimulus-induced, short-lived 2% growth blip in 3Q08. During this period of economic stagnation, the question whether the Fed’s expansionary policy will find traction is likely to stay high on investors’ minds, and markets will probably start to toy with the idea of further interest rate cuts. 2006/07, turned upside down. In a way, the period ahead may well feel like the mirror-image of the period from mid-2006 to mid-2007, when the Fed held the funds rate at 5.25%. Back then, growth was still strong and many observers argued that, due to strong stock markets, low credit spreads and easily available credit, Fed policy wasn’t tight enough and rates needed to be raised further. In contrast, based on our natural rate analysis, we thought that monetary policy was tight despite the financial tailwinds and that economic growth would slow considerably over time if the Fed held on to its policy stance. Thus, we trusted in the potency of monetary policy to influence the ups and downs of the economy. In fact, the sharp slowing of the interest rate-sensitive components of domestic demand over the past year or so suggests that the Fed’s stance was probably even tighter than we thought back then. Conversely, we now feel that the Fed’s very expansionary policy stance will contribute to economic healing over time, though probably not before next year. Healing and, oh yes, inflation. Another less favourable consequence of easy monetary policy in the US and elsewhere in the world is continuing global inflation pressures. Recall that our (simplified) natural interest rate analysis suggests extremely loose monetary conditions in China, India and Russia, the three largest EM economies (J. Fels & M. Pradhan, “All Easy in EM”, The Global Monetary Analyst, April 9, 2008). As we see it, this unnatural policy stance contributes importantly to soaring food and energy prices and thus to rising headline inflation around the world. The longer monetary policy stays loose, the more likely it becomes that a wage-price spiral is set in motion. Global inflation risks are mounting and, as we argued last week, markets are not priced for it.
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Mrs. Lagarde Turns Sarkonomics into Supply-side Reforms
May 08, 2008
By Eric Chaney | London
A Positive Surprise While the long list of measures designed to reform and streamline the government (known under the acronym RGPP for ‘general revision of government policies’) was disappointing overall (see Slower Growth, More Cautious Pace on Reforms, April 15, 2008), the 30-item draft bill presented by Finance Minister Mrs. Lagarde contains several positive surprises. First and foremost, the government is making concrete decisions to shake up the retail sector, boost competition and remove many of the entry barriers that had impeded retail business for the sake of protecting small retailers. Second, small entrepreneurs and entrepreneurs-to-be stand to benefit in a country where a large part of the youth still dreams of joining the civil service. If the bills work as planned, opening and running small businesses should be freed from most of the bureaucratic and tax-related red tape that deters many people from running their own businesses. There is nevertheless a condition for these welcome and, in our view, long overdue supply-side reforms to translate into stronger growth, higher employment and lower retail prices: the draft bill will be handed to the National Assembly (May 27) and to the Senate (June 15). During the parliamentary debate, a heteroclite coalition of vested interests, from large companies supplying hypermarkets to small shoppers, is widely expected to do its best to weaken the initial project. My understanding is that the cabinet is well aware of this risk and has already defused some of the trickiest issues. Yet, history shows that one should not underestimate the political leverage of professional interests, which is rooted deeply in French history. A Mini-Revolution: Opening the Retail Sector Two key measures should boost competition but also free up resources for the retail sector. First, opening outlets having up to 1,000 square metres (10,764 square feet) will be free from all administrative permits but the building permit, as was the case until now for outlets taking less than 300 square metres. Practically, this will increase the number of medium-sized supermarkets and should be an important opportunity for hard discounters, which do not necessarily need very large surface areas, especially in city centres. Second, representatives of incumbent industries (‘Chambres de Commerce’) will no longer sit on the Commission in charge of delivering permits for larger outlets. More than 25 years of Malthusianism, originally designed to protect small retail outlets but which has led to creating monopolistic or oligopolistic rents in the retail sector, are coming to an end. In reality, French authorities were seriously challenged by the EU Commission, so much at odds with the basic rules of competition was the French regulation. Once again, the EU has helped France implement reforms. This is not to say that large retailers will be completely free to build hypermarkets on every street corner. Instead of the old commission, named CDEC, on which representatives of small retailers were sitting, the new CDAC (District Commission for Commercial Construction) will include representatives of city halls, local governments, environmental experts and consumer associations. Overall, I expect this to not only open a lot of opportunities for new hypermarkets but also to drastically reduce lead times for both green and brownfield commercial projects. Higher Potential GDP, Stronger Competition These two measures should have two consequences. First, they will increase the size of the retail sector, which is abnormally small in France, in comparison with the US, the UK or even Germany. This will result in an increase in aggregate supply (potential GDP) and an increase in employment as more commercial outlets will hire more employees. Second, they will increase the level of competition in the retail sector, a goal openly put forward by government experts. Of course, the flip-side of enhanced competition is that the average profit margin of the retail sector is likely to shrink, as monopolistic rents are given back to consumers. According to an insightful paper by Romain Bouis from the French Treasury (Trésor-Eco Working Paper # 27, January 2008, http://www.dgtpe.minefi.gouv.fr/TRESOR_ECO/tresorecouk.htm) on the level of competition across sectors, not only are mark-ups in the retail sector significantly above the all-sector average, but they have also increased over the last 20 years. On Bouis’ indicator, the mark-up (retail price over marginal cost) in the French retail sector was 1.55 over 1995-2002, versus 1.26 for the French economy, or 1.24 and 1.05 for the German and Danish retail sectors, the latter being one of the most competitive in the world. This probably explains why large retail companies have given a lukewarm welcome to the reform. Yet, ultimately, the retail sector is likely to benefit from the reform for two reasons: first, increased supply and lower prices will lead to stronger consumer spending and thus higher volumes; second, increased competition will free up resources so far inefficiently allocated and thus boost the average return on assets, as inefficient companies are priced out of business. No More Interference in Business Negotiations The second item of the reform of the retail sector, which is also the most hotly discussed in French media, is the abolition of ‘backward margins’ (for lack of better translation), a system that allowed large retailers to cut suppliers’ margin in exchange for services such as better visibility for their products. In short, the draft bill makes commercial negotiation between suppliers and retailers just business as usual. Retailers have welcomed this reform, saying that their bargaining power in front of large supplying companies, such as large food processing firms, was unfairly bridled. In fact, one retailer contends that freer commercial negotiations could help cut inflation for mass consumption goods (mostly food) by up to two points in the second half of the year. Given that super and hypermarkets take 17% of overall household consumption, this implies that the level of prices could be cut by up to 0.34 percentage points. We believe that a 0.2pp cut is a more reasonable assumption. Making Life Easier for Small Companies and Entrepreneurs The next positive surprise that came with Mrs. Lagarde’s draft bill is a series of measures designed to make it easier for small companies and individuals willing to run their own businesses. The most visible measure is a proposition to cut most of the red tape for new individual entrepreneurs (they should be able to register on line) and to create a simplified tax regime that would collapse all taxes (VAT, social contributions and profits) into one single low-rate tax on sales. The tax rate would be 13% for trade and 23% for services. In the same spirit, the bill will soften rules that practically exclude from business those formerly convicted (for civil or criminal offences) and will add muscle to the 2005 bankruptcy bill, often nicknamed the ‘French Chapter 11’. What Is NOT (Yet) in the Modernisation Bill Last, the modernisation bill includes several items designed to allow France to catch up with international best practices to improve the access to capital for public entities, such as research laboratories, universities or public hospitals, by giving a legal status to endowment funds. This initiative nicely complements the reform of the wealth tax: wealthy taxpayers may now choose the beneficiary of their tax among a large list of universities, research laboratories and innovative companies. However, the bill fell short of liberalising other sectors, such as hotels and restaurants (shown as generating abnormally high mark-ups in Bouis’ paper), and regulated professions such as pharmacists, notaries and taxi drivers. There will be much more to do to make the French market for goods and services highly competitive and to free up supply and jobs. Yet, the example of the retail sector, which was thought not so long ago to be the last sector where deregulation would take place because of the political power of incumbents, shows that further reforms are likely during Nicolas Sarkozy’s mandate. As we have already argued, both President Sarkozy and Prime Minister Francois Fillon have considerable political incentive to implement supply-side reforms, provided that they start bearing political fruits, i.e., jobs, not later than 2011. The presidential mandate will end in 2012, and their political future is closely linked to the success of reforms.
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No More a Kabuki Play, More of a Reality
May 08, 2008
By Takehiro Sato | Tokyo
Raising Our Ultra-Bearish 2008 Outlook, Lowering Our 2009 Outlook We revise up our ultra-bearish forecasts that we made last December. With personal consumption in the US moving in a positive direction now, we do not look for an adjustment pressure to intensify drastically in the short term. Also, the financial crisis has eased, providing further evidence that excessive pessimism may no longer be justified. That said, we remain cautious ahead. 2009 could bring a more acute double-dip. We revise our outlook even though Jan-Mar GDP data have not been released yet, for three reasons: (1) led by net exports and personal consumption, we expect Jan-Mar GDP (due out on May 16) to show annual growth of about +3.2% (our estimates), marking continued strength from the +3.5% recorded in Oct-Dec last year; (2) recent jumps in food and energy costs prompt us to make fairly sizable upward revisions of our previously conservative price forecasts (see Modest Inflation Alert, April 25, 2008); and (3) the volatility for energy and other primary commodities has increased considerably, making it necessary to factor in the scenario of a further deterioration in trade terms. Industrial output could post a decline in 1H08, but in our view, it would be an exaggeration to characterize this as a recession. A long soft patch might be a fairer way to put it. As such, we think it would be better to end the kabuki play at this stage. Our revised forecasts for real GDP are +1.6% in 2008 (+1.3% in F3/09) and +0.9% in 2009 (+1.1% in F3/10). Our revised outlook assumes a temporary lull in the Apr-Jun quarter, rather than long, deep dual recessions in the US and Japan. We raised our IIP forecast from negative to positive year on year. Compared to the current market view, our outlook for 2008 is no longer ultra-bearish. For 2009, however, our revised outlook for a more pronounced slowing probably puts us in the minority.
Our Assumptions
Our global economic forecasts are based on input from our colleagues in each region. In the US, we now see the potential for a scenario in which a ‘mini-recession’ in 1H08 is followed by moderate gains in the summer, driven by fiscal stimulus measures, then a double-dip recession lasting through the Oct-Dec 2008 and Jan-Mar 2009 quarters; after which the economy regains its footing to return to an above-par growth trajectory in the Apr-Jun quarter. However, as we discuss below, in the case of Japan, the implications could be different under the food and energy inflation. In the case of emerging markets, we take a mild decoupling point of view; we suspect there will be some slowing, but not enough to drag the global economy into recession. Current trends among the emerging economies are uneven, with the effects of higher energy prices beginning to show in east Asia, while the economies of Latin America, with their stronger ties to the US, are actually unexpectedly gaining momentum thanks to their abundant natural resources. With respect to crude, having made a steady stream of hikes in our price forecasts to date, we now abandon the subjective approach and instead simply use the current futures contracts (as of April 23) as the basis for our prices forecasts. For the dollar yen rate, we use our currency strategy team’s forecasts except for the current Apr-Jun quarter. The oil price continues to climb, and there is even talk of oil eventually reaching US$200 a barrel; however, this should be seen as the main risk scenario. Outlook for Current April-June Quarter Although we revised up our annual figures, the outlook for the domestic economy in the Apr-Jun quarter is not good. Industrial production data show a continued slide in the IT and auto industries, though the government expects to see the beginning of a turnaround in these areas in May (forecasting growth of -0.3%M in April and +3.4% in May). However, with global IT goods demand having turned down in December and auto inventory correction in North America continuing, it is hard to envision a turnaround in output in May, raising doubts about the quality of the seasonal adjustment. Exports are also in a downward trajectory overall, with March customs clearance data suggesting that exports to the US have already peaked, while even currently strong exports to Asia ex-Japan are also beginning to see the same sort of slowdown, evident in semiconductor components, possibly due to weakness in the US. Note that nominal export growth was already close to zero in the Jan-Mar quarter, and that it was only an easing in the key export deflator of yen appreciation that allowed for the maintenance of real export growth. It is also worth noting that in the Jan-Mar quarter personal consumption received a boost from the extra day due to the leap year, and so the Apr-Jun consumption is handicapped. Turning to overseas economies, our US economics team assumes annual growth in GDP of around -2.0%, as the economy moves into a full-blown recessionary phase. Although income tax rebates beginning on April 28 can be expected to provide a short-term boost, liquidity constraints are likely to curb capex, and the sharp decline in housing investment is set to continue. In Europe, surveys of the manufacturing sector such as Ifo and INSEE point to a slowdown in output (see Carlos Caceres and Eric Chaney’s Euroland Business Cycle Watch: Turning Point, Risk of Manufacturing Recession, April 30, 2008). In Asia ex-Japan, output is already in a steep decline, led by India and east Asia. Although China is maintaining double-digit growth, exports are beginning to undermine excessive domestic demand. In Japan, recession is being kept at bay by the relatively high net exports contribution alone, meaning that any downturn in exports would be a death blow. At the end of the day, we expect the Japanese economy to post slightly negative growth in the Apr-Jun quarter. Upcoming Catalysts A key market theme right now and something to which we will be paying close attention is the impact of fiscal stimulus measures in the US. The government will start sending income tax rebate checks on April 28 and finish around the middle of June, and the pace of expansion in economic activity in the May-Jun and the Jul-Sept quarters will depend on what level of impact the stimulus has on propensity to consume. Our US economics team assumes a consumption propensity of about 20%, leading to an annualized rate of consumer spending of +3.1% in the Jul-Sept quarter. Based on past experience with tax cut stimulus efforts, this seems to be on the conservative side, even from a cautious Japanese perspective. That said, it really is an open question as to what level of impact there will be on propensity to consume. In watching how things play out at the personal consumption level, we will pay particularly close attention to weekly retail data. Stock markets are also likely to fluctuate in response to the consumption data. Also, we would take note of the US housing starts, which may well have gotten closer to the bottom in March when they fell below an annualized rate of 950,000 units, nearing the all-time low of 800,000-900,000 units. Since the peak of 2.3 million units in January 2006, this marks an average monthly pace of decline of about 50,000 units. Past cycles suggest that the bottom could be reached in the next 2-3 months. Meanwhile, capex is likely to stagnate due to the tighter monetary conditions, as was shown in the Fed’s senior loan officer survey in April. Outlook on the July-September Quarter Driven in part by a rebound from the negative growth in the Apr-Jun quarter, in addition to the modest rebound of the US economy, we expect the domestic economy to see a modest rally in the Jul-Sept and Oct-Dec quarters. However, the impact of continued high energy and resource prices will be like a body blow to corporate earnings, so momentum is likely to remain weak, preventing any sort of real lift. Looking at overseas economies, our US economics team sees a temporary boost to the above-par growth of +2.1% in the Jul-Sept quarter, assuming the effect from the tax rebate stimulus. This could help accelerate inventory adjustment, for example in autos, and provide a small boost to Japanese exports. But with pressure on housing prices set to continue, the effect of the stimulus rebates is likely to be temporary, while the strain on household budgets from high gasoline prices can be expected to reduce consumer purchasing power. These factors make below-par growth in the Oct-Dec and Jan-Mar quarters a likely scenario. Risks in 2009 In the face of continued backlash from the tax stimulus, our US economics team expects to see a double-dip recession in the US in Jan-Mar 2009, which should put a drag on the global economy. At the same time, however, it also expects an end to the slide in home prices to help drive a gradual easing in the negative wealth effect after this time, and for the significant monetary easing carried out in 2008 to also contribute, putting the economy on a moderate recovery trend that eventually returns it to growth above 3% in the second half of the year. A recovery in the US would also be expected to help Japan to recover gradually. But we believe that the momentum at which the Japanese economy recovers could underperform that of overseas economies for the following reasons: First, if energy and materials costs continue to rise, trading gains will deteriorate and purchasing power will continue to flow overseas. For this reason, we expect growth in real GNI (gross national income) to continue to lag behind growth in real GDP. This factor is a barrier to personal consumption and capex. (Note that real GDI equals real GDP plus trading gains/losses, and real GNI equals real GDI plus net overseas income received; for more on this and GDP-related details, see Robust GDP, Fragile Income, April 16, 2008.) Second, in emerging economies, explosive demand growth and rising demand for bio-fuels is driving increasingly significant food inflation that shows no signs of easing anytime soon. Note that on a calorie consumption basis, Japan imports about 60% of its food and its self-sufficiency ratio of cereals except for foods is extremely low. A jump in soft commodities like food can be just as damaging to household budgets, and thus consumer purchasing power, as a rise in energy costs. As a matter of fact, the government’s official wheat resale price, after being hiked 10% in October 2007, was hiked another 30% in April 2008, and is likely to be raised a further 20-30% next October to account for a gap against international prices. This sort of food inflation raises consumer prices, which is tantamount to a direct attack on real income. Incidentally, our core CPI forecasts are +1.3 in 2008 (1.4% in F3/09) and +1.6% in 2009 (+1.6% in F3/10), putting them above the BoJ’s (+1.1% and +1.0%, respectively) and the market consensus. That said, given the current inflationary momentum in energy and food prices, risks in this regard are on the upside. Food-exporting countries stand to benefit from the rise in food prices, but this will come at the expense of net food importers like Japan and other east Asian countries. Japan not only imports much of its energy and raw materials, but now must also contend with a diminishment of purchasing power due to higher imported food. A third factor is the impact of developments in other Asian economies. As export-led economies like Japan, the newly industrializing economies of Asia and the ASEAN countries are seeing a serious deterioration in trading gains, which also has a negative impact on Japan. Meanwhile, China is beginning to slow apart from the US economic cycles as a result of measures such as those to curb an overheat in its domestic economy. With exports to the rest of Asia accounting for nearly 50% of Japan’s total exports (about 40% excluding exports to the US via other Asian countries), it is only logical that a deterioration in purchasing power in Asia ex-Japan would be particularly detrimental to Japan. Compared to the IT bubble period of 1999-2001, the proportion of exports accounted for by the US, the newly industrializing economies of Asia and the ASEAN countries is lower now, while the presence of China, Europe and other areas has risen. This would suggest an increased ability to withstand a recession in the US, but the flipside is increased exposure to the risk of a slowdown in China (or exports to the US via China) and Europe. The contribution from other areas such as the Middle East is higher now, so overall risk is better distributed compared to the IT bubble years. But given the above-noted handicaps, recovery in Japan is, in any case, likely to lag a bit behind the pace of any recovery in momentum in the US economy. Corporate Earnings: Despite Upward Revision of Economic Outlook, Profits Still Set to Decline Recurring profit at major corporations (capitalized at over JPY1 billion, excluding financial firms, based on the MoF Corporate statistics) are seen to have risen a modest +3.0% in F3/08, slightly short of our forecast due to the large undershooting of the Jan-Mar quarter’s recurring profit. But despite the technical upward revision of our economic forecasts for F3/09, the downside margins of corporate earnings are set to become wider. The main factor is an about US$20 hike in our price assumption for crude compared to our March estimate. In March, we assumed a gradual downward trend in oil. But due to the previously noted switch from a subjective estimate approach to one based simply on the futures contracts shift results, we now assume almost no decline through F3/10. Incidentally, the US$10 rise in crude reduces corporate recurring profit by approximately 1.5pt, if we simply take note of the income transfer effect. Forex is another key factor. We estimate that a JPY5 shift in the dollar yen rate has an impact on recurring income at the major corporations of about 3pt. Most firms assumed a rate of JPY115/US$1 in F3/08, but most now assume that the yen will trade in the JPY100-105 range in F3/09. This works out to a 6-9 point decline in corporate earnings guidance from this factor alone. Meanwhile, we don’t see a currency impact on recurring profit outlook this time, as we held our currency assumptions virtually intact. Eventually, the sharp rise in the cost of raw materials and imported foodstuff, and an inability to pass on these added costs by raising prices in a timely manner, inevitably squeezes margins. As a result, our top-down model assumes a 2% growth in revenues, but 5.5% decline in recurring profit in F3/09. For F3/10, we forecast 3.1% growth in revenues and a modest 3.3% rebound in recurring profit. The reason we still expect positive earnings growth despite the downward revisions for F3/10 is that there is a positive base effect in the first place and that we assume a slowdown in the pace at which raw materials prices rise. Basically, this is predicated on the view that even while input costs slow, corporations are likely to keep on raising prices in order to pass on past price cost increases, thus driving an improvement in margins at a time when the economy itself is slowing. This sort of corporate pricing strategy is likely to appear when primary products costs rise so remarkably. As noted, we raised our previous conservative price forecasts and now expect prices to rise beyond the consensus estimates. We expect this to be driven not only by higher energy and food costs, but also by a change in corporate behavior with an eye to restoring margins. Policy Implications With respect to monetary policy, we assume that a retreat of concerns for a financial crisis has reduced the possibility of a proactive rate cut and that any consideration of rate cuts will be shelved until 2009 to let fiscal stimulus measures in the US have a chance to run their course. Even if the policy rates were lowered, it would likely be no more than a reactive move in light of the increased systemic risks, meaning probably a 25bp policy rate lasting not long, only for two quarters. Meanwhile, the stock market is rallying now as the ongoing rise in prices drives expectations that deflation in Japan is finally over. However, until there is clear evidence that the economy is on a solid footing, the BoJ is likely to remain in a state of entrenchment. Prices may be rising, but cost-push is retarding growth in nominal wages, raising the likelihood that real incomes will actually decline in the short term. Also, as noted previously, while the domestic economy as measured by GDP may be growing on strong external demand, the jump in energy and primary commodity prices is undermining trading terms, leading to lower trading gains; we expect GNI growth to lag behind GDP growth as a result. Even if headline GDP growth is achieved, purchasing power in the national economy is not likely to see the same sort of growth, with personal consumption in particular likely to struggle in the face of lower wages. The BoJ also raised this as a cause for concern in the latest April Outlook Report. Basically, a rate hike could not be justified within the context of a cost-push inflation environment. With energy and commodities prices beyond the control of the central bank, a tightening could be overkill for the domestic economy. It is hard to imagine the BoJ taking such a course, and it is worth noting that Governor Masaaki Shirakawa emphasized at the press conference after the April MPM that the BoJ would carefully consider the nature of price increases and the ability of the economy to sustain continued growth in any deliberations regarding the policy management. Risks We raised our outlook for 2008 but continue to see risks for 2009. The real issue is what sort of momentum will be seen in the US economy from the Oct-Dec quarter onward once the effects of the fiscal stimulus subside. Capital shortage at the financial institutions remains a problem, while balance sheet adjustments are functioning as a negative financial accelerator, and the negative wealth effect of declining housing prices raise concerns about a pressure on consumption. At the end of the day, there is a possibility that the US economy in 2009 could fare worse than our official outlook assumes and that the growth rate could undershoot further. In this scenario, depending on how long sub-par growth continues, a deterioration in corporate earnings could undermine market psychology. Energy and primary commodity price assumptions are a critical factor. The Japanese economy is already slowing as a result of increases in these prices, and an event risk such as a natural disaster or war could easily send already-overheated prices for commodities, particularly oil, much higher. Oil at US$200 a barrel is a bit of an exaggeration at this point, but there is no question that a continued rise in prices for imported primary commodity items would result in a further deterioration in trading gains and in the purchasing power of both consumers and companies. Another risk unique to Japan is the government chaos leading to a protracted policy gridlock. Surveys by major newspapers place support for the Fukuda cabinet at only about 20%, a dangerous level in terms of maintenance of political viability. However, with virtually no chance of the ruling party, which holds an absolute majority in the Lower House, calling for early general elections, the siege mentality among market participants is growing. The DPJ tries to adopt a motion in the Upper House to censure the prime minister with the aim of driving the administration from power, but it lacks legal basis so is not likely to be effective. In this regard, our colleague Robert Feldman, encouraged by current revenues earmarked for road construction and the results of by-elections held in the Yamaguchi prefecture, believes that there is a possibility for the Japanese market to outperform despite the uncertain outlook for government policy (see Robert Feldman’s First Steps Back to Reform, May 1, 2008). Certainly, as the political situation moves closer to a major reshuffle following the recent situation, the market is likely to welcome the prospect of some sort of change. But, as Robert points out, there is a risk that a general election would not be won by a reformist alliance (center-right coalition cabinet), but by an old-guard alliance reminiscent of the mid-1990s. Which way things swing would depend in large part on the state of the economy and the stock market before the election. In short, if the sense of stagnation in the society stemming from such problems as income inequality (widening economic gap) grows excessively stronger, the potential for the scenario of an anti-reform coalition coming to power would increase.
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