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Global
Stagflation – More Than a Scare May 22, 2008 By Joachim Fels | London From threat to reality. What was still a threat about half a year ago now appears to have become a reality – stagflation. Back then, I anticipated an unpleasant period of relative economic stagnation coupled with rising inflation in the advanced economies. I argued that still strong growth in emerging market economies would prevent an outright recession in the advanced economies on aggregate, but that emerging markets had also become a source of global inflation pressures that would keep inflation in the advanced economies high, despite slower growth (see J. Fels, The Stagflation Threat, November 9, 2007). Judging by the data flow since then, stagflation has arrived in the Just a stagflation scare? Importantly, I think that the current stagflationary phase will turn out to be longer and more serious than most people believe. The pushback I get on the stagflation call is that, given the usual time lags, it is normal for inflation to still be high or even rise in the early phase of an economic slowdown, but that inflation can be expected to fall once the slowdown has created sufficient ‘slack’ in the economy. This ‘usual’ behaviour of inflation shows that in the previous three This time will be different, in my view. While I acknowledge that, viewed in isolation, economic slack will exert downward pressure on inflation, I still expect inflation to remain higher and more protracted than in the past few episodes, for three reasons: • First, the Fed’s policy stance has been less restrictive going into the recession, and is now more expansionary than it has been at similar stages of previous recessions. • Second, during the past three • Third, global factors are a much more important driver of inflation than domestic factors nowadays. In our empirical work, we have shown that ups and downs of the domestic economy don’t have much of an impact on national inflation – global factors matter more (see M Pradhan, More Global, Less Local, April 2, 2008, and the references there). Easy money is the culprit. What are the global factors driving inflationary pressures? On the surface, the rising demand of a large population in strongly growing EM economies such as Scary parallels with the 1970s. Against this backdrop, it is unsurprising that former central bankers like Paul Volcker and current central bankers like Jean-Claude Trichet have recently warned of a repeat of the policy mistakes made in the 1970s. In fact, there are at least five important parallels between the stagflationary 1970s and the current situation. • Sharp increases in energy and food prices are pushing up headline inflation, eating into consumers’ purchasing power. • As in the 1970s, monetary policy is very lax on a global scale, fuelling and accommodating the run-up in energy and food prices. Also, fiscal policy in many countries looks likely to be loosened in order to cushion the economic downturn. • Then and now, easy • In the 1970s, productivity growth slowed sharply in the • The competitive pressure from Of course, history never repeats itself, but it rhymes. While I don’t expect a return of the double-digit inflation rates we saw in the 1970s in the Market implications. A 1970s-type stagflationary environment is bad news for most asset classes. Equities and credit should struggle due to the economic weakness. Nominal bonds should sell off because inflation is not in the price. By contrast, inflation-linked bonds should do relatively well as sluggish growth keeps real interest rates low and inflation surprises on the upside. And with central banks constrained in their fight against inflation by growth concerns, yield curves should steepen.
Czech Republic
Still Constructive on CZK May 22, 2008 By Pasquale Diana | London The CNB’s recently published inflation report shows a marked drop in inflation from current levels (6.8%Y), to below the 3% target at the monetary policy horizon (4-6 quarters ahead). In late 2009, both headline and ‘monetary policy’ inflation (which excludes the impact of tax changes) should be close to the more ambitious 2% CPI target, which will formally apply from 2010 onwards. Consistent with this inflation forecast and its assumptions is a drop in nominal interest rates, equivalent to around 100bp from current levels over the next 12 months. This is far more aggressive than the market, which is pricing for broad stability in rates initially, followed by only modest easing. We do not believe that Czech rates are about to be slashed aggressively, as the CNB’s new interest rate forecast may suggest. This is essentially because the new CPI forecast looks too benign to us, and the risks are tilted to the upside. Here’s why: • Growth risks are biased to the upside. The forecast largely relies on a sharp slowdown, with GDP growth falling to 3%Y in late 2008 (less than half its recent pace), on the back of fiscal tightening, FX strength and slower growth abroad. While slower growth this year is very likely (as indeed the 1Q08 data already show), the CNB’s forecast is close to the bottom of the analysts’ range. Even after the recent upgrade to the bank’s forecast for GDP growth in 2008, risks still remain tilted upwards, in our view. • Large FX pass-through expected to materialize, yet little evidence thus far. The CNB still assumes a very sharp drop in import prices over the next two years, on the back of the past CZK gains, and assumes an FX pass-through of around 20% over 4-5 quarters. The last time that CZK strength depressed import prices and CPI was in 2002. However, the macro backdrop was different back then and the economy was growing below trend. The current resilience of the economy could be a reason for the pass-through to be slower and less pronounced this time around. Indeed, the CNB admits that thus far there has been little evidence of FX pass-through into lower prices, though the recent wave of appreciation began almost one year ago. • Threat of second-round effects is still real. The labor market continues to tighten and wage growth continues to grind higher. The jobless rate has dropped by 3 pp in the last two years and, at just over 5%, it is the lowest in CNB set to remain on hold for some time. The most likely path for CNB rates in 2008 is that they remain unchanged. While a near-term correction higher in EUR/CZK may still trigger a last 25bp hike, this is no longer our base case, and we see rates holding at 3.75% this year. Modest easing is possible next year, assuming that the ECB reduces interest rates and none of the above mentioned inflation concerns materialize. Medium-Term Constructive on CZK As we have written several times in the EM Economist, our sense (also shared by the CNB and local analysts) is that recent CZK appreciation has far outpaced its real ‘equilibrium’ pace of around 4% per year (recently revised to 5.6%Y for 2008). The unwinding of carry trades in late 2007, together with anecdotal evidence of delayed repatriation of dividends by Czech-based multinationals (prompting less CZK selling than usual), likely explain at least in part the recent move in CZK. A near-term correction remains a possibility, though we have lost confidence in this. More medium term, however, we still see compelling reasons to like the CZK, for three reasons: • First, price convergence will happen via FX, if the CNB has its way. A feature of the Czech economy is that it has achieved a high level of real income convergence, but it remains relatively ‘cheap’. GDP per capita (adjusted for purchasing power) exceeds 80% of the EU average, far ahead its regional peers. Yet, the price level looks relatively low in comparison (around 60%). This suggests that a relative adjustment in prices is likely in the coming years. It is reasonable to assume that this will happen partly via inflation and partly via a stronger FX. Crucially, however, the CNB has a strong incentive to ensure that the bulk of this adjustment will happen via exchange rate movements, rather than inflation – its 2% inflation target (starting in 2010) will make the central bank more or less explicitly biased towards accepting continuous, steady CZK gains. At first blush, this might seem to contradict the recently announced deal between the MoF and the CNB to try and cap CZK gains. However, our view (reinforced in our recent visit to • Second, corporates cannot make a convincing case for pain from FX, for now. Although some of them are hedged, corporates have complained about FX gains. At the same time, however, they report that they cannot find enough workers to satisfy output demands. These two complaints are not entirely consistent. Also, the trade position of the • Third, EMU is still several years away – |