Emerging Markets: The Abundance Upgrade
June 10, 2008
By Gray Newman | New York
When Brazil’s external debt was awarded investment grade status first in late April and then again in late May, it was grounds for celebration throughout emerging markets. After all, here was a country that just a little over five years ago epitomized all of the risks of emerging economies, when investors were worried that it was on the brink of default and capital controls. Today, in contrast, Brazil has international reserves covering nearly three times the entire gross public external debt stock and covering all public and private external obligations. While the exact timing of Standard & Poor’s and Fitch’s moves were a surprise, it was not hard to see why Brazil was granted investment grade: with reserves dwarfing public external debt, the risks to Brazil’s ability and willingness to service its external obligations had shrunk dramatically.
The move from pariah to poster child of emerging markets is a testament – as both rating agencies noted – to Brazil’s institutional and policy framework. But the move was also a testament to the power of the abundance of inflows that have helped Brazil and many other emerging economies to rebuild international reserves, replace external debt with domestic debt and improve debt profiles. Of course, Brazil is hardly the only case of the power of abundance in transforming emerging markets. Russia dwarfs Brazil whether reserves are measured in dollar terms or as a percentage of total outstanding public and private external debt. And China, in turn, with over US$1.7 trillion in official currency reserves, dwarfs Russia. Indeed, the abundance enjoyed by emerging markets in recent years has led to the emergence of a new, powerful force in financial markets, the sovereign wealth funds. Meanwhile, a who’s who of emerging markets – from the Czech Republic and Russia to Turkey and Venezuela – have external debt to GDP ratios on average that are nearly half of where they stood six years ago. Country after country has taken advantage of abundance to rebuild international reserves, improve debt profiles and swap external for domestic debt and cut their external debt/GDP ratios. And while Mexico and Indonesia have cut their public external debt/GDP ratios to less than half of where they stood in 2001, Russia’s public external debt ratios have declined by nearly 30 percentage points in the past six years to now stand at just 2.9% of GDP. It should be of little surprise that the remarkable gains that we have seen in emerging economies during the past five years have been translated into ratings upgrades. The improvement in ratings reflects a genuine improvement in the balance sheets of many emerging economies. But it is still worth asking how much of the progress made has come thanks to home-grown reforms and how much has come thanks to the era of abundance that emerging economies have been enjoying during the past five years. It is not enough to argue that many emerging markets are in better shape than in the past to deal with a downturn in the global economy. If the world slows by more than the global economics team at Morgan Stanley expects, we believe that the risk that a downturn in growth leads to a major financial crisis in the Latin America’s largest economies is lower today than in the past. With the trio of massive reserve accumulation, current account surpluses and better fiscal results, Latin America has its house in better order today than in decades. Ultimately, the question must be addressed, how much of the improvement has come from external abundance? Two points worth highlighting: • First, the remarkable gains that we have seen in emerging economies during the past five years have come as the globe has experienced an extraordinary period of above-trend growth – a stretch of above-trend years that we have not seen in nearly four decades. • Second, our review of Latin American growth dynamics suggests that the principal drivers of better growth have been a series of external factors, reflected in a period of favorable financial and credit conditions, strong global demand and a remarkable surge in the terms of trade. We have run a series of models trying to determine the role that external conditions (terms of trade, external demand and international financial conditions) have played in determining growth in the region. The most dramatic case is that of Argentina: had external factors played out since 2003 as our model predicted in the ensuing years, Argentina’s growth would have averaged 3.7% per annum rather than the observed 8.8% – a difference of just over five percentage points. In the case of Brazil, the gap would have been 1.6 percentage points, largely eliminating the recent growth spurt. For more details, see “Latin America: Growing Disconnect, Growing Risk”, EM Economist, March 7, 2008. In contrast, we are concerned that policymakers have not done enough to ensure that the current growth boom gives way to more sustainable, long-term growth. Long-term growth dynamics depend on boosting human capital and infrastructure, on the rule of law and a regulatory environment that promotes competition and fosters entrepreneurial efforts. On a host of metrics that attempt to measure progress on those fronts, Latin America has done poorly in recent years. Not only does Latin America have the poorest institutional and regulatory environment on our measures based on the World Bank’s Doing Business survey, but the pace of reform has also lagged. While abundance has brought stability and good growth to emerging economies, it has also brought widespread complacency among policymakers. That may be inevitable. It may seem hypocritical for critics in the developed world to take emerging economies to task for political gridlock on the long list of micro challenges. After all, policy gridlock knows no boundaries. There is, however, an important difference that makes the failure of progress in the emerging economies much more worrisome. The shortfalls in human capital, the often limited funding for infrastructure and public investment, the inadequacies in the regulatory environment to promote competition and the wide disparities in assets and incomes mean that in downturns the ‘safety net’ is, at best, often frayed. And at worst, prolonged downturns can easily set off political and social turmoil in emerging economies, with damage lasting for an entire generation. Micro versus Macro After five years of above-trend global growth, it is time to ask how emerging markets have fared in building the base for stronger, more sustainable growth. No emerging markets practitioner should be without a set of metrics to define who is making progress on the micro front. We don’t promise to have the full answer, but we have tried during the past two years to provide a broader picture of how the micro issues fit into the concept of country risk (see Macro and Micro Radars, 2nd Half 2006, August 18, 2006, Macro and Micro Radars, 1st Half 2007, May 15, 2007 and Macro and Micro Radars, 2nd Half 2007, October 17, 2007). Our latest set of Macro and Micro Radars is due for release shortly. The aim of these metrics is to help us understand how strong the institutions and the regulatory framework across emerging markets are. While the literature linking institutions to growth has had difficulties in quantifying the precise relationship, there is general agreement that institutions play a major role in long-term growth and general prosperity. What Is Country Risk? For years, we and other emerging market watchers focused on a set of liquidity and solvency ratios to measure country risk. The focus made sense in the 1990s when external bonded debt issuance soared, particularly as emerging market economies returned to capital markets after the difficulties of the 1980s. Country risk and sovereign credit risk, and the country ratings from the largest rating agencies, seemed almost synonymous. Today, by contrast, as external debt continues to lose ground to local issuance and to increased equity stakes by direct foreign investors, the traditional sovereign credit ratings are becoming less relevant. While forthcoming upgrades might tell us about a sovereign’s ability and willingness to service its shrinking external debt, they tell us less and less about broader country risk. With an unprecedented number of countries in the past 18 months buying back external debt and swapping it into domestic debt, it should come as little surprise to find that the trading volumes of the emerging markets-led trade association, EMTA, have now flipped. Local debt has now replaced external debt by a wide margin as the instrument of choice for emerging markets practitioners. Micro Radars Our set of Micro Radar charts – to be released in a separate stand-alone publication – are designed to complement the long-standing series of radar charts that Morgan Stanley has used to summarize a country’s key credit statistics relative to benchmark values appropriate to the country’s level of credit risk. The Micro Radar charts are based on the work of the World Bank, which for five years now has published a database of business regulations, publicly available at www.doingbusiness.org. The database provides indicators of the cost of doing business by identifying specific regulations that enhance or constrain business investment, productivity and growth. Unlike other measures of country risk that rely on subjective ratings of the quality of institutions or the business climate, the World Bank data are based on a set of common assumptions used across 178 countries. We have taken 11 of the indicators – and updated them with the most recent 2007 dataset – including starting a business, employing workers, credit information and rights, shareholder suits, tax costs and time involved in filing as well as bankruptcy recovery rates and contract enforcement costs. Neither our traditional Macro Radars, which measure solvency and liquidity risks, nor the Micro Radars provide a full picture of country risk. But the Micro Radars are an additional facet of country risk that we think is increasingly important to focus on, especially as emerging markets have made important strides in many of the traditional areas of macro concern. Still, the micro radars also have limitations. The efficiency of application or enforcement of the law is poorly measured, if at all, in our Micro Radars. Corruption remains a major problem in emerging markets and is not taken into account in our set of Micro Radars – nor is the issue of security. High crime rates and difficult security situations impose a significant cost on doing business, as do vast informal economies. Still, the Micro Radars should serve to provide investors with another measure of country risk to complement the more widely used ratios of external debt and current account to GDP, reserve adequacy, liquidity, inflation, investment and GDP growth. Findings On a regional basis, Eastern Europe remains on top in institutional and regulatory environment among emerging markets. Specifically, Eastern Europe has very favorable contract enforcement institutions as well as lower-than-average legal and bureaucratic barriers for starting businesses. The picture, however, is far from uniform: Eastern Europe falls comparably short, albeit by a modest margin, on institutions relating to credit information and also in bankruptcy recovery. The generally high marks for the region are not entirely surprising, given the reform momentum generated by the EU accession process. Not only does Latin America have the poorest institutional and regulatory environment, but the pace of reform has also lagged. The World Bank notes that in 2007 only 36% of the countries in the region made at least one positive reform, compared to 79% of Eastern European nations and 63% of South Asia nations. Latin America earns particularly weak marks on the tax category, which includes notoriously arcane tax systems and relatively high tax burdens. Regional aggregates can mask significant differences between their constituents. In Brazil it takes a whopping 2,600 hours – nearly 14 times the OECD’s average – each year to prepare, file and pay taxes, representing the Doing Business sample’s heaviest administrative burden. Brazil ranks near the bottom in several other metrics with important shortfalls due to low bankruptcy recovery rates, a relatively heavy tax burden, a Byzantine legal framework that creates significant hurdles to start a business and a rigid labor force. Chile, by contrast, ranked in the sample’s top quintile, while Colombia moved up 20 places to rank 66 out of 178 in 2007, and was singled out as one of the world’s top ten reformers. By extending port operating hours and adopting more selective customs inspections, Colombia helped to reduce port and terminal handling activities by three days. The country also introduced an electronic tax filing system, helping to cut the average time businesses need to spend on filing taxes by 188 hours per year. In contrast, South Africa’s micro indicators look better than the emerging market averages. South Africa’s strong micro grade stands in contrast to the macro challenges it faces, given its large current account shortfall even as global liquidity remains in question. Bottom Line The investment grade fever is a positive development for Latin America and throughout emerging markets. It is a testament to the improved policymaking in many emerging economies, but it is also a testament to the era of abundance that has benefited developing countries. We can take sides on the ‘great decoupling’ debate, but neither the decouplers nor the recouplers know for sure who will prove right. But on one front there can be little doubt: that much more needs to be done within the emerging economies to tackle serious shortfalls on the micro front. Much of the strong growth in emerging economies has come from the hand that they have been dealt in the form of high commodity prices, easy and less expensive access to funding and a remarkable stretch of above-trend global growth. However, the ultimate test of whether today’s abundance will lay the foundation for sustainable growth is likely to come from how emerging economies play the hand they are dealt. On that front, much more progress needs to be made to help develop and maintain a thriving entrepreneurial base. Our presentation of the micro radars alongside the traditional macro radars is designed to help provide a set of metrics to measure the progress that has been made and the challenges ahead. This essay is excerpted from the latest set of “Macro and Micro Radars, 1st Half 2008”, which will be available shortly.
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China: Will China Be the Next to Raise Retail Fuel Prices?
June 10, 2008
By Qing Wang | Hong Kong
The Rush to Hike in EM Asia Malaysia announced on June 4 that the country’s retail fuel prices would be raised by an average of 47.8%. Amid surging world oil prices, Malaysia is the fourth economy in the region to decide to raise domestic retail fuel prices recently; the others are India (10-15% on June 4), Taiwan (13-16% on May 28) and Indonesia (25-33% on May 24). Will China be the next to hike retail fuel prices? At it stands now, China’s domestic retail fuel prices are only about half of the international benchmark levels. This means that if China’s domestic retail fuel prices were to be allowed to converge to international levels, they would need to rise by 70-90%, depending on the product type. Can China Afford Not to Hike? The last retail fuel price hike in China was made in November 2007, when domestic prices were raised by 8-9%. International crude oil prices have since surged by nearly 40%, while domestic refined product prices have remained unchanged. Our colleague, Hussein Allidina, thinks that crude oil prices could easily reach US$150 per barrel (see Global Economics: The Oil Shock Debate: Recession, Inflation, or Both, by Dick Berner, May 28). We estimate that the total amount of implicit subsidies (i.e., including both direct financial support from the state budget and the loss incurred by state-owned oil companies) in 2007 was about US$27 billion, or 0.8% of GDP. Moreover, if international crude oil prices were to stay at US$130 per barrel and domestic refined product prices to remain unchanged at their current levels, we estimate that the total amount of implicit subsidies could reach about US$100 billion, or 2.2% GDP, in 2008. Despite the rather high costs stemming from the fuel price subsidy, China is in a relatively favorable position compared with its peers in the region in coping with these oil-related fiscal pressures. This is because China has one of the lowest government debt levels, reflecting consistently low fiscal deficits (i.e., around 1% of GDP) and even occasionally small surpluses over the past years. Even if the government were to decide to pay the entire amount of subsidies directly out of its own budget (instead of asking oil companies to share it in the form of lower profit or outright loss), the government debt level will still be less than 25% of GDP, which is still considered a comfortably low level by international standards. China’s fiscal strength suggests that: i) if the government has a strong desire to maintain stable domestic prices through subsidies, it can afford to do so at least for the foreseeable future without running into a debt sustainability problem; ii) the government can afford to delay potential price hikes for longer than other countries in emerging market Asia can; and iii) if the government decides to hike prices, it can afford to do so incrementally instead of in one go with a view to smoothing out the shock impact on the economy. Will China Hike? And When? Based on our communications with officials, we believe that Chinese policymakers are eager to normalize domestic fuel prices to be in line with international levels. In fact, even as early as the start of this year, when debating between the inflationary impact of fuel price liberalization and the inefficiency due to artificially low prices, the authorities considered the former ‘the lesser of two evils’. We believe that there is a strong consensus among several key policy-making agencies that normalization of the prices for key production factors (e.g., refined products) should play a key role in helping to rebalance the economy and improve the quality of growth. The recent earthquake and the attendant sudden demand for reconstruction-related financial support appear to have made the government uncomfortable with the rapidly rising spending pressures, despite a strong overall fiscal position. Specifically, we note that in a press release at the conclusion of a recent State Council meeting, the “relatively heavy fiscal spending pressures” were mentioned for the first time as one of several key issues in the current economy. The most important reason why the authorities have been slow in adjusting domestic fuel prices is their concern about the currently high domestic CPI inflation. The government does not want to exacerbate inflationary pressures or expectations by implementing a fuel price hike. The bottom line is that the authorities are eager to deregulate fuel prices out of concern about both long-term efficiency and near-term rising fiscal spending pressures. We therefore expect that domestic refined product prices will be allowed to increase as soon as headline CPI inflation establishes a downward trend. However, the potential price hike will likely be made incrementally, e.g., 10-20% per move, as the government wishes to smooth out the shock impact on the economy in general and to ensure a downward headline CPI trend despite the fuel price increase in particular. When do we expect headline CPI inflation to establish a clear downward trend? Although headline CPI inflation peaked in February, a downward trend does not appear to have been established yet, with CPI readings still standing at 8.3%Y in March and 8.5%Y in April. If CPI inflation in May were to register a reading below 8%, the downward trend in headline CPI would have started to be established, in our view. Our estimate based on high-frequency data for food prices suggests that headline CPI inflation in May could be in the range of 7.7-8.0% (see China Economics: Food Price Monitor: May CPI Likely Down Significantly, June 2). This potential easing in inflationary pressures would present an opportunity for the authorities to implement an initial price hike in the coming months. While predicting a policy change in China is always a challenge, we would think that the next few weeks through mid-July should present the first window of opportunity for such a move. After mid-July, it would be too close to the Olympic Games in Beijing (August 8-24), and the government would be unlikely to introduce policy changes in the run-up to and/or during the Olympic Games, in our opinion. However, were there to be no price hike before the Olympic Games, the probability of a price hike after the Games would rise even further, in our view. First, we expect that headline CPI would have declined substantially from its current level by September. Second, the political sensitivity of a price hike would be much lower with the conclusion of the Olympic Games, in our opinion. The Macroeconomic Impact of Fuel Price Hikes We estimate that the direct impact of a 10% fuel price hike on headline CPI inflation is about 0.3-0.4 percentage points (pp), as we estimate that fuel accounts for 3-4% of the CPI basket. We estimate that the direct impact on PPI would be about 0.5-0.6pp. This generally moderate impact on inflation reflects China’s relatively low dependence on oil as a source of energy, with only about 20% of its energy supply coming from oil (see China Economics: Impact of High Oil Prices: Facts and Ready Reckoners, November 23, 2007). Higher retail fuel prices should have a demand destruction impact, dampening domestic demand for refined products and subsequently China’s demand for crude oil. However, our regression analysis finds that while there is a statistically significant positive relationship between consumption of refined products and China’s industrial production, a negative statistical relationship does not exist between consumption and domestic prices. These results suggest that the demand destruction impact of a fuel price increase in China would likely be rather small, especially if the price change is relatively small, and thus the linear relationship identified in the regression analysis holds. The Sectoral Impact of Fuel Price Hikes We estimate the impact of a 10% hike in refined product prices on different sectors that use these products as inputs. Based on China’s Input-Output table, we first identify the share of refined product inputs in the total intermediate inputs for 14 sectors. We then assume that the firms would absorb the higher refined product costs by compressing their gross margins such that the final prices for their products remain unchanged. We estimate how much the firms affected by a 10% hike in refined product prices would have to squeeze their operating margins in order to maintain the prices of their final products unchanged. Not surprisingly, the impact on different sectors is likely to be uneven. Four sectors – transportation, metal products, building materials & non-metal minerals and construction – are likely to be most affected, with the impact ranging from a 4.2% to a 12.2% reduction in their operating margins. The estimated impact on other sectors is relatively small (e.g., agricultural, mining and quarrying, commercial trades) or even negligible (e.g., textiles, foodstuffs, real estate). Note that the 10% price hike is chosen for computational ease, and the impact can be scaled linearly to approximate the effect of price increases of other magnitudes. I acknowledge the contributions of Wee-Kiat Tan and Sara Chan to this report.
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Review and Preview
June 10, 2008
By Ted Wieseman | New York
A volatile week across almost all markets ultimately wound up with Treasuries posting strong front-end-led gains that largely reversed the prior week’s big sell-off but left the curve substantially steeper. The market rallied early in the week on renewed financial sector fears that had previously been steadily waning since the mid-March panic, as investors worried about upcoming earnings reports from several major companies with May quarter-ends, management changes at some big banks, reports about the possibility of substantial needs for more capital raising, and some reintensification of general systemic concerns (the reappearance of which was highlighted by Lehman Brothers’ seeing the need to issue a statement mid-week denying that it had used the Fed’s primary dealer credit facility). These concerns were then largely set aside from Wednesday afternoon through early Friday, with the market selling off as investors shifted their attention back to potentially more hawkish monetary policy and renewed inflation worries. These fears were first increased by Wednesday afternoon comments from Fed Chairman Bernanke that in comparing the current situation to the Great Inflation of the 1970s made clear that conditions now are far less dire, but did note that inflation is much higher than the Fed would like it to be and that some measures of inflation expectations have shown some concerning, though relatively modest, recent upside. ECB President Trichet followed this up by absolutely crushing the European front end Thursday morning when he unexpectedly warned of the possibility of a July rate hike. The US didn’t come close to matching the spike in European short-end yields, but was still dragged along to some extent by their huge losses. Trichet’s remarks also fully reversed what had been a nascent rebound in the dollar and associated pullback in commodity prices sparked by dollar-supportive comments by Chairman Bernanke Tuesday, and the renewed dollar weakness raised domestic inflation and monetary policy fears in light of Bernanke’s Tuesday comments. During the Wednesday and Thursday weakness, the market was also pounded each day by a wave of mortgage-related paying in swaps that was such a major problem for the market in the prior week’s sharp sell-off and that sent swap spreads much wider on the week, largely in two relatively compressed bursts Wednesday and Thursday afternoon. Throughout these back and forth market moves, economic data – which to that point had been overall stronger than expected, with somewhat better-than-expected ISM surveys and chain store sales in May and upside in construction spending in April that pointed to a smaller drop in 2Q GDP than we previously expected, with the main offsetting negative being another month of abysmal auto sales – had been largely ignored. This changed Friday, however, when investors were shocked by one of the biggest one-month spikes in the unemployment rate ever. In retrospect, the more surprising pattern for the unemployment rate was not that it reached 5.5% in May, but that it was steady at 5.0% from December to April despite steady payroll job losses. Still, the sudden catch-up was a stunning enough development to drive the market rallying sharply again to end the week. The Friday surge appeared to be more flight to quality than anything, though, as stocks, credit and the dollar tanked and commodity prices surged, since there was little corresponding change in Fed pricing and swap spreads blew out further, but this time not as a result of mortgage-related paying but of Treasury strength. On the week, benchmark yields fell 6-26bp and the curve steepened in a major way, with 2s-10s up 14bp to 155bp and 2s-30s up 19bp to 226.5bp, highs in a month. The 2-year yield plunged 26bp to 2.385%, the 5-year 21bp to 3.195%, the 10-year 11bp to 3.94%, and the 30-year 6bp to 4.65%. Fed Chairman Bernanke’s attempt to talk up the dollar along with Treasury Secretary Paulson briefly had a fair amount of success that was accompanied by a significant pullback in commodity prices. Bernanke’s efforts were quickly undone by ECB President Trichet’s hawkish comments (faint echoes of 1987?), however, with the dollar ending more than US$0.02 worse for the week against the euro at US$1.578 and commodity prices going completely ballistic. After an amazing surge on Friday, July oil ended the week more than US$11 a barrel higher at a record US$138.79. July gasoline spiked US$0.20 a gallon US$3.55 – which would amount to about a further US$25 billion hit to consumers’ spending power if sustained. Agricultural commodity prices also saw major upside on the week, so food price inflation is likely to remain a major issue as well. TIPS had a mixed reaction to this. The very short end naturally outperformed significantly, but the outperformance faded moving into the intermediate part of the curve and then turned into significant underperformance at the long end. The 5-year yield fell 25bp to 0.73% and the 10-year 10bp to 1.43%, but the 20-year yield actually rose 2bp to 2.14%. When the market sold off Wednesday and Thursday, mortgage-related paying in swaps was a big reason why. Big moves higher in spreads on these days were added to by a further flight to quality-driven increase Friday. For the week, the benchmark 10-year spread jumped 10.5bp to 75bp and the 5-year 13.75bp to 94.75bp, the former the high since early March and the latter since mid-April. Risk markets were volatile through the week (stocks more so than credit), but ultimately ended down significantly, with a particular poor day Friday greatly aiding the big Treasury rally. The S&P 500 lost 2.8%, and closed Friday at its lowest level since April 15. The investment grade CDX index was 14bp wider on the week at 116bp late Friday, which would also be its worst close since April 15. Through Thursday, the high yield index was only 10bp wider on the week at 581bp and even after falling about another three-quarters of a point Friday was still on pace to perform relatively well compared to investment grade. The leveraged loan LCDX index also performed relatively very well, moving only 2bp wider on the week to 354bp as of midday Friday. The commercial mortgage CMBX market showed modest downside on the week, with the AAA index widening 7bp to 113bp and the AJ (junior AAA) 11bp to 351bp, both still a good bit better than recent worst closes of 128bp and 411bp hit May 9. The subprime ABX market mostly continued sinking (the A index showed slight upside, but all the others dropped), with the AAA index dropping almost a point-and-a-half to 52.29, its worst close since April 1 after a six-point decline in the past three weeks. There was little change in near-term Fed pricing in the futures market, with the timing of the first Fed rate hike still considered a close call between the October and December FOMC meetings, but a somewhat more dovish view for the end of this year and into next. The November fed funds contract gained 1.5bp to 2.125%, January 8bp to 2.255%, February 13.5bp to 2.395% and March 17.5bp to 2.465%. A 28.5bp gain by the Jun 08 eurodollar contract to 3.29% and 26.5bp rally by Sep 08 to 3.535% led gains in that market. 3-month LIBOR rose about 1.5bp on the week to 2.70%, which caused the spot 3-month LIBOR/OIS spread to rise marginally to 68bp. Eurodollar and fed funds futures prices are roughly consistent with this spread, rising towards 75bp by the middle of the month and holding there through mid-December. The key round of early data for May was mixed. Most details of the employment report were in line with expectations, as the pace of job loss picked up again after moderating in April. The big shock in the employment news was one of the biggest monthly rises in the unemployment rate ever, though in retrospect the more surprising aspect was that the rate held steady for the four previous months as payroll employment declined. The May spike appeared to be a correction and catch-up of this prior apparent understatement. Meanwhile, the two ISM surveys were better than expected in May. The manufacturing index rose modestly, but was still just below the 50 boom/bust line, largely it seemed as a result of continuing strength in exports, while the non-manufacturing index dipped only slightly and held modestly above 50. Early indications for May consumer spending were somewhat mixed. Motor vehicle sales were awful again, further deteriorating after having plummeted in April. Chain store sales, on the other hand, were fairly sluggish, but somewhat better than expected. Non-farm payrolls fell 49,000 in May, a fifth straight drop in overall employment and sixth straight for private sector jobs. Manufacturing (-34,000), construction (-26,000) and retail (-27,000) continued to post steep declines, while business services (-39,000) turned down again after a gain in April moderated the loss in overall jobs. The main offsetting positive continued to be strong growth in healthcare jobs (+42,000). Finance employment (-1,000) also continued to hold up much better than expected recently, given the turmoil in the sector and reports of heavy job cuts at banks and brokerages. The big shock in the employment report was a spike in the unemployment rate to 5.5% from 5.0%, one of the biggest monthly rises on record. This appeared to reflect a catch-up to past job weakness, as the rate had held steady from December to April despite a string of payroll job losses. The average workweek was steady at a near-record-low 33.7 hours, while average hourly earnings picked up to +0.3%. With aggregate hours worked down 0.1%, aggregate weekly payrolls, a proxy for total wage and salary income, posted a modest 0.2% rise, though this will likely be negative in real terms once the inflation figures are reported, given the recent spike in energy prices. The manufacturing ISM composite index rose a point to 49.6 in May, holding just below the 50-breakeven level. The upside was accounted for by a good rise in orders (49.7 versus 46.5), though to a level still barely in contractionary territory. Strength in exports continues to provide significant support, with the export orders index at an elevated 59.5. Meanwhile, production (51.2 versus 49.1) moved modestly higher into growth territory, while employment (45.5 versus 45.4) was little changed at a weak level. The industry breakdown remained soft, with only 7 of 18 sectors reporting growth. The prices paid index climbed another 2.5 points to 87.0, the third-highest reading since 1979. A number of energy, metals, chemicals, paper and farm products were reported up in price. Meanwhile, the non-manufacturing ISM composite index dipped to 51.7 in May from 52.0 in April. Underlying details were more positive, as a sharp drop in the supplier deliveries index (51.0 versus 56.0) after a big rise the prior month was the biggest reason for the weakness. The employment gauge (48.7 versus 50.8) also fell a couple points into negative territory, but orders (53.6 versus 50.1) and business activity (53.6 versus 50.9) both rose a few points further above the 50 breakeven level. 13 of 18 industry groups reported growth in May, up from 12 in April, led by entertainment and, surprisingly, real estate and construction. The prices paid index rose 5 points to 77.0, the second-highest reading in the 11-year history of the data. A lengthy and varied list of items was reported up in price. After plunging to their slowest pace since the 1998 GM strike in April, motor vehicle sales fell a bit further in May to a dismal 14.3 million unit annual rate from 14.4 million. And the mix was much worse than the dip in overall sales, as sales of cheaper cars jumped to 8.0 million from 7.5 million, while trucks plunged to 6.2 million from 6.9 million. This was the weakest month for truck sales since 1995 even as sales of imported cars jumped to a nearly 20-year high. Spiking gasoline prices are clearly having a major impact on consumers’ motor vehicle buying patterns. Meanwhile, chain store sales overall were relatively sluggish but somewhat better than expected. Sales at clothing and department stores were very weak, but discounted posted modest upside and clubs were strong. A large part of the upside in club sales, however, reflected surging gasoline prices. We look for retail sales to rise 0.7% in May both overall and excluding autos, though the bulk of this upside is expected to come from a price-related surge at gas stations (plus a boost to general merchandise from the upside gas prices provided to club store sales). Incorporating this estimate and the weak auto sales numbers, we trimmed our 2Q consumption forecast to 0.3% from +0.5%. Other data bearing on 2Q growth, however, predominantly a better-than-expected construction spending report for April that pointed to a surprisingly solid trajectory for business investment in structures, more than offset this weaker estimate for consumption and we boosted our 2Q GDP forecast to -0.7% from -1.0%. We also see 1Q GDP being revised up a bit further to +1.1% from +0.9%. Retail sales on Thursday and CPI on Friday highlight a moderately busy economic calendar in the upcoming week. The Fed will release the Beige Book prepared for the June 24-25 FOMC meeting on Wednesday, and a number of Fed speakers are scheduled. Both Chairman Bernanke and Vice Chairman Kohn will be participating in a Boston Fed Conference on Understanding Inflation and the Implications for Monetary Policy: A Phillips Curve Retrospective, though Bernanke’s speech Monday night on Outstanding Issues in Inflation Analysis sounds likely to be more technical and academic in nature than market moving. There will also be supply to deal with, with the Treasury announcing the terms of the 10-year reopening Monday to be auctioned Thursday. The size will likely be held steady at US$10 billion after being boosted US$2 billion to that level at the March reopening in anticipation of a US$2 billion increase in the new issue size at the May refunding. Other data releases due out include the trade balance Tuesday, Treasury budget Wednesday and business inventories Thursday: * We expect the trade gap to widen to US$61.2 billion in April, reversing most of last month’s big narrowing, with exports up 1.4% and imports rising 2.5%. Almost all of the import gain is expected to come from a price-related surge in petroleum products. Indeed, the American Axle strike likely kept auto imports depressed after the sharp fall seen in March, and port data continue to point to sluggish incoming shipments of other goods. On the export side, industry data and factory shipments figures point to a good gain in capital goods, led by aircraft. Meanwhile, a moderation in food prices following on the heels of the prior surge should lead to some flattening out in that category, but exports of industrial materials should show some further price-led upside. * We expect the federal government to report a US$160 billion budget deficit in May, much larger than the US$68 billion recorded a year ago, largely as a result of nearly US$50 billion in tax rebate checks that were distributed in May. A calendar shift that resulted in almost all of the April 15 payments being processed in April this year instead of partly spilling over to May should also lead to a sharp fall in non-withheld taxes, and withheld income and payroll taxes appear to have been little changed from a year ago. Meanwhile, because June 1 was a Sunday, a big chunk of early June outlays were shifted into May this year. * We forecast a 0.7% rise in May retail sales, overall and ex-autos. A price-related spike in sales of gasoline is expected to help drive retail sales higher in May. Indeed, excluding the gas station category, we look for non-auto sales to be up only 0.2%. And the motor vehicle sales reports appeared to translate into only a slight uptick in the auto dealer category following some significant softness in prior months. Meanwhile, the chain store reports showed somewhat better-than-anticipated results for general merchandise offset by softness at the apparel outlets. Finally, the tax rebate checks that were distributed starting in late April appear to have had only a minimal impact on May sales but will likely have a more noticeable effect in coming months. * We look for a 0.4% rise in April business inventories. The surge in wholesale inventories should be partly offset by the flat reading for manufacturing and likely little change at the retail level as auto inventories continued to decline, leading to modest rise in overall stockpiles. The I/S ratio is likely to dip a tenth to 1.25. * We forecast a 0.6% surge in the consumer price index in May and a 0.2% rise excluding food and energy. The seasonal adjustment factor for gasoline offsets some of the run-up in pump prices that occurred during May, but not nearly as much as in last month’s report. With food prices continuing to climb, we should see a sharp jump in the headline CPI. Meanwhile, the core is expected to be very close to +0.25% in May, implying that we see upside risk to our rounded estimate of +0.2%. One of the key factors again this month is expected to be hotel rates. Survey data point to some recent modest softening of room rates on an underlying basis, but the sharp fall-off seen in the April CPI report seemed overstated. So, we look for a partial rebound in May. Also, we expect to see some upside in the medical care component, which has been unusually soft over the past few months. Finally, on a year-on-year basis, we estimate that the core will just barely round down to +2.3%, which is where it stood in April.
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Taylor-Made Monetary Policy
June 10, 2008
By Marcelo Carvalho|
Brazil’s central bank appears to be moving away from its initial indication that the tightening cycle would be relatively short. How high can rates go? Our forecast assumes a hiking cycle of 300bp. A simple Taylor-rule exercise would suggest that risks around that forecast currently seem biased to the upside. In turn, a more pronounced period of monetary tightening could intensify policy tensions in Brazil. Hiking for Longer than First Planned? It was little surprise that the COPOM hiked rates last week. The central bank increased its policy rate by 50bp to 12.25% as most observers expected, although markets were divided between 50bp and 75bp. We had suspected 75bp. The decision was unanimous. The key change was the brief statement accompanying the announcement of the decision. The previous statement had been longer than usual. It had indicated that April's initial 50bp hike was already a “relevant part” of the full cycle. What is a “relevant part”: a quarter, a third? Back in April, most analysts concluded that the COPOM was planning for a relatively short hiking cycle, say 150-200bp. But things have changed since then. Inflation data surprised to the upside, global pressures have intensified and domestic inflation expectations have increased significantly. The June statement removed any reference about the magnitude of the full cycle. Instead, it resumes its usual, laconic mode. It simply says that the COPOM is continuing the adjustment in the policy rate, initiated at the April meeting. There is no longer any indication about the expected order of the magnitude for the cycle. We believe that the COPOM is getting ready to hike for longer than it initially planned, if necessary. The central bank would prefer to keep its options open. Policy decisions are likely to be data-dependent, and the COPOM is expected do whatever it takes to make sure inflation stays under control. There is no longer any indication that the hiking cycle will be relatively short. It seems it has become a more open-ended process. The risks, in our view, are that the COPOM will end up hiking for longer than it had planned initially. This would not be the first time that the COPOM has to revise its initial plans for a moderate cycle. The previous hiking cycle started in September 2004. Back then, the central bank said it was starting a “moderate” tightening cycle, with an initial 25bp move. A few months later, it had to drop the “moderate” wording. The central bank ended up hiking 375bp altogether. All eyes now turn to the COPOM minutes, to come out on Thursday, June 12. They are set to retain a hawkish tone overall. On the “dovish” side, the COPOM may claim that it had already foreseen a worsening inflation picture. But the minutes will still have to acknowledge a substantial rise in market inflation expectations since the April meeting. To be fair, Brazil’s inflation is actually not far from target, judging by current international standards. In the vast majority of inflation-targeting countries, inflation is running not just above the target center, but also above the target tolerance ceiling. Brazil’s current inflation target center is 4.5%, with a tolerance band of two percentage points either way. And we expect the minutes to recognize the global nature of current inflation pressures. The notes will almost surely mention signs that global inflationary pressures have intensified − in developed economies as well as in emerging markets. In particular, global food price inflation stands out. Brazil’s food price picture is comparable to global trends. Food price inflation in Brazil is currently running higher than in many other countries, but the share of food in household consumer baskets is similar to the international average. But the minutes are also likely to highlight concerns about broader CPI contamination amid strong domestic demand. We believe the COPOM is worried that initially localized inflationary pressures can end up spoiling broader CPI trends. The minutes should show concern that heated domestic demand and high resource utilization can magnify the pass-through from wholesale into consumer prices. In all, the minutes should leave no doubt that the COPOM remains firmly in a tightening mode. How High Can Rates Go? We estimate an econometric model for the central bank’s reaction function. We follow a Taylor-rule framework, in which the central bank’s policy rate is essentially a function of deviations of inflation from target, and of deviations of growth from its potential. Specifically for Brazil, we used the central bank’s survey data for IPCA inflation expectations (12 months ahead), and the output gap as measured by deviations of industrial production from its potential. The model is just an exercise, and involves several simplifying assumptions. Still, it provides broad ranges and suggests orders of magnitude. And it underscores the crucial role of inflation expectations for monetary policymaking. A simple Taylor-rule for Brazil suggests that the full hiking cycle could prove sizeable, possibly in the range of 275-450bp. Under certain assumptions, rates could peak somewhere in the range of 14.0-15.75% by 2Q09. Our forecast assumes a full cycle of 300bp, taking the policy rate to 14.25% by end-2008. Recent policy action suggests that the COPOM prefers a 50bp pace per meeting, but markets will still likely wonder about a potential acceleration to 75bp. Our forecast sees rates declining late next year, to 13.25% by end-2009. Risks to our 300bp cycle forecast would currently appear to be biased to the upside. Model assumptions. To simplify matters, let’s assume that the economy follows the path foreseen by the consensus view, with industrial production growing by 5.5% in 2008 and 4.5% in 2009. Let’s also assume that the central bank eventually succeeds in bringing inflation expectations back to the target, so that 12-month-ahead IPCA inflation expectations during 2009 converge to 4.5% by the end of 2009. Monetary policy would then crucially depend on how inflation expectations evolve in the coming months. Inflation expectations are key. They have risen substantially in recent weeks. Expectations for 12-month-ahead inflation jumped from 4.4% about a month ago, to quickly approach the 5.0% mark. If expectations stabilize at about 5.0% through the end of the year, then a simple Taylor rule would suggest that rates might peak at around 14.5%. If expectations climb further to the 6.0% mark, then rates would theoretically peak closer to the 16% mark. There are risks in the favorable direction too, to be fair. If (12-month-ahead) expectations quickly decline back to the 4.5% target in the coming months, then rates would not need to exceed the 14% mark. For instance, major declines in global commodity prices could alleviate international inflation pressures. Of course, falling commodity prices might then bring another set of challenges for commodity-exporting countries like Brazil. But that is another story. Given time lags, note that policy rates remain set to climb further, no matter what. In other words, there are enough pressures in the pipeline to make sure that 2008 inflation remains elevated, and that domestic policy rates in Brazil will increase further from the current 12.25% level. Enough Is Enough Alternative policy measures do not appear to be enough to avoid monetary tightening. As seen elsewhere in emerging markets, the authorities might feel inclined to intervene more directly in the price formation process, with measures ranging from subsidies to changes in export and import taxes. But such attempts often fail to permanently solve the underlying issues. Similarly, observers appear skeptical that proposed fiscal measures would effectively slow domestic demand enough to alter the need for rate hikes. Credit restrictions are possible too – but probably not yet. If monetary policy proves ineffective to cool down the economy fast enough, then we could hear more market talk about potential measures to slow (currently rapid) credit expansion. At least for now, the policy rate remains the main monetary tool. One potential risk for the rate outlook is that the authorities might eventually conclude that enough is enough. Monetary tightening can intensify policy tensions. For instance, rising interest rates would tend to strengthen the currency, but few in the administration would welcome the accompanying loss of export competitiveness. And not everybody will welcome the growth deceleration and fiscal costs which monetary tightening usually entails. Expect increasing debate about making the inflation-targeting framework more flexible. Inflation targets around the world look bound to be tested in the coming quarters. In many cases, it will be their first real test. In Brazil, the central bank can be expected to stick to the rules of the game – at least for now. The COPOM will reiterate that it aims at 4.5%, the very center of the target. Given time lags and unforeseen events, actual inflation may end up away from the targeted intention. But the central goal remains unchanged. That is, the central bank will likely argue that the tolerance band is meant to accommodate unanticipated deviations, ex-post. The band is not meant to allow the central bank to intentionally aim at a goal above the target center, ex-ante. The national monetary council will soon decide on inflation targets. On June 26, the council is scheduled to ratify (or not) the currently indicative target for 2009, now at 4.5% with a 2pp tolerance band. It will also announce for the first time the target and tolerance band for 2010, presumably a repeat of the 2009 figures. Official targets have already been changed in the past. And more than once. In light of large currency devaluation, inflation in 2002 was 12.5%, way above the official 3.5% target. In January 2003, the authorities changed the target for that year, from 4.0% to 8.5%. Actual inflation in 2003 turned out at 9.3%. In June 2003, the authorities changed the 2004 target from 3.75% to 5.5%. Actual inflation in 2004 was 7.6%. The latest target change was in September 2004. The COPOM announced it would pursue an “adjusted” target of 5.1% in 2005, higher than the original target center of 4.5%. The main idea was to partially accommodate the inertia from 2004 and avoid unnecessarily large costs for the economy. Actual inflation in 2005 was 5.7%. Is There Sunshine After the Rain? How soon can rate cuts eventually resume? Even before interest rates peak next year, market participants will wonder how soon and how far rates can decline again. Our forecast assumes that policy rates fall by 100bp late next year, to 13.25% by end-2009. A Taylor-rule exercise supports the notion of a rate decline next year, although a lot depends on how much the economy decelerates, and on how fast inflation expectations converge back to target. If growth does not slow enough or inflation expectations prove to be stubbornly high, risks are that interest rates end up remaining higher for longer than anticipated. Brazil’s ability to deliver lower real rates over time might be questioned. A longer-term question remains: how low can real interest rates fall? Brazil was lucky in recent years. Commodity prices have advanced repeatedly over the last several years, while global inflation remained subdued. Unhappily, that picture is now changing. Commodity prices may rise or fall from here, but global inflation looks set to increase significantly above what recent years would suggest. Our global economics team sees global inflation climbing to 5.5% in 2008. Tougher global conditions can complicate Brazil’s ability to engender sustainable lower interest rates. Bottom Line Brazil’s central bank seems to be moving away from committing to a short tightening cycle. Our forecast assumes a hiking cycle of 300bp. A simple Taylor-rule exercise suggests that risks for rates currently seem biased to the upside. In turn, monetary tightening can intensify policy tensions.
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The Double-Dip Supply Shock
June 10, 2008
By Richard Berner & David Greenlaw | New York
A double-dip recession is coming, courtesy of soaring energy prices and the ongoing restraint from the housing downturn, falling home prices and tighter financial conditions. Despite recent economic resilience, we’ve trimmed our growth prognosis by three quarters of a point over the four quarters ending in Q2 2009 to 0.5% from 1.3% last month, with modest declines now likely in both the spring and autumn quarters. Surging energy prices likely will boost headline inflation to 5-5½% over the next few months, and risks are rising that the consequent escalation in inflation expectations will spill over into a more lasting increase in inflation. Our year-over-year inflation forecasts (in terms of the CPI) for both 2008 and 2009 are now 70 bp higher in both years, at 4.6% and 3.5%, respectively. Although we think that the current episode is quite different from the miserable 1970s economy, the result − like that long feared by our colleague Joachim Fels − will feel like a prolonged whiff of stagflation. Indeed the risk is that the 1970s ‘misery index’ − the sum of the inflation and unemployment rates − will rise above 11% at some point in the next year. We have long agreed that investors should pay heed both to downside risks to growth and upside risks to inflation. Here’s why. | 2007E | 2008E | 2009E | Real GDP | 2.2% | 1.2% | 0.9% | Inflation (CPI) | 2.9 | 4.6 | 3.5 | Unit Labor Costs | 3.1 | 2.4 | 2.9 | After-Tax “Economic” Profits | 2.6 | -6.2 | 0.9 | After-Tax “Book” Profits | 4.3 | -12.0 | -5.3 |
Source: Morgan Stanley Research E = Morgan Stanley Research Estimates First-Half Resilience This most recent downgrading of our growth prognosis may seem strange at first blush. Despite a prolonged housing downturn, the influence of a credit shock, and the early effects of the recent surge in energy quotes, there’s no mistaking the better-than-expected performance in recent and incoming data for the first half of 2008. First-quarter real growth was revised higher to 0.9%, and we expect a further upgrade to 1.1%. And we now expect a second-quarter decline of just 0.7%, compared with 2% last month. The reasons: Vigor in capital spending and the influence of strong global growth on net exports more than offset the headwinds buffeting housing and consumer outlays. As evidence, a healthy 4% jump in April nondefense capital goods orders and increases in shipments point to smaller declines in business equipment spending than we thought last month. Strong April results and upward revisions to prior months’ data for nonresidential construction indicate a sizable increase in Q2 spending. And while exports tumbled in March, possibly reflecting the first signs of slower global growth, imports plunged by more, suggesting more support from net exports than anticipated. Finally, expected price hikes may be prompting some firms to buy goods in advance and hold them in inventory, limiting the slide in stockbuilding. Indeed, there is a risk that the tax rebates for individuals and the business tax incentives in the Economic Recovery Act of 2008 will promote a stronger result than the 0.7% decline we estimate for Q2 real GDP. As of the end of May, consumers had received $50 billion in tax rebates. Although vehicle sales remained depressed last month, May’s better-than-expected retailing results at chain stores could reflect the first signs that consumers will spend a portion of the rebates sooner than we think. Likewise, the “use-it-or-lose-it” nature of the investment incentives may be triggering some capex gains, albeit at the expense of 2009. Four ‘Adverse Feedback Loops’ Nonetheless, the analytics we see unfolding point to more economic weakness ahead. In particular, four ‘adverse feedback loops’ create downside risks to growth, especially to the consensus view that the economy has skirted recession and that a stronger second half is likely. First, the interplay between the housing downturn, falling home prices, deteriorating credit quality, and lender caution is undermining consumer wealth and ability to borrow. With inventories of unsold new homes still at 10.6 months’ supply, and foreclosures contributing to resale availability, a further 30% decline in 1-family housing starts seems needed to bring supply into balance with demand. Although housing affordability has improved with falling home prices and interest rates, price declines are keeping would-be buyers and lenders cautious. The first-quarter rise in delinquencies on 1-4 family loans reported by the Mortgage Bankers’ Association and chargeoffs on residential mortgages reported by banks − to 6.4% and 0.8%, both new records − has doubtless reinforced that caution. Household net worth in relation to income has declined by 35 percentage points (to 533%) in the 15 months ended in March. Recent surveys from the University of Michigan suggest that cautious consumers “are more interested in reducing their debt and increasing their savings,” and 57% of respondents opined that banks were less willing to lend than before. So while our assumption that only 20% of the tax rebates will be spent may be too low, these factors suggest that their impact will nonetheless be limited. The second adverse feedback loop stems from the supply-induced surge in energy prices that will undermine discretionary income in the US and abroad, probably depressing consumer spending and challenging the vigor of global growth. If gasoline prices nationwide peak at $4.25/gallon − hardly a bold forecast given the 20-cent surge in wholesale gasoline prices last week and the fact that prices averaged $4.03/gallon the week before − and if food prices rise at a 4.2% annual rate between May and September, the rise in food and energy quotes will have drained nearly $180 billion annualized from consumer budgets between December 2007 and September 2008. By comparison, the rebates will total $117 billion over all of 2008. Outside the US, countries such as India, Indonesia and Malaysia are reducing the subsidies that have long helped their consumers pay below-market prices for energy. The resulting price increases, combined with those in many other economies around the world, will erode spending power and thus global growth (see The Oil Shock Debate: Recession, Inflation or Both?, May 27, 2008). A third feedback loop involves slipping profitability, tighter financial conditions and economic uncertainty that will likely slow capital spending and hiring. This feedback loop is especially important for lenders: Weaker economic growth will erode credit quality and make lenders more risk averse, tightening lending standards further. While capital spending seems to be holding up for now, hiring is clearly fading. Nonfarm payrolls have declined by an average 65,000 in each of the last five months, and for all the talk of how little payrolls have declined in this slowdown, the current pace is identical to the pace of decline seen in the first five months of 2001. Combined with sliding real wages, these job declines signal declines in real wage and salary income for the first time since 2001. Finally, rising inflation and inflation expectations in Europe likely rule out monetary ease and could prompt the ECB to tighten (see ECB Watch: No Longer Ruling Out a Rate Hike, June 5, 2008). And in many emerging market economies − including China, where officials just announced a 100 bp hike in the ratio for required reserves, and Poland, Turkey, Israel, South Africa, Brazil, Peru and Columbia − officials likely will tighten monetary policy further to fight rising inflation. ECB officials and those elsewhere will welcome slower growth to bring down inflation pressures, and it seems likely they will eventually get their wish. For the first time in 35 years, we expect global forces will significantly push up US inflation, and the Fed faces the most serious inflation threat in a decade or more. Surveyed inflation expectations are rising sharply, echoing rising energy, food, and import quotes, and those hikes now threaten to spill over into domestic pricing. Measured by the University of Michigan’s 5-10 year median, inflation expectations rose in May to 3.4%, a 13-year high. The doubling in energy quotes over the past year is affecting pricing in a broad array of industries, including transportation, agriculture, chemicals, construction and construction materials. Thus, core intermediate goods producer prices rose at a 9.4% annual rate in the six months ended in April, and more hikes are coming. Prices for imported consumer goods excluding motor vehicles rose by 2.8% in April, the fastest pace in 15 years. These developments potentially could create a vicious inflation circle, because the rise in energy, food and import prices is affecting inflation expectations. And we’ve long argued that the dollar and oil prices might become locked in a vicious circle of their own, as oil producers seek to hedge their currency risks with higher prices. The good news is that these inflation pressures do not so far appear to have filtered into the wage setting process. Instead, they are squeezing margins in private industry and budgets for state and local governments. Over time, growing slack in product, housing and labor markets and hearty productivity gains will help mitigate the threat of a wage-price spiral. But that more benign picture is a story for 2009, when operating rates slide more significantly and the jobless rate rises to 6%, not now. This setting clearly poses a dilemma for the Fed. As we see it, the resolution lies in leaving monetary policy on hold until spring 2009 − far longer than is currently priced in to financial markets. Indeed markets oddly are priced for a first rate hike as soon as the late-October FOMC meeting, just when the stimulus from tax rebates will be fading, and at least some “payback” in growth is highly likely. Despite the coming economic weakness, the rise in inflation and surveyed inflation expectations means that the Fed is unlikely to ease monetary policy again. Those inflation increases have reduced real rates, making policy effectively more stimulative. They also threaten to erode the Fed’s track record and credibility in keeping inflation in check. Chairman Bernanke’s warning that the dollar’s decline has boosted inflation is one aspect of the Fed’s concern. As a result, we think policymakers are on hold and will tolerate and even welcome economic weakness to cap inflation and eventually bring it back down. For investors, that policy stance will continue to shape risks to the yield curve. With the Fed anchoring short-term rates, rising inflation risks will put a floor under long-term yields and could push them above 4% again. Rising oil prices and inflation uncertainty probably will promote a bearish steepening in the yield curve. Indeed, our colleague Manoj Pradhan provides tests suggesting that core CPI inflation volatility has been a structural driver of breakeven inflation, implying that investors should be compensated with a higher inflation risk premium and breakevens (see “Breakevens to Break Even Higher?”, The Global Monetary Analyst, June 4, 2008). Our rates strategy colleagues Jim Caron and George Goncalves are concerned that inflation risks might begin to shift the entire yield curve higher. But weakness in the economy likely will cap real yields and limit the sell-off for now, keeping 10-year yields roughly in a 3¾% to 4¼% range through year end.
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