Testing the Inflation Target
May 05, 2009
By Daniel Volberg | New York
We are revising our inflation and interest rates forecasts for Peru for 2009 and 2010. We are revising our interest rate forecast for 2009 to 3.50% from our previous forecast of 5.00% and for 2010 to 6.00% from our previous forecast of 5.50%. We are revising our inflation forecast for 2009 to 2.6% from our previous forecast of 3.6% and for 2010 to 3.6% from 2.5% previously. We suspect that while it is no longer a focus in the near term, underlying inflation is set to move above the target range next year and may test the monetary authority’s commitment to the current inflation target.
Recent Inflation Trends a Mixed Bag Recent inflation data have been a mixed bag. The central bank missed its 2% inflation target last year: average inflation in 2008 was 5.8%, near double the 3% upper bound of the target range. There are now signs that inflation has peaked and will continue to come down this year. Tradable goods inflation has come down sharply since its June-August peak of 6% to the 1.6% reading in March. Meanwhile, non-tradable goods inflation has been much more sticky – peaking only in January of this year at a hefty 8.8% and has since fallen continuously to the most recent 7% reading in March. We suspect that the clearer evidence of a peak in non-tradable inflation was a key element in prompting the more aggressive and unexpected, 100bp, interest rate cut by the monetary authorities on April 8. Much of the uptick in inflation last year was due to food, which now appears to be normalizing. Food inflation jumped to double digits late last year, pulling headline inflation with it. After all in Peru food accounts for fully 47.5% of the consumer price index basket, the largest such share in Latin America where food usually accounts for a fifth to a third of consumer expenditures. Food – with its many supply shocks due to weather – is an often volatile component that was exacerbated by last year’s global surge in international food and energy prices. Ex-food inflation has been relatively well behaved – running at 2.8% in April after peaking at 4.2% in November. We expect food inflation to continue to normalize in the remainder of the year, helping to bring overall inflation down. Food disinflation helps, but may not be enough to keep a lid on overall inflation for long. In fact, the much stickier non-tradable inflation component peaked largely due to disinflation in the food component. Annual non-tradable food inflation peaked at 15% in January of this year and has since fallen nearly in half to 8.8% by March – the latest data we have with such a detailed breakdown. But the food disinflation may not be enough to sustainably bring inflation down, as other prices appear to have begun to tick up. We are concerned that the services component – that accounts for over two thirds of non-tradable inflation and near 40% of overall inflation – is quickly moving higher. Non-tradable services annual inflation has moved from an average of 3.9% last year to over 6% in February and March. Inflation Outlook to Challenge the Inflation Target We suspect that underlying inflationary trends remain inconsistent with the central bank’s inflation target. For us, the inflation outlook has three key components: the growth outlook, inflation expectations and the underlying inflation dynamic. On balance, we are revising our inflation forecast and expect end-of-period inflation to dip to 2.6% this year before moving back out to 3.6% in 2010. That contrasts with our previous forecast of 3.6% inflation in 2009 and 2.5% in 2010. We expect weak growth to be a disinflationary force in the months ahead. GDP growth this year will dip below its long-term potential, opening up significant slack in the economy – a key disinflationary force. How disinflationary the growth downturn will be depends on both the magnitude of the actual downturn and the true long-run growth potential. But whether economic growth this year dips to 0.9% − as we forecast − or the 4% that the central bank expects, it will be below the long-term trend growth in Peru. Slack on the growth front should translate into a widening output gap, rising spare capacity and softening labor markets – traditionally a disinflationary environment. In fact, the February GDP result – the economy grew 0.2%Y – was surprisingly weak. February’s economic weakness was largely driven by intensification of a slump in manufacturing, which contracted 7.5%Y after posting a 2.7% contraction the month before. Moreover, the March unemployment figures suggest that more weakness may be in store – the jobless rate went from an average of 7.7% in the three months through November last year to 9.3% on average in the three months through February and March. In contrast to the benign macro backdrop, underlying inflation trends may be more challenging. We constructed two measures to help us better gauge underlying inflationary pressures: a trimmed means inflation index and a diffusion index. Underlying inflation remains sticky. We constructed the trimmed means measure by dropping from headline inflation the biggest moving inflation items on both the upside and the downside. We use the 20% trimmed means measure that has been adopted as one of the empirical core inflation measures by many central banks. We find that while headline inflation has dipped below 5% since March, trimmed means inflation has remained persistently above the 5% mark so far this year. We expect the growth downturn to pressure inflation lower, but we are concerned that the uptick in inflation may be more persistent and that even though inflation may dip into the target range this year on the back of food disinflation, underlying inflation remains sticky and may move back above the range next year. And the inflationary uptick is gaining breadth. We construct the diffusion index by tallying up the number of items above the 3% upper bound of the target range and comparing that to the total number of items in the inflation index. We find that more than 60% of items have been moving above target range since November last year. The broad nature of the inflationary uptick is further grounds for concern that the underlying inflation dynamics remain challenging. One concern is that the longer inflation remains elevated, the more likely we are to continue to see other prices moving higher, reinforcing the inflation persistence suggested by the trimmed means inflation gauge. Finally, inflation expectations remain above the target range in both 2009 and 2010. As of March, inflation expectations were 3.2% for 2009 and 3.1% for 2010 according to a central bank survey – above the central bank’s 1-3% target range. Inflation expectations are an important gauge of the credibility of the inflation-targeting regime and can be an important component in actual price formation. Expectations can be reactive and have been coming down since October of last year. In fact, we suspect that as inflation continues to fall this year so will inflation expectations. But the significant uptick in 2010 expectations, despite significant monetary tightening when inflation rose last year, points to limited credibility of the monetary authorities and thus to potential for upside inflation surprises to be more extended as price formation may not be well anchored. On balance, we expect inflation to fall further this year, but to still remain a challenge to the aggressive inflation target adopted by the central bank. We are revising our inflation forecast and expect end-of-period inflation to dip to 2.6% this year before moving out to 3.6% in 2010. That contrasts with our previous forecast of 3.6% inflation in 2009 and 2.5% in 2010. We are not concerned about inflation in Peru – inflation near 3% is consistent with price stability and unlikely to materially shorten the planning horizon for investment. But given the aggressive inflation target, we are concerned that the monetary authorities may be tested in their commitment to that target in the months ahead. Interest Rate Outlook: Easing Now, Tightening Later The continued weaker-than-expected economy and food disinflation should allow the central bank to continue to ease policy in the near term. We expect the central bank to cut the policy rate by 75bp at the upcoming monetary policy meeting on May 7, bringing the interest rate down to 4.25%. More broadly, we now expect the central bank to slash policy rates to 3.5% this year. However, given that underlying inflation persistence points to inflation above the 3% target next year and given the limited credibility of the central bank – as demonstrated by the uptick in 2010 inflation expectations even as the central bank engaged in policy tightening last year – we expect the emergency rate cuts this year to be removed in 2010, as the authorities are forced to defend the inflation target. We expect the central bank to hike the policy rate to 6% in 2010. Bottom Line We are revising our inflation and interest rates forecasts for Peru for 2009 and 2010. We are revising our interest rate forecast for 2009 to 3.50% from our previous forecast of 5.00% and for 2010 to 6.00% from our previous forecast of 5.50%. We are revising our inflation forecast for 2009 to 2.6% from our previous forecast of 3.6% and for 2010 to 3.6% from 2.5% previously. We suspect that while it is no longer a focus in the near term, underlying inflationary pressure remains a problem and may test the monetary authority’s commitment to the current inflation target next year.
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Review and Preview
May 05, 2009
By Ted Wieseman | New York
The Treasury yield curve saw a huge steepening to multi-year highs over the past week as supply pressures from an enormous two-week run of new issuance were pushed out the curve as the front end was boosted by a flight-to-safety bid on concerns about the potential impact of the spreading swine flu. From the 5-year TIPS auction on April 23 through the 30-year bond auction on May 7, $180 billion in gross coupon supply will be issued, far outpacing ongoing Fed buying and pushing yields along much of the curve to the highs of the year over the past week. Credit and, to a lesser extent, stocks had positive weeks, which were not helpful for interest rate market performance, but the bid at the short end of the market suggested that Treasury market investors were more concerned about the potential economic impact of the flu outbreak than risk markets. Economic data released over the past week were somewhat mixed and didn’t have much market impact. The economy collapsed at a near record pace over the 4Q/1Q period, but the vaunted ‘second derivative’ of a number of releases looked positive moving into 2Q, even if in absolute terms the data still look awful, just not as bad as the collapse seen over the prior couple quarters. This was seen for the manufacturing ISM survey and consumer confidence, which both saw further improvement in April while remaining at badly depressed levels in absolute terms. On the other hand, after a modest rebound in consumer spending in January and February following a collapse during the holiday shopping season, consumer spending turned down again in March. And April looks like it may have extended the weakness after a renewed downturn in motor vehicle sales following a rebound in March. A renewed contraction in consumption in 2Q after a small bounce in 1Q (though likely not nearly at the near record pace seen in 2H08) should contribute to a further substantial contraction in the economy in 2Q, though not quite at the near record rate of the prior two quarters. At this early point, we see 2Q GDP on pace for a 3.5% decline. On the week, 2s-30s posted a huge steepening move to a more than five-year high as the front end posted decent gains and the long end sold off to the worst levels of the year. The old 2-year yield fell 7bp to 0.88%, and the 3-year held steady at 1.37%, while the old 5-year yield rose 7bp to 2.01%, old 7-year 13bp to 2.68%, 10-year 18bp to 3.17% and 30-year 21bp to 4.09%. After the enormous outperformance seen the prior week following the strong 5-year auction that extended through the middle of the latest weeks, TIPS performance was ultimately more mixed in the latest week as a whole, with the 5-year continuing to do relatively well, but the longer end substantially lagging. The 5-year TIPS yield rose 3bp to 1.22%, 10-year 27bp to 1.76%, and 20-year 26bp to 2.46%. This dropped the benchmark 10-year inflation breakeven 10bp to 1.42% after it had closed at its highest level since September at 1.54% on Wednesday. After managing to post decent gains the prior week as Treasuries sold off and extending the strength into Monday, mortgages sharply reversed course over the rest of the week to fully reverse the prior gains and send yields of 4% MBS several bp above 4% and back to the highs seen since the big rally following the announcement of the Fed’s stepped up buying in the March 18 FOMC statement. National average 30-year mortgage rates dipped slightly in the latest week to return back to the record low of 4.78% hit in early April, but rates are likely to move higher in the coming week in line, unless the MBS market sells off quickly and reverses course in coming trading sessions. Meanwhile, though it didn’t show up in any improvement in swap spreads, the recent improving trend in interbank rates and spreads continued, suggesting some further easing in bank balance sheet pressures as bank lending continues its recent sharply contracting trend. 3-month Libor fell another 6bp on the week to 1.01% and has now declined more than 30bp from the recent highs hit in the first part of March. The spot 3-month Libor/OIS spread fell 9bp to 79bp, for the first time getting back to levels that prevailed in the first week of September before the huge blowout that followed the Lehman collapse. This improving trend also continued to be extrapolated into forward spreads. The forward Libor/OIS spread to June fell about 8bp on the week to near 73bp, September 5bp to 73bp, December 4bp to 83bp and March 6bp to 69bp. After stumbling early in the week on swine flu concerns, equity and credit markets recovered to post gains on the week and provide a negative backdrop for the Treasury market as the week’s hefty supply was being taken down. The S&P 500 gained a bit more than 1% on the week to reach its best level since early January and trim its year-to-date loss to 3%. Financials performed poorly on the week, however, as investors worried about the implications of the upcoming release of the bank stress-test results, with the BKX banks stock index losing 7%. Credit had a better week than stocks, with the investment grade CDX index 10bp tighter on the week at 165bp late Friday, coming a bit off a bit at the end of the week from the best levels seen in several months at Thursday’s close. The high yield index was 117bp tighter at 1117bp at Thursday’s close before also giving up a bit of ground in Friday trading, and the leveraged loan LCDX index had a similarly strong week, tightening 121bp to 1174bp through midday Friday. Subprime and commercial real estate derivatives ended the week mixed. The AAA subprime ABX index gained a point and a half on the week, continuing to gradually extend its recovery from the all-time low of 23.10 hit a few weeks ago. Lower rated indices were slightly softer, however, and remain stuck near the lows. The commercial mortgage CMBX market was having a strong week across the board through Thursday but took a big hit Friday to end the week mixed. The AAA index was little changed on the week at 70.27 after losing nearly 3 points Friday and the junior AAA lost 0.70 point to 25.94 after plunging almost 2 points to end the week. Lower rated indices were more mixed for the week as a whole after also taking a hit Friday from good earlier gains. Real GDP plunged at a 6.1% annual rate in 1Q, which after the 6.3% drop in 4Q made for the worst two-quarter contraction in fifty years. A sharp further inventory correction − which so far has made little dent in bloated inventory to sales ratios as demand has plunged just as quickly − knocked nearly 3 points off growth. This was partly offset by a 2 point add from trade, with both exports (-30%) and imports (-34%) posting near record drops. Final domestic demand plunged 5.1%, as a meager rebound in consumption (+2.2%) after a near record drop in 2H08 was way more than offset by a record decline in business investment (-38%), the biggest fall in residential investment (-38%) in thirty years and major weakness in government spending (-3.9%). The personal income report showed that all of the upside in consumption in 1Q relative to expectations was in upward revisions to January and February. Real PCE fell 0.2% in March, and this weak starting point combined with still terrible consumer fundamentals point to a renewed decline in consumer spending in 2Q. At this early point, we see 2Q consumption declining 1% and GDP 3.5%. The main positive swing relative to near record 6%+ annualized collapse in 4Q and 1Q is likely to be a flattening out in the inventory contribution − though with another steep decline in inventories likely again as companies struggle to bring down sharply elevated inventory/sales ratios. The volatile federal government spending component will also probably swing into positive territory after declining 4% in 1Q. With consumption on pace to turn down again and business and residential investment poised for another quarter of steep declines, however, the decline in private final demand is likely to be nearly as severe in 2Q as in the prior couple quarters. Very little data have been released for 2Q to this point, but early figures out the past week were somewhat mixed. The manufacturing ISM composite index rose to 40.1 in April from 36.3 in March, a seven-month high and up from the low of 32.7 hit in December though still holding far in recessionary territory. The key orders (47.2 versus 41.2), production (40.4 versus 36.4), and employment (34.4 versus 28.1) gauges all posted less negative readings than last month. Weakness by industry remained very broadly based, however, with 17 of 18 sectors reporting contraction in April. The prices paid index ticked up slightly but remained well below the 50-breakeven level, at 32.0. A number of metal and energy products were reported down in price again this month. Meanwhile, the first indication for April consumer spending was soft after the renewed contraction seen in March. Based on a nearly complete count, we estimate that motor vehicle sales fell to a 9.3 million unit annual rate in April after having rebounded to 9.8 million in March from the low since 1981 of 9.1 million hit in February. The calendar shift that pushed the employment report to the second Friday this May makes it the focus in an otherwise fairly quiet upcoming week for key economic data. Prior to Friday’s employment, the market will need to take down another week of heavy supply, with the $35 billion 3-year auction Tuesday, $22 billion 10-year Wednesday and $14 billion 30-year Thursday. On Thursday, the delayed results of the bank stress tests will be released. Bloomberg reported that about a third of the 19 banks being subjected to the tests − which are really not all that stressful at all, in our view, with the downside economic scenario pretty much in line with our base case − could fail and be instructed to raise more capital, which could help extend the ongoing credit crunch for some time as financial firms continue to focus on shoring up their balance sheets partly through slashing lending. Other than the employment report, the most notable economic data releases will be the monthly sales results from most major retailers on Thursday and the Fed’s senior loan officer survey sometime during the week. Other notable data releases due out include construction spending Monday and productivity Thursday: * We forecast a 1.5% decline in March construction spending. Unseasonably mild weather appeared to provide some temporary support for construction activity in February, but we expect to see a reacceleration in the pace of decline this month. In particular, we look for some renewed slippage in the nonres category. And while the federal government’s stimulus package will eventually provide a boost for public infrastructure spending, it will take some time for this to show up in the data. * We look for nonfarm business labor productivity to dip 0.1% in 1Q and unit labor costs to rise 3.7%. The estimated fall-off in hours worked during the quarter (-7.5%) does not appear to have been quite as large as the very sharp drop in output (-8.2%). So productivity is expected to show an outright decline for the second straight quarter. Meanwhile, unit labor costs are expected to post a somewhat more moderate gain than seen in 4Q. Still, the year-on-year rate for unit labor costs should rise to 2.4%. * We forecast another 600,000 plunge in April nonfarm payrolls. Although there is still some uncertainty regarding the impact of possible seasonal distortions, initial unemployment claims show tentative signs of having peaked in recent weeks. Moreover, the latest readings for continuing claims have displayed a slightly slower rate of increase. Thus, we look for a bit of moderation in the pace of overall job loss this month. Special factors do not appear likely to play a major role in the April data. For example, average temperatures across the nation were somewhat cooler than normal, but now that we have moved out of the winter months, weather conditions are less relevant. Also, April is a 5-week survey period, but we doubt this will cause any significant distortions because the raw payroll number should be relatively flat this month. Finally, we expect the unemployment rate to continue to climb – hitting another new post-1983 high of 8.9%.
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