Venezuela
To Devalue or Not to Devalue
October 21, 2009

By Giuliana Pardelli | Sao Paolo & Daniel Volberg | New York

When the planning ministry, economy ministry and the central bank held a joint press conference earlier this month, they confirmed that the direction of economic policy will be towards reinforcing the current fixed exchange rate regime.  Indeed, the official exchange rate has not been adjusted since 2005, as higher oil prices meant that there was little pressure to devalue for either liquidity or budgetary reasons.  And while the press conference was short on details of policy initiatives, the authorities signaled that they will start providing more dollars at the official exchange rate, issue more dollar debt to strengthen the parallel (black market) exchange rate and commit to maintaining the current fixed exchange rate at Bs$2.15.  We had been calling for a significant devaluation of the exchange rate next year as we expected Venezuela to struggle in the global downturn.  But with the markets and the global economy healing, we are revising our forecasts for Venezuela.  Most importantly, we are removing our call for exchange rate devaluation next year.  In our new forecast, we expect the exchange rate to remain at Bs$2.15 in 2010 instead of a previous forecast of Bs$4.00.  There are three main factors that support our view:

1. Inflation Costs

Elevated inflation in Venezuela continues to be a concern, and a significant devaluation may only aggravate the problem.  Sharp devaluations are often associated with sharp increases in inflation. For example, back in 2002 the devaluation of the bolivar from 870 in April to 1,450 in September was associated with annual inflation rising from 18.4% to 30.1%.  And given that inflation is already elevated in Venezuela, we suspect that the authorities may be reluctant to pursue policies that may risk raising it further.  After all, despite some deceleration from last year's above 30% pace, annual inflation remains entrenched: in the three months through September, annual inflation averaged 26.8%.

High inflation in Venezuela is, in part, driven by loose monetary policy.  Indeed, M1 and M2 money supply is growing at an annual pace of over 30% while domestic real rates remain highly negative and we continue to see further upside in inflation in the months ahead.  True, the nominal monetary aggregate growth has slowed when compared to recent years. But when we subtract real GDP growth from the nominal expansion in monetary aggregates, we find that little has changed - real money supply expanded 21.5% in 2008 and has been growing at 31.8% on average in the first six months of this year, fueling inflationary pressure.  Indeed, we suspect that one key driver of loose monetary policy in Venezuela has been sustained fiscal deterioration and the need by the authorities to finance it in part through the inflation tax.  After all, government spending has continued to expand faster than the overall Venezuelan economy and has now reached 34% of GDP, up from 31.9% in 2004.  As a result, despite price controls, a contracting economy and a fixed nominal exchange rate for over three years, inflation remains above 25%.

But while loose monetary policy is a factor, exchange rate devaluation may drive inflation significantly higher.  We are still trying to sort through the connection between fiscal accounts, inflation and exchange rate policy in Venezuela, but we suspect that there may be at least three factors that should be taken into account.  First, we expect a devaluation to elevate imported inflation as a weaker exchange rate is passed into domestic prices that are imported at the official exchange rate.  However, if some fraction of the importers currently operating in the significantly weaker parallel market move their operations to the official exchange market, it may prove to be a potentially mitigating influence on the inflation cost of a devaluation.  Finally, given that a large portion of fiscal revenue is dollar-based while virtually all expenditures are in local currency, if the devaluation helps to ease the fiscal imbalance by raising the oil export revenue in local currency terms, it may allow the authorities to tighten monetary policy with the consequent mitigating effects on inflation.

We will continue to evaluate the various costs and benefits of a devaluation, but one issue that may be particularly important in the decision process is the eventual effects on food inflation.  Traditionally, the government chooses to subsidize certain strategic industries - mainly heavy machinery, foodstuffs and medicines - by allowing them to trade bolivars at the official rate and driving other non-essential goods producers to the parallel market.  One reason for this policy of subsidies may be that food and medicines represent a larger portion of expenditure for lower-income households that make up the core constituency of the current administration.  Indeed, the official exchange rate has been fixed at Bs$2.15 since 2005, as rising oil prices meant that there was little pressure to devalue for either liquidity or budgetary reasons, allowing the authorities to maintain the exchange rate subsidy for essential goods imports.  But earlier in the year, when oil prices plunged, the authorities reacted by rationing dollars sold by CADIVI (the entity in charge of administering the exchange controls), forcing the private sector to finance a rising share of imports at the depreciated black market exchange rate and thus fueling inflationary pressure.  Indeed, in 1H09, CADIVI disbursements contracted 37.3% to US$13.6 billion, from US$21.3 billion in the same period in 2008.  One sector that has been hit particularly hard by the dollar shortage has been food importers, thus fueling food inflationary pressure.

The rationing of foreign exchange at the official rate forced food importers into the parallel exchange rate market, fueling further food inflation.  Food remains the largest category of imports that are granted access to the official exchange rate - in the first six months of the year, food imports accounted for almost 26% of the total amount of imports that came in via the official exchange rate market. And healthcare items were the next largest category, accounting for 16.3% of official exchange rate imports.  But despite the large amount of resources channeled to imports of essential items, a growing portion of these imports have been forced to rely on the parallel market.  For example, we estimate that during 1H09, 36.4% of food imports came through the parallel market, up from 28.2% on average last year.  And considering that the parallel market exchange rate has depreciated from Bs$4.28 on average in 2008 to Bs$6.2 on average during 1H09, it is natural to expect food inflation to see significant exchange rate pass-through.  Not surprisingly, food inflation has been one of the main drivers of headline inflation.  Indeed, despite the sharp correction in commodity prices, food inflation in Venezuela has remained elevated.  For instance, in the three months through September, food inflation was 25%.  Not surprisingly, the authorities have signaled that they are evaluating how to reduce the gap between the official and parallel exchange rate, in order to slow imported inflation.  But we suspect that the authorities are unlikely to reduce this gap between official and parallel exchange rates by devaluing the currency.

In our view, given that devaluation would likely raise the domestic price of imports that are currently bought at the official exchange rate, especially food, we suspect that a significant devaluation is unlikely.  Given the politically sensitive nature of food inflation - since lower-income households that are a core constituency of the administration tend to spend a larger share of income on food and are thus more sensitive to price fluctuations - we suspect that the potential for a devaluation to generate significant food inflation upside may keep policymakers from deciding to devalue the currency except as a last resort.  After all, nearly two-thirds of food imports are purchased at the official Bs$2.15 exchange rate - devaluation would push these prices significantly higher and likely force further increases in food inflation.  Still, we are cognizant that the overall inflationary effects of devaluation may be ambiguous, and we will continue working on the issue.  However, several additional considerations may be important when thinking about the government's decision on whether to devalue or not.

2. Fiscal Pressure

Fiscal pressure for currency devaluation is diminishing as oil prices rebound.  After all, the sharp decline in oil prices earlier in the year and the drop in economic activity had put severe pressure on revenues in 2009 and led to a sharp deterioration in the fiscal balance.  One way of remedying the situation would have been a devaluation to raise the local currency value of oil revenues and help to reduce the deficit.  But the authorities had resisted making this policy choice back then, signaling that an exchange rate devaluation was a measure of last resort. 

The sharp decline in oil prices earlier this year has resulted in a significant weakening of Venezuela's fiscal position.  The latest available fiscal data run only through 1Q09 and show that, following a 31.7% decline in oil revenue, total revenue dropped 13.9%, while the cumulative total expenditure to March was up 12.9%Y in nominal terms.  In our view, policy distortions - in particular the policy of price controls - prevented the authorities from significantly reducing spending growth.  For example, subsidies - the fiscal cost of running a policy of price controls - represent more than 50% of total expenditures and grew 20.3%Y in 1Q09.  As a result, the overall restricted public sector financial deficit for the first three months of the year slipped to Bs$7.8 billion (-0.9% of GDP), which compares to a Bs$7.3 billion surplus (1.1% of GDP) in 1Q08.  And given that the bulk of fiscal outlays falls in the December quarter, this fiscal slippage bodes ill for the fiscal results this year.

The authorities are clearly concerned about the fiscal slippage.  Indeed, in order to offset the impact from lower oil revenues, the government unveiled a series of emergency measures including higher taxes and increased projected borrowing (from Bs$15 billion to Bs$37 billion), and announced in late March a reduction in its projected expenditure by 6.6%, to Bs$156.4 billion.  Indeed, given that the original 2009 budget had already penciled in expenditure reductions, the downward revision in projected expenditure would represent a significant 18.5% cut in expenditures relative to last year.  We will only know if the authorities were able to implement the announced austerity program once more up to date fiscal data are released.  However, during the first months of the year, instead of falling 12.8% as first projected (before the revisions) or the more austere planned 18.5% reduction, total expenditures expanded 12.9% and the central government continued to sink further into deficit.  A fiscal adjustment would have required either more severe spending restraint or an exchange rate devaluation (to boost local currency receipts from oil earnings) in order to contain the ballooning deficit.  Based on 1Q09 data, we estimate that the authorities would have had to devalue the official exchange rate to Bs$4.80 to close the fiscal gap (considering the effects of the new exchange rate on both revenues and expenditures).

However, the rebound in oil prices reduces the pressure to devalue the exchange rate in order to stabilize the fiscal accounts.  Oil prices have rebounded 73.2% since the beginning of the year, and though still down in annual terms we expect them to show positive annual growth in 4Q09.  The rebound in oil prices should translate into a better revenue stream for the authorities - we expect fiscal revenues to start growing again in annual terms in the December quarter.  Indeed, we expect that the oil price-driven rebound in fiscal revenues will stabilize the fiscal deficit at roughly 6.5% of GDP in the months ahead, reducing pressure for a devaluation, at least in the near term.

3. Savings Cost

Finally, Venezuela's savings may be jeopardized by a devaluation. One of the key anchors of confidence in Venezuela has been the large war chest that the authorities have saved for a rainy day.  A significant portion of these assets is held in local currency. Thus, a devaluation would not only improve oil revenues in local currency, but also reduce the government's stock of savings.  According to estimates at the close of August 2009, the government could count on US$41.9 billion in extraordinary resources, of which US$27.8 billion were held in local currency. Therefore, a devaluation of the official exchange rate to Bs$4.00 would cut roughly US$13 billion from assets, equivalent to about 6% of GDP.  In our view, the near 6% of GDP cost in lost savings nearly erases the fiscal benefits (closing the 6.5% of GDP deficit) of a devaluation.  Indeed, given that the authorities have publicly announced that they are committed to the current fixed exchange rate regime, we suspect that they would be reluctant to break the status quo exchange arrangements unless the benefits of a devaluation far outweigh the costs.

Policy Measures Ahead

Rather than devaluing the official exchange rate, we suspect that in the coming months the authorities may instead focus on new measures to contain the parallel exchange rate.  One of these measures may involve the authorities raising the supply of dollars in the economy.  One of the channels to achieve this higher dollar supply may involve the state oil company, PdVSA, clearing Bs$10 billion (US$4.7 billion) in payment arrears to private sector contractors and suppliers in 4Q09.  Another channel is the likely issuance of additional dollar-denominated debt by the Treasury and the state oil company.  Indeed, the authorities have made statements to this effect beginning in the middle of August.  And PdVSA has already issued US$3 billion in June.  Further, on September 28, the authorities announced the first dollar-denominated bond issue in 18 months.  The authorities stated that they would issue US$3 billion of bonds maturing in 2019 and 2024, and that they plan to sell Bs$12.15 billion (US$5.7 billion) of securities denominated in the local currency by year-end.  However, on October 7, when the issuance came to market, the authorities raised the total amount from US$3 billion to US$5 billion on the back of strong demand (which according to the government had reached near US$19 billion).  After the announcement, the parallel exchange rate appreciated to Bs$5.26 per dollar, the strongest since last December and a 25% rally since August when the parallel rate weakened beyond Bs$7 per dollar. Looking ahead, PdVSA announced last week that it plans to issue about US$3 billion in euro-clearable bonds maturing in 2-3 years in the local market during the second half of October.

Forecast Revisions

In addition to the major revision to our exchange rate forecast, we are making several other revisions to the economic outlook for Venezuela. We are revising the exchange rate forecast for 2009 to 2.15 (from 2.85 previously) and for 2010 to 2.15 (from 4.00 previously).  We are also revising growth in 2009 to -1.9% (from -5.0% previously) and in 2010 to 1.3% (from 0.0% previously).  And we are also revising the fiscal balance in 2009 to -6.5% of GDP (from -2.9% of GDP previously) and in 2010 to -5.9% of GDP (from -0.3% previously).  We are also making adjustments to our international reserves, interest rate, trade and current account forecasts.

Bottom Line

Despite mounting imbalances in the economy, Venezuela should be able to avoid a sharp devaluation next year, in our view. At the turn of the year, there were risks that the global downturn would squeeze Venezuela on either the liquidity or fiscal fronts, prompting the authorities to devalue as an escape valve.  But with the markets - particularly crude prices - and the global economy healing, the authorities are likely to have enough maneuvering room to maintain their commitment to a fixed exchange rate at Bs$2.15 and thus prevent a more serious spike in already-elevated inflation.  In turn, the extra revenues derived from higher crude are likely to allow the authorities to keep spending and allow the government to boost dollar sales, in order to diminish the gap between the official and the parallel market exchange rate.   Looking further ahead, however, Venezuela's economic policy mix may not be consistent with the current fixed exchange rate, and we expect that the authorities will eventually be forced to devalue, but just not in 2010.

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Brazil
Exit Strategy
October 21, 2009

By Marcelo Carvalho | Sao Paolo

As Brazil's economy rebounds briskly and conditions normalize, the authorities will need to start withdrawing emergency policy stimulus. With fiscal policy likely to remain expansionary next year, monetary policy will need to carry the burden of the adjustment. It is hard to handicap the exact timing of the monetary exit strategy - we assume it starts by 2Q10. But we suspect that risks look biased for rate hikes to start earlier rather than later, if strong growth quickly eliminates slack in the economy and starts undermining inflation expectations.

Exit Signs

Exit strategy is a global theme. Impressive global fiscal and monetary stimuli have been put in place to counteract the global recession, but as the global economy finds firmer footing, we suspect that ‘exit strategies' will be a key theme around the globe. Israel and Australia have already started hiking interest rates. Our global economics team expects Norway to hike soon, and sees policy rates going up in a variety of countries over the next several quarters. Indeed, for the vast majority of countries that we follow, the latest policy rate move has been a cut, but the next rate move will be a hike (see The Global Monetary Analyst, October 14, 2009).

Brazil's policy rate looks set to go up next year. Brazil's economy has rebounded sooner and more strongly than other places; if rapid domestic growth persists, we would not be surprised to see Brazil's monetary policy committee (COPOM) hiking rates sooner rather than later. While the local yield curve has long priced in significant monetary tightening throughout 2010, the consensus policy rate forecast among economists has now started to move higher too. According to a regular central bank survey, the median consensus forecast among analysts for the end-2010 policy rate has climbed from 9.25% a month ago to above the 10% mark in the latest surveys. Our forecast assumes 11% for end-2010.

COPOM's Thinking

The near-term inflation outlook is benign, but domestic overheating in lagged response to cumulative fiscal and monetary policy stimulus is the main medium-term risk, the central bank suggests. As always, the key driver for Brazil's monetary policy decisions is the inflation outlook and the balance of risks associated with the baseline outlook. The central bank looks for improvement in medium-term global prospects and foresees continued domestic recovery, in a baseline scenario where inflation is still benign. However, in its balance-of-risks analysis, COPOM argues that the main medium-term domestic risk for inflation comes from the cumulative and lagged stimulus from the fiscal and monetary policy easing implemented this year, as its impact on the economy could peak precisely when slack in the economy is significantly smaller than now, given recent trends in rising capacity utilization and tightening labor markets.

There is still lagged stimulus in the pipeline. COPOM has cut rates by 500bp this year, to an unprecedented low mark of 8.75% currently, and it underscores that a relevant portion of the impact from the easing in financial conditions is yet to materialize over coming quarters. Similarly, part of the impact from fiscal expansion already implemented is yet to materialize. In this context, uncertainties tend to be higher about the magnitude and time lags involved in the monetary transmission channels, COPOM argues. While the central bank will not want to remove policy stimulus prematurely, it will not want policy easing to overstay its welcome either.

What Could Force a Rate Hike?

Inflation expectations seem key. Previous interest rate cycles in Brazil suggest that inflation expectations are a crucial driver for monetary policy decisions. The near-term inflation outlook appears benign. In fact, the central bank foresees annual consumer price (IPCA) inflation falling further, from the current 4.3% mark to a trough of 3.6% in 2Q10. However, the problem is not inflation for the coming months or even 2010. Instead, the concern is about prospects going into 2011. In its recent quarterly September inflation report, the central bank has already revised up its forecast for inflation in mid-2011 to 4.6%, from its previous forecast of 4.0% - the official calendar year target is 4.5%. Market consensus forecasts for inflation are no longer falling, and we suspect that the consensus forecast for 12-month-ahead inflation could be drifting higher through the 4.5% target during 2010.

Watch services and food price inflation. Administered (or monitored) price inflation is set to run below overall headline inflation next year, in part due to its lagged indexation to (currently low) IGP inflation. By contrast, services price inflation has been stubbornly above average, sticky at around 7%, perhaps reflecting the resilience of the domestic services sector during the growth downturn. For its part, food price inflation remains a wild card - it accounts for about a fifth of the CPI index and can prove quite volatile. Food price inflation has slowed to 4.1% as of September, down from a peak of 15.8% in mid-2008, but could rebound if commodity prices go up - although commodity prices have been relatively stable when measured in local currency. Indeed, currency appreciation can help to curb inflation pressures, although divergent recent trends defy previous usual estimates of the pass-through coefficient.

The starting point for interest rates is extraordinarily low by Brazil's standards. Judging by the historical relationship between real interest rates and real GDP, the exogenous global shock had an impact on Brazil equivalent to a rate hike of several percentage points. However, as the global shock dissipates and monetary policy gains traction, current real interest rates look quite expansionary, if history is any guide. To be fair, historical patterns must be interpreted with caution, as relationships are probably changing if Brazil's real rates are indeed trending lower over the years, as seems plausible. In the end, no one really knows where the ‘neutral' or ‘equilibrium' rate in Brazil should be today. But two statements seem fair, in our view. First, the equilibrium rate is lower today than it was, say, five or ten years ago, as Brazil has become a better place, deservedly obtaining investment grade status. Second, actual current real interest rates are probably below the ‘neutral' level (see "Brazil: Are Lower Real Rates Here to Stay?" EM Economist, July 2, 2009).

Slack in the economy could disappear more quickly than anticipated, as the output gap shrinks under robust domestic growth. On our estimates, the output gap - or the distance of actual real GDP from its trend line - might evaporate sometime during 1H10, as other leading indicators also suggest. Also, bear in mind that the amount of ‘slack' can differ markedly across sectors within the economy. Capacity utilization in industry is recovering steadily but from very depressed levels, as the global shock hit industry the hardest. By contrast, resilience in the services sector during the growth downturn suggests that there is probably much less ‘slack' in this part of the economy.

Labor markets are tightening. One alternative rough measure of slack in the economy can be found in the unemployment rate. Labor markets have proven remarkably resilient in Brazil. Indeed, the average unemployment rate this year (8.1%) should be higher than last year's average (7.9%), but the headline unemployment rate in December this year should fall to 6.7%, a touch below the 6.8% reading last December, and marking the lowest point since the start of the series back in 2002 - all estimates here are according to central bank forecasts. Similarly, recent net formal job creation (CAGED data) is now back to pre-crisis standards. In such an environment, we suspect that nominal wage increases could resurface as a potential inflationary concern. Indeed, 77% of collective wage negotiations so far this year have entailed wage gains above CPI inflation, a share already higher than the 72% mark for last year.

Credit conditions are picking up. Strongly encouraged by the authorities, public sector banks have taken the lead in extending domestic credit aggressively this year. Looking ahead, public sector banks look unlikely to sharply cut back their lending appetite anytime soon, while well-capitalized private sector banks seem increasingly eager to resume stronger lending, especially now that non-performing loans seem to have peaked. For private and public sector banks alike, recent capital injections further boost their lending capabilities.

Fiscal policy looks set to remain expansionary. While monetary and fiscal policy both worked in the same direction in 2009 (easing), we suspect that they will splash apart in 2010. For any given overall policy stance, the looser fiscal policy is, the tighter monetary policy has to be. As the economy rebounds, the burden of stimulus removal may fall disproportionately on monetary policy if fiscal policy remains expansionary.

What could keep rates lower for longer? By symmetry, COPOM would be inclined to keep rates unchanged for longer if conditions go in the opposite direction of the risks mentioned above, as long as the central bank feels sufficiently comfortable with the balance of risks around a benign baseline inflation outlook. For instance, a growth slowdown that keeps inflation prospects benign for a more prolonged period of time could encourage COPOM to stand pat for longer.

What about the political calendar? We assume that technical considerations will continue to drive monetary policy decisions, and that the October 2010 general elections will not prevent the central bank from hiking interest rates. Likewise, regardless of potential changes in the individual composition at the board of the central bank, we assume that the institution will remain firmly and credibly committed to the inflation-targeting regime.

Tighter reserve requirements will not prevent rate hikes. The central bank has eased reserve requirements during the global financial turmoil, to the tune of about R$100 billion, and may decide to partially unwind such easing as conditions normalize. But such move should not be seen as a substitute for eventual rate hikes.

Hiking Cycle: Timing and Magnitude

The central bank is not in a rush to hike at the moment. After all, there is still slack in the economy, as indicated by usual measures of the output gap, and near-term inflation prospects look benign. In particular, market consensus inflation expectations remain fairly stable, and still below the 4.5% target. Judging by previous cycles, the central bank usually starts hiking rates only after market consensus inflation expectations have already been increasing for a while. So, it should surprise no one that the central bank stays on hold at the COPOM meeting on October 21.

But conditions might change relatively fast. Since the start of the inflation-targeting regime in 1999, the central bank never stayed on hold for more than six consecutive months, for what it is worth. We suspect that the timing for a monetary exit strategy can prove to be an increasingly lively debate among market participants in the coming months. As the economy rebounds, we would not be surprised to see some market participants wondering whether the central bank might start hiking rates already as soon as at the turn of the year - say at the December 2009 or January 2010 COPOM meeting.

In all, we assume the first rate hike in 2Q10, if not before. We suspect that by then the central bank's assessment about the balance of risks will have shifted sufficiently to justify a rate hike. That said, risks seem biased to an earlier hike, if recovering domestic growth starts pushing inflation expectations sufficiently higher. In addition, the central bank estimates that the time lags between monetary policy decisions and their impact on inflation have increased lately - the logical implication is that the central bank now needs to start moving earlier than usual in order to achieve the same results. In other words, a proactive, pre-emptive central bank would be biased to act sooner rather than later.

The market debate will eventually shift from ‘timing' to ‘pace and magnitude' of the hiking cycle, although these aspects are not entirely separate; that is, early and aggressive rate hikes would tend to be associated with a shorter and smaller hiking cycle, while delayed and gradual action might mean that the central bank would have to hike ultimately more, for longer. In all, our forecast assumes rate hikes starting in 2Q10, taking the policy rate to 11.0% by end-2010 and to a peak of 12% by end-2011, for a full hiking cycle of 325bp from the current 8.75% mark - a pattern not too far from previous hiking cycles. We assume that the central bank will seek to bring rates close to around some notion of ‘neutral', but it remains an open question as to whether COPOM might have to go above the ‘neutral' level to sufficiently slow the economy. The local yield curve has priced in about 400bp of hikes during 2010, with individual rate hikes in every one of the eight regular COPOM meetings next year.

Bottom Line

As Brazil rebounds and conditions normalize, emergency policy stimulus will need to be unwound. The central bank seems in no rush to hike, for now. But given fiscal expansion, monetary policy will need to carry the burden of the adjustment. It is hard to handicap the exact timing of a first rate hike - we assume 2Q10. But we suspect that risks look biased for rate hikes to start earlier rather than later, if strong growth quickly eliminates slack in the economy and starts undermining inflation expectations.

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United States
Recovery Myths
October 21, 2009

By Richard Berner | London

Three myths are fueling debate over the sustainability and strength of the incipient US economic recovery:  The benefits from an inventory cycle will soon be over; the credit crunch will force consumers to deleverage for years; and store closings last year are artificially boosting current readings on consumer spending.  If valid, those claims would seriously undermine our case for sustainable growth.  And confirming evidence in renewed weak economic data would no doubt promote significant setbacks in equities, credit and other risky assets that already have a lot of good news in the price. 

A close look, however, suggests that all three are folklore.  As we see it, the inventory cycle has a long way to run and will contribute to grow through 2011.  Second, the credit crunch is abating, while consumers are concurrently and aggressively deleveraging and repairing their balance sheets.  The latter process could reach a sustainable equilibrium by 2011.  Last, same-store sales comparisons are relevant for stock pickers but don't affect published retail sales and consumer-spending data.  Those data are famously subject to measurement error and revisions, but the results so far are consistent with our view that a modest consumer recovery is underway.  Details for all three myths follow. 

The inventory cycle has a long way to run.  US companies have been liquidating inventories for six straight quarters, one quarter shy of the record set in1982-83.  But the cycle is far from over; as we see it, this inventory cycle will set a new record for longevity and will contribute to growth through 2011.  With inventories still high in relation to sales, liquidation is likely to continue through the end of 2010, depressing the level of GDP.  However, we expect that the contribution to GDP growth will be positive through 2010 as the pace of liquidation slows.  And when stocks are leaner, companies may begin accumulating them again in 2011.  In all, we expect that the inventory cycle will add 0.6 percentage points (pp) to growth over the four quarters of 2010, and 0.4pp over the course of 2011.

The realization that inventories will add significantly to GDP growth in the third quarter is leading some to think that an inventory buildup is underway.  That's simply untrue.  So while we've discussed inventories extensively elsewhere, some background and analytics on this process may again be helpful.  First, there is no inventory buildup in the works; the book value of manufacturing and trade inventories plummeted by 1.5% in August, declining for the twelfth straight month.  Second, apart from motor vehicles, where stocks are now lean even in relation to post-‘cash for clunker' sales, inventory stocks are still somewhat elevated in relation to sales.  We estimate that the real manufacturing and trade inventory/sales ratio excluding motor vehicles declined to 1.34 (months) in September - well below its January peak of 1.4 but above an acceptable 1.3 level and considerably above the 1.25 that might be considered lean.  To attain those more normal levels, we expect that companies will still be liquidating inventories throughout 2010. 

Third, companies do not need to cut production further, nor do they have to increase production more slowly than the growth of final sales.  On the contrary, with the level of output (GDP) roughly 1½% below the level of final sales (both flows) in the second quarter, and final sales beginning to grow, GDP can grow faster than sales until the two converge, and inventories will still shrink.  That's arithmetically because the change in the stock of inventories (e.g., liquidation when it is negative) is essentially the difference between the level of output and sales.  As that difference narrows, the pace of inventory liquidation will slow, but the contribution of inventories to GDP growth is based on the change in the change in inventories, and that has turned positive.

Analytically, economists since the days of Roy Harrod and Lloyd Metzler in the 1930s and 1940s have analyzed these relationships between stocks of inventories and flows of production and sales using a so-called ‘stock adjustment' model - a cornerstone of business cycle analysis.  Indeed, stocks in relation to demand are key metrics for gauging excess, and such adjustments typically call the tune for the business cycle.  Changes in the stock of inventories relative to sales dictate production adjustments and thus inventory liquidation or accumulation.  Importantly, the model predicts that, faced with uncertainty about demand, producers will make such adjustments gradually, which would stretch the inventory cycle well into recovery.

Such adjustments, reflecting their ‘second derivative' nature, are called an ‘accelerator' mechanism.  As output accelerates, it begins to generate renewed demand for inventories (and capital, or investment).  Measured by the second derivative in output, or the change in the growth rate, the process began in the second quarter when the decline of the growth rate diminished from -6.4% to -0.7% - an acceleration of 5.7 percentage points.  And in the third quarter, we estimate that GDP accelerated further by 4.6pp, to 3.9%, with inventories contributing 1.1 percentage points to that gain.  According to metrics in the ISM survey, companies have incentives to run output faster; the gap between orders and inventories is strongly positive, and the level of customer inventories is now below normal. 

Of course, if demand (and orders) were to falter, the picture would change significantly.  Headwinds restraining demand growth abound, so while downside risks have faded, they are still significant.  But the intensity of those headwinds is what is now at issue.  That leads us to consider the second myth, namely that the credit crunch is still strangling growth and that dire news awaits. 

Credit confusion: The credit crunch is abating and deleveraging is underway.  The financial press and some analysts point to the decline in US consumer credit outstanding as evidence that the credit crunch for consumers is intensifying.  In contrast, we think the credit crunch has abated - although it has not ended - and that the adverse feedback loop from credit to the economy is starting to turn virtuous.  In our view, consumers are deleveraging, some voluntarily.  If income is growing, it can support both debt paydowns and modest spending growth, and balance sheet repair will set the stage for more sustained gains in spending.  Measured by debt/income and debt service/income, deleveraging at the end of 2Q was in line with the timetable we outlined in May (see Deleveraging the American Consumer, May 27, 2009).  Debt/income was a bit higher (at 118%), and debt service/income was slightly lower (at 13.1%) than we expected.  Those results, together with incoming data on consumer credit (down $31 billion in the past two months) make us comfortable with that timetable, which projected debt/income at just under 100% and the debt-service ratio going to 11.5% by end 2010. 

How does that rational demand story square with ominous stories about the supply of credit?  Credit-card lenders are cutting credit lines and otherwise tightening lending standards for small businesses that have no access to capital markets, and even consumers with jobs and income are feeling pinched by such moves.  Those stories are valid, in our view, but they are not new; indeed, at the margin, it appears that credit supply headwinds are ebbing.  Lenders are still tightening lending standards, but according to the Fed's Senior Loan Officer Survey, they tightened aggressively last year and now fewer are doing so.  Indeed, a small fraction eased standards somewhat in the third quarter.  Only slightly larger fractions of respondents report having tightened standards and widened spreads to small firms compared with larger and medium-sized firms.  The proportion of banks tightening credit card standards has fallen by half since the crisis began.  Small business surveys like the NFIB canvass are showing a peaking in the credit squeeze.  And while their direct access to the capital markets is nil, small businesses are benefitting from the revival of the ABS market, as finance companies who have access to it are lenders to small businesses.  Business receivables owned or managed by finance companies rose by 1.1% in July (the most recent data), the first increase in a year.

But looking to outstandings really doesn't help distinguish credit supply from credit demand, especially in the early stages of the recovery.  Business demand always is weak early in recoveries as inventories are liquidated and companies cut back on capex.  Moreover, writeoffs typically reduce legacy debt faster than new originations will boost outstandings; that's probably especially true today.  Yet banks in the aggregate have begun to earn their way out of their failing loans, and they have substantially delevered.  My colleague and large-cap bank analyst, Betsy Graseck, believes that banks under her coverage will cover their remaining losses in two years.  Of course, the macro baseline assumption for Betsy's estimates is our moderate growth scenario.  But even in a bear scenario, they should be able to cover them in three years.  Through reserve building, a lot of yet-to-be-realized losses are already covered.

To understand the demand-side fundamentals we look at corporate and household external financing needs.  The former relative to GDP have plunged to record lows.  The latter (as suggested by a generally rising saving rate) are now suggestive of writeoffs and paydowns as well as weak demand.  Thus, some of the behavioral change we see is voluntary and prudent, reflecting wealth losses and recession-induced uncertainty. Unprecedented wealth losses and prospects for slow revival are prompting ‘life-cycle' consumers to save more, and uncertainty around the outlook for income has made all consumers more cautious.  In contrast, some of the change is involuntary and immediate, as defaults, the credit crunch and income losses squeeze consumers.  The recession and the credit crunch have promoted defaults, reduced access to credit, and a squeeze on income for ‘rule of thumb' and liquidity-constrained consumers. 

These changes are likely to depress the growth of credit even as some credit-sensitive parts of the economy, notably housing demand, are now starting to recover.  If consumers are boosting saving to pay off existing debt, and lender writedowns and chargeoffs are slowly bringing down the outstanding amounts, then declines in consumer debt outstanding are likely to continue in our moderate recovery scenario. 

Data disconnect: Same-store sales are relevant for micro, not macro.  Some observers think that the closure of underperforming retail stores and liquidation of some brands are materially boosting same-store sales reports, thus overstating reported growth in consumer spending.  Our retail team believes this effect may be helping some retail chains, but we both agree it is irrelevant for official data on retail sales and consumer spending. 

Softlines (clothing, general merchandise) analyst, Michelle Clark, believes that the liquidation of two clothing and household retailers helped some stronger store brands.  That consolidation has pushed consumers to buy at the larger chains, and Michelle believes that the math on the comp pickup indicates a benefit to them of roughly 50-100bp.  However, she notes that "many of the softlines retailers are still growing their stores (albeit modestly), without closing underperforming ones (outside of the usual 5-10%, and that's not even happening for many).  Only two chains are closing stores in any material way, and the big store closures at one have yet to start." 

Retail analyst, Greg Melich, believes that the demise of two large chains in his industry has had a bigger impact on same-store comparisons, especially in consumer electronics.  He thinks that the benefit might be 200-250bp across retail, as US sales/occupied square foot this year are likely to fall only 1-2% while total sales are down 3-4%.  Store closings have increased vacancy rates to 20% from 16%, but retailers are most often renters, so rising vacancies are generally the developers' problem. 

Whatever the relevance of these comparisons for individual companies, they are not relevant for the macro analysis of consumer spending using official retail sales data that were released last week or using the data on consumer spending that will be published on October 30.  As David Greenlaw notes, the Census Bureau conducts its own sampling to compile these data.  They sample by mail about 12,000 retail businesses that have paid employees, and make estimates for others by aligning the results with a more comprehensive Annual Retail Trade Survey.  By sampling firms who pay taxes, they can update quarterly to reflect employer business ‘births' and ‘deaths', typically with a 9-month delay.  Same-stores sales don't matter for those samples; Census wants to capture all sales regardless of where they are made.  In turn, retail sales are used as an input for estimates of consumer spending, which rely on other source data, such as vehicle sales, surveys of services spending and reports from industry groups.  In both cases, the reported chain store comparisons aren't used as inputs, and thus the biases reported above are irrelevant for those data. 

Burden of proof.  We may have dispelled some myths about the recovery, but we still bear the burden of proof for the sustainability story.  The economy still faces numerous headwinds, and assessing the balance between them and the effects of monetary and fiscal stimulus, the benefits of stronger overseas growth and the reduction of excesses will dictate the outcome.  Given that tug of war, evidence for sustainability will accumulate only slowly, and it will be bumpy.  So investors should focus on forward-looking metrics for validation.  Hopefully, this analytical framework will help to distinguish head fakes from the underlying narrative.

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