India
Budget F2011: It Was All About Fiscal Consolidation
March 02, 2010

By Ahya Chetan | Singapore & Tanvee Gupta | Mumbai

Summary

If there was one single message from Budget F2011 - it was fiscal consolidation. The government aims to cut the fiscal deficit to 5.5% of GDP in F2011 from 6.7% of GDP in F2010. The Finance Minister also gave a commitment to cut the fiscal deficit to 4.8% of GDP by F2012 and further to 4.1% of GDP by F2013. This was the first budget after two years that focused on maintaining the growth of plan expenditure (development expenditure), while containing non-plan expenditure. The budget targets divestment collections of Rs400 billion, much higher than our expectation of Rs250 billion. Most importantly, continuing with last year's budget approach, the Finance Minister has been conservative in assuming GDP growth and tax revenue growth assumptions, implying that if the government manages to meet the targets of divestment and 3G auction license fees, we see a good chance the government will achieve a lower deficit than budgeted.

Five Key Themes to Highlight

Prior to the announcement of the budget, we had identified five key themes to track in terms of the potential policy actions. We believe that the budget announcements have largely met our expectations. In the following paragraphs we summarize them:

Theme #1: Fiscal Consolidation - Near Term

The government took the first step towards reducing the deficit to more sustainable levels in the February 2010 budget. For F2011, the government announced a fiscal deficit target of 5.5% of GDP. This compares with 6.7% of GDP registered in F2010 (revised estimates). Hence, the combined deficit, excluding off budget items, stood at 8.1% of GDP in F2011 compared with 9.8% of GDP in F2010.

The government is estimating to achieve this reduction by:

* Increase in tax to GDP: The government hiked the excise duty rates by 2pp in the budget. Note, as part of the stimulus measures, the government had cut excise duty by 4pp. Moreover, the government is budgeting to increase net tax revenue collection to 7.7% of GDP in F2011 from 7.5% in F2010 on account of recovery in growth.

* Cut in expenditure as percentage of GDP: The government will cut expenditure to GDP by 0.5pp in F2011. The budget targeted expenditure growth lower than the estimated nominal GDP growth of 12.2%. This is helped by the absence of any major one-off expenditure items such as wage hikes or fresh stimulus measures in F2011.

* Higher non-tax receipts: The budget is targeting about Rs400 billion (0.6% of GDP) in divestments compared with Rs250 billion (0.4% of GDP). Moreover, the government should be able to collect potentially about Rs350 billion (0.5% of GDP) from 3G license fees.

This reduced level deficit has meant lower market borrowing program for F2011. In F2011, the government's gross market borrowing will be flat, at Rs4,571 billion, compared with Rs4,510 billion and the net market borrowing program will be reduced 13.4% to Rs3,450 billion. Prior to the budget announcement, consensus expectations according to a Reuters poll were for a 2% rise in borrowing in F2011. We believe that this lower borrowing target appears very much achievable. We therefore maintain our view that the 10-year bond yield will remain capped in the 7.5-8% range.

Theme #2: Fiscal Consolidation - Medium Term

The government has also accepted in principle the recommendation by the 13th Finance Commission where they have worked out a fiscal roadmap for fiscal deficit (FD) and revenue deficit (RD) for the period F2010-15. In line with the commission's recommendations, the budget has indicated the following medium-term fiscal consolidation plan:

a)         The government has committed to cut the fiscal deficit to 4.8% of GDP in F2012 and further to 4.1% of GDP in F2013.

b)         This will enable the government to reduce the public debt to GDP to 48% of GDP by March 2013 from the estimated 51.5% in March 2010.

Theme #3: Divestment Program Gets Boost

The budget has confirmed that the government will initiate a meaningful divestment program targeting the collection proceeds. The budget targets to raise Rs400 billion (US$8.7 billion, 0.6% of GDP) from divestments in F2011 as compared with an estimated Rs250 billion (US$5.4 billion, 0.4% of GDP) in F2010. As we have mentioned in past research, the current high level of fiscal deficit is making it difficult for the government to increase its spending on rural infrastructure and other development expenditure. We believe that in such an environment, the government needs to augment its financial resources through divestment of stakes in government companies. Since the formation of the United Progressive Alliance (UPA) led coalition government in May 2004, the pace of the divestment in state-owned enterprises has been slow. Indeed, the total proceeds from divestments during the five years ended March 2009 were just US$3.1 billion.

As per our estimate, the value of the government's stakes in the listed state-owned enterprises is about US$300 billion. If we include the unlisted companies, the total value would be approximately US$450 billion. The divestment program, we believe, can play a key role in augmenting government resources for the investment in productive areas such as rural infrastructure without causing deterioration in government finances. The 13th Finance Commission report also suggests that the government can augment resources to the tune of 0.9% of GDP every year on an average over the next five years (F2010-15) through divestment of government stake in listed and unlisted PSUs and listed banks. The commission indicates that the government can easily collect about US$80 billion (at current prices) over the next five years from divestment. We believe that over the next three years the government will be able to accelerate the size of the divestment program to US$10-15 billion per annum.

Themes #4: Tax Reforms

The budget confirmed government plans to implement the consolidated nationwide goods and services tax (GST) system from April 1, 2011. Implementation of the GST will result in a transition from the current system of different types of indirect taxes and multiple rates of indirect taxes. The new law will cover a wider base, including all goods and services. The current system taxes production, whereas the GST will aim to tax consumption. Indeed, current law levies tax on movement of goods from one state to another, effectively creating borders within borders. It distorts the allocation of resources and inhibits productivity growth. Transition to the GST will be an important milestone from a macro perspective, in our view.

The budget also confirmed the plan to implement the direct tax reforms as recommended in the direct reforms code (DTC) in F2012. These reforms aim to broaden the tax base and will minimize exemptions. The removal of these exemptions will improve tax to GDP and improve efficiency in the allocation of resources. The new code will also simplify the language and law to reduce litigation and check tax evasion. Moreover, the new code also aims to encourage long-term savings.

Theme #5: Social/Rural Sector Push

Higher allocation towards the social and rural sectors has been the key feature of the UPA government over the last few years. The government gave a big rural sector push under the National Rural Employment Guarantee Act (NREGA) with spending under this scheme increased to US$8.7 billion (0.6% of GDP, budget estimate) in F2011 from US$8.1 billion in F2010. Similarly, the spending under the Bharat Nirman programme was increased to US$10.4 billion (0.7% of GDP, budget estimate) in F2011 from US$9.4 billion in F2010.

CEEMEA
Is Food Price Inflation Still a Potential Threat?
March 02, 2010

By Tevfik Aksoy | London & CEEMEA Economics

Food prices constitute different risks for the short and medium term: Similar to the case in headline inflation, where the outlook differs noticeably among the countries in the region, food and unprocessed food price inflation realisations had been quite diverse. Following a rather low food price inflation picture in 2006 and 1H07, prices went up significantly until mid-2008. Since then, almost all countries enjoyed declines and especially in the Czech Republic, Romania, Hungary and Ukraine, where food price inflation went down from 51%Y as of May 2008 to 10%Y as of end-2009. Recently, food inflation has been rising in the Czech Republic (from a low base and still negative on a year-on-year basis), Israel and Turkey, but in a quite striking fashion. As of end-2009, Ukraine and Turkey held the top spot on food price inflation in the CEEMEA region. Given adverse weather conditions, record cold temperatures and heavy snowfall as well as regional flooding, the near-term risks might be on the upside, in our view. However, looking forward in some of the countries such as Turkey, we believe that the downside risks to headline inflation, i.e., a lower rate, are significantly high as and when food prices normalise.

Ukraine and Turkey leading the pack: Looking at the cross-section of food price inflation in the CEEMEA region as well as the countries in Europe, we see that the highest inflation rate materialised in Ukraine at 10%Y followed by 9.5%Y in Turkey. The inflation rate then drops noticeably with Russia at 6%, followed by Poland, South Africa and Israel. Food prices are estimated to have dropped by about 2%Y in the UAE. They also declined by about -3.4%Y and -3.5%Y in the Czech Republic and Bulgaria, respectively. In the EU, the average change in food prices was also negative at 1%Y.

In general we notice a broad-based co-movement in processed food prices in Central Europe, with occasional divergences arising due to exchange rate factors, the strength of domestic demand or the degree of competition at the retail level.

Weights matter: The information contained in food price inflation is clearly useful in determining current and future trends, but by itself it might be misleading due to the variance of the weight of food in the CPI basket across countries. For instance, there is a significant divergence in the share of food in the consumer basket between those that have a very high share and others with a rather low one. In Ukraine, food comprises a massive 50% of the index, followed by Russia's 37% and Romania's 35%, while the UAE has the lowest ratio of 14%, followed by South Africa and the Czech Republic at 14.3% and 15%, respectively. With Ukraine having the highest food inflation rate in our universe, it also has the highest headline CPI, mostly on the back of the high weight of food. A similar case is valid for Turkey as well, with a relatively high weight of food and high food price inflation, leading to the second-highest headline inflation rate in the region following Ukraine.

No subsidies: In terms the determination of food prices in the countries in the region, we see a nearly homogenous approach to subsidies; essentially there is almost none. There exists no food subsidy in Turkey, Russia, South Africa and the CE-3. There had been some subsides in bread prices in Ukraine, but even those had been managed and changed by the local governments and therefore never displayed a national pattern. During the height of the food price inflation in 2007-08, the government in the UAE resorted to a limited fixing of food prices, but it should be borne in mind that most of the foodstuff, especially the unprocessed food, is imported.

Unprocessed food price inflation by far the highest in Turkey: An interesting picture also emerges when one considers the developments on the unprocessed (fresh) food front. Here, Turkey leads the countries in the region as well as all other countries in Europe by a significant margin. At 21%Y, unprocessed food price inflation contributed significantly to the headline data. Recently, the excise taxes on alcohol had been raised in Russia, which is likely to have a limited impact on the headline print. The sharp spike in general food inflation that South Africa experienced in 2008/09 was driven predominantly by processed foods (meat in particular). Unprocessed food inflation reached its peak close to nine months before processed food; in that cycle, CPI food inflation was relatively sticky, while food at the agricultural level was in clear deflation. This gap presumably arose due to higher electricity (storage/preservation) costs as well as distribution (from farm gate to shop shelf) costs on the back of rising oil prices. 

We expect food price inflation in South Africa to remain relatively stable in 2010. Thus far, wheat futures prices are now down 10% from their October 2009 peak; yellow maize (an important input in meat production) has fallen 24% since its December 2009 peak; and white maize futures have fallen 30% since the start of this year. For the year as a whole, we expect food prices to average some 1.5-1.8%Y, down from our previous 2% estimate.

In Central Europe, processed food price inflation tends to broadly move with a similar trend across all countries, with differences being determined by demand conditions, as well as degree of competition at the retail level. There is far more divergence across countries on the unprocessed food front, as national crops can have a very significant impact on food inflation, typically with a lag of 6-12 months, and even trade with cheaper import substitutes might not fully offset it. As an example, we note how Hungarian fresh food CPI far outpaced its peers in 2006 on the back of a poor 2005 harvest. Also, one notable feature among the CE-3 has been the higher level and volatility of Hungarian fresh food prices, which is an interesting phenomenon with as yet no clear explanation (Hungarian prices are not especially low so there is no catching-up to do). The NBH thinks that differences in product markets (efficiency) may be the key. In our CPI forecasts for 2010-11, we assume broad softness in the coming months followed by a clear pick-up in food CPI trends later this year and into 2011.

At the other end of the region, namely UAE, during the period of high inflation in 2006-08, the cost of food and beverages contributed significantly to headline inflation. The impact of high food prices was particularly significant in 2008, when the rise was nearly 16% on average. Since then there has been some moderation, and we estimate that food price inflation might have dropped to 1-2%Y in 2009.

Since unprocessed food price inflation has been strikingly high in Turkey, a closer look might be worthwhile to judge if the trend could turn in the near future or if it would be likely to stay for some time. Looking at one of the key components of unprocessed food, namely meat, we see that Turkey displays by far the worst picture in comparison to all other countries in Europe and in CEEMEA. At nearly 35%Y inflation, meat prices seem to be a serious threat to price stability in the near term, reminiscent of the experience that South Africa went through back in 2008, as discussed earlier.

One of the reasons behind the high meat prices in Turkey had been related to the lack of sufficient amount of livestock available for use, and this was mostly attributed to the market pricing of milk. According to sector representatives, the sharp decline in milk prices during 2008-09 led to an unfortunate choice by farmers to sell meat instead of milk and cut the future supply of livestock. Hence, prices had been rising at a very fast pace that had started to threaten the headline inflation. In fact, with some 4.5% weight in the CPI basket, the contribution of meat price inflation on the headline inflation reached approximately 1.5pp over the past 12 months. Since there is a ban on meat imports (both in terms of livestock and meat), prices seem to be bound to remain high for some time. However, recently there had been some market speculation that certain changes in the legislation (i.e., opening of the imports channel) could become an option. The first impact of this had been seen in milk prices, with some downward pressure on an otherwise rising trend of late. In our view, any constructive action taken on this front could potentially help lower food prices and hence headline inflation.

Food price volatility adds further challenge to inflation forecasts: It seems fairly clear that the exposure of fresh food prices to exogenous factors such as weather conditions raises the volatility of prices. Especially in countries like Turkey, Bulgaria, Hungary and to some extent Ukraine and Poland, we witness a rather high degree of volatility in unprocessed food prices. This partially reflects on overall food price volatility, which in our view lowers the accuracy of predictions not only on part of analysts but also policymakers.

While the issue might seem trivial, taking into account the fact that in those countries where food price volatility is nearly four times higher than that of the EU and the added fact that the weight of food in the CPI basket is nearly twice as much as the EU average, the challenges might mount significantly against the efforts of maintaining price stability. Turkey once again is a good example of this: Taking into account the high weight and high volatility in prices, the extent of price swings could reach nearly eight times that of the EU. In its most recent Inflation Report, the CBT devoted a special section to this topic, where the high degree of volatility had been mentioned as one of the challenges in predicting overall price behaviour.

One of the main conclusions that we can drive from this analysis is that there does not seem to be any clear price co-movement among all the countries in the CEEMEA region. In addition, the level of price volatility, both on the processed and on the unprocessed category, differs significantly across countries. Add to this the wide range of weights that food prices take up in the CPI baskets across countries in the region, the outcome of price swings have a considerably different impact on the headline rate. Specifically in Turkey, we find the country to offer a significant downside risk to headline CPI forecasts (i.e., lower inflation) in the medium term. As and when unprocessed food prices stabilise and to some extent converge the regional averages, there seems to be a very high possibility that the country might finally achieve the 5% medium-term target since at least 1pp improvement could come from food alone. This might be managed either by opening the import channels and/or better legislation to cut inefficiencies in the market and cut intermediation costs.

United States
Review and Preview
March 02, 2010

By Ted Wieseman | New York

Treasuries posted major gains across the curve over the past week that reversed most of the losses seen over the prior couple weeks when worries had for a time eased about the budget situation in Greece and other fiscally strained European countries.  These fears reemerged in a significant way over the past week, and the flight-to-safety boost this provided Treasuries was added to substantially by a run of weak domestic economic data and a strong bid Friday from month-end related buying after a more mixed response through the week to a mixed run of auctions, with February having a significant month-end index duration extension.  Greece fears were stoked by a warning from Moody's that it could cut Greece's sovereign debt rating this year if budget targets are not met, which would make Greek government bonds ineligible as collateral for ECB operations when normal operating procedures are restored at year-end, thus make holdings of Greek debt more difficult for banks to finance.  And this risk appeared to be quickly rising after EU inspectors in Athens expressed pessimism about Greece's ability to bring its deficit down as rapidly as planned, given its rising financing costs and weakening growth outlook.  Greece's 2-year government bond spread over Germany widened about 70bp over the past week for a more than 100bp move the past two weeks to near 520bp, back to not far from the peak close of 564bp hit February 8.  The renewed strains on Greece, at least, were not spread broadly across other Euroland countries, but they did come as more data emerged pointing to an ongoing slowdown in the broader European economy, with focus on a drop in the German Ifo index.  So even if Greece's acute near-term financing stresses are eased by a eurozone support package, the broad fiscal retrenchment that could be forced on Europe this year would be coming at a bad time for the economy. 

Adding to what seem to be mounting downside risks to European growth was a run of weaker US domestic data, including plunges in consumer confidence and new and existing home sales, a second big rise in jobless claims, and a soft durable goods report that partially reversed big strength in capital goods orders and shipments seen late last year.  This outcome was consistent with our expectations for some slowing in growth in early 2010 after the very strong gain in output in late 2009, and we think this represents a consolidation rather than the beginning of a more pronounced slowdown.  The durables report led us to trim our 1Q GDP forecast to +2.2% from +2.5% after the as-expected revision to 4Q to +5.9% from +5.7%.  If we're only going to manage growth a bit above 2% in 1Q and a little above 3% for all of 2010, it's clearly not going to be an environment in which the data are going to be showing steady acceleration and sustained upside surprises.  Some recent underlying weakening after a mostly strong run of data seen late last year and early this year will probably continue to be broadly exacerbated over the next month by the blizzards that have battered the East Coast recently as we start to get the run of key February data in the coming week.  This should have a pronounced, though probably only temporary, impact on Friday's employment report as well as hurt upcoming data on construction and production and possibly retail sales.  With the data softening, investors bet that the "extended period" of "exceptionally low" rates that Fed Chairman Bernanke again predicted in his semiannual monetary policy testimony would last until late in the year even with the Fed continuing its recent movement towards an exit strategy with the ramping back up of SFP bill issuance announced and begun the past week - which will drain an additional $195 billion in bank reserves over the next couple months - on top of the discount rate normalization the prior week and recent or looming expiration of various liquidity and credit support programs, with the end of most of the TALF, the TAF, and then MBS and agency buying coming in March. 

On the week, benchmark Treasury coupon yields fell 16-22bp (bills saw mild further normalization, helped by the SFP supply), with the intermediate part of the curve outperforming despite heavy supply there, reversing the bulk of the 17-25bp losses over the prior two weeks (which were intermediate led also).  The old 2-year yield fell 16bp to 0.76%, 3-year 18bp to 1.32%, old 5-year 22bp to 2.24%, old 7-year 22bp to 3.01%, 10-year 19bp to 3.59%, and 30-year 17bp to 4.53%.  TIPS managed a decent rebound through the week from losses seen Monday after the 30-year TIPS returned in a cautious auction that tailed badly, adding to weakness seen in response to the surprising dip in core CPI reported the prior Friday.  Still, underperformance versus the big rally in nominals was major.  Mild weakness in commodity prices added to relative pressure at the shorter end, but the level of real rates at the longer end seemed to be the key problem, with investor selling pressure mounting as long-end TIPS yield moved lower and the 10-year yield fell much below 1.5%.  On the week, the 5-year TIPS yield fell 5bp to 0.21% and 10-year 5bp to 1.45%, while the 30-year closed the week at 2.12% after being auctioned Monday, in the first 30-year TIPS auction since 2001, at 2.23%.  Following the past week's rally and the prior two weeks of losses, the nominal 10-year yield wound up little changed for all of February, as lower inflation expectations offset rising real rates - in February the 10-year TIPS yield rose 17bp, but the benchmark 10-year inflation breakeven fell 19bp.  We expect real rates to continue to trend higher over the course of the year and inflation expectations to eventually move back up towards 2.50% from the end-February level of 2.14%.  There was not a strong indication in Treasury performance versus other rates markets that a simple flight to safety explained much of the upside.  Swap spreads actually narrowed slightly on the week by around 1bp along the curve.  Agencies lagged swaps by 1-4bp on the week, so they held in pretty well versus Treasuries.  Mortgages were a bigger underperformer, but absolute gains there were still quite good and lower coupons held in well against swaps and Treasuries, which lowered current coupon yields about 15bp to near 4.32%.  Since mid-January, mortgage yields have mostly been quite steady in a narrow range of around 4.3-4.4% aside from a few weaker days early the past week and late the prior week.  Current coupon spreads versus 5-year Treasuries haven't moved much from 200bp during this period, so there haven't been any indications of rising market worries about the looming end to Fed buying. 

Worries about the domestic economic outlook and the situation in Europe that drove interest rate market gains apparently were not of much concern to equity and credit markets, which ended the week about unchanged, holding on to most of the big upside seen the prior week.  The S&P 500 only dipped 0.4% on the week.  Performance by major sectors ranged from about -2% to +2%, with energy and materials on the weaker end and financials the stronger.  Credit losses were also marginal.  In late trading Friday, the investment grade CDX index was 1bp wider at 92bp.  The high yield index was a small 18bp wider at 581bp through Thursday and was also moving back to unchanged through Friday afternoon trading with a nearly half point gain in the index.  The commercial mortgage CMBX market was a lot weaker, extending a poor start to the year.  The AAA CMBX index fell 2% on the week, AJ (junior AAA) 5%, and AA 6%.  The AAA is only down 1% year to date, but the AJ is off 12% and AA 11%.  On the more positive side, for now at least credit protection on muni bonds is largely resisting the renewed widening in Greece along with the fairly solid relative showing by the rest of the European periphery, so for now the renewed concerns are being treated as Greece-specific more than systemic.  In late trading Friday, the 5-year MCDX index was only trading a few bp wider on the week near 161bp. 

In addition to worries about Greece and the broader European economic and budget outlook, US domestic economic data were broadly soft over the past week, raising worries about the US outlook after the upwardly revised 5.9% surge in 4Q growth.  That rate of growth was clearly unlikely to be sustained, so the run of softer data seen recently pointing to some first quarter slowing really shouldn't be too surprising.  We now see 1Q GDP growth slowing to +2.2% instead of the +2.5% we expected coming into the week as a result of weaker results for January capital goods orders and shipments in the durables report.  Underlying activity appears to have been a bit more solid in 1Q, however, and probably about in line with what we believe will be sustainable trend through 2010.  Of the 5.9% 4Q surge in growth, 3.9pp were accounted for by inventories.  Net exports added another 0.3pp, and final domestic demand only grew 1.6%.  We actually look for final domestic demand - GDP excluding inventories and trade, or the combination of consumption, business investment, residential investment and government spending - to accelerate a bit to +2.7% in 1Q.  Trade appears on pace to subtract about a half point in 1Q and inventories only to add about a tenth.  For all of 2010, we continue to see overall GDP running at +3.2%.  We expect final domestic demand running at a modest +2.5%, and we expect trade to add nearly a half point to growth as a result of the much stronger outlook we see for emerging market domestic demand this year than US demand.  We also expect a move towards a more normal and sustainable pace of inventory accumulation - even after the huge add in 4Q from a much slower pace of destocking, inventories were being liquidated at a modest pace in 4Q - to add a few tenths to GDP growth over the course of 2010. 

After a somewhat disappointing durables report, business investment appears to be on a less robust pace moving into 1Q.  Durable goods orders rose 3.0% in January, but all of the upside was in two volatile categories, civilian aircraft and defense.  Excluding these two area, orders fell 1%, and nondefense capital goods ex aircraft bookings, the key core gauge, were weaker at -2.9%.  This followed, however, a 6.6% surge in November and December, with the volatility concentrated in machinery, which fell 10% in January after an 11% gain the prior two months.  Machinery seems to have developed some notable issues over the past year with seasonal adjustment around quarter ends.  Partly offsetting this January pullback in machinery was good upside in high tech products (+4.6%) and electrical equipment and appliances (+1.4%).  Substantial volatility was also seen the past few months in capital goods shipments.  Core capital goods shipments fell 1.5% in January.  This was a weaker-than-expected result, but equipment investment is still on pace for a modest further gain in 1Q on top of the 18% revised surge in 4Q.  We now see equipment and software investment gaining 5% in 1Q and overall business investment 3%.

On the weaker side, residential investment now appears on pace for a decline of about 10% in 1Q after gaining 5% in 4Q and 19% in 3Q.  At this point actual homebuilding activity looks as if it will be only down slightly, with weather probably a meaningful negative, but the smaller brokers' commission component appears on pace for very large drop in line with major recent weakness in home sales.  New home sales plunged 11.2% in January to a record low 309,000 annual rate, extending a severe payback since sales ran up over the summer with a big boost from sales pulled forward ahead of the initially scheduled expiration of the homebuyers' tax credit.  Existing home sales also extended a payback in January, falling 7% on top of a 16% drop in December to a five-month low of 5.05 million.  New home sales surged 26% in the four months through July and have plunged 26% since then.  The number of new homes available for sale ticked up 0.4% after 32 straight declines that brought them to a 40-year low.  Combined with the drop in sales, this boosted months' supply to 9.1 from 8.0 in December and a recent low of 7.3 in October.  Very few new homes are being built still, so inventories should resume falling if sales can end their recent weakness.  We see the brokers' commissions component of residential investment on pace for a decline of nearly 45% annualized in 4Q after gains averaging 50% in 3Q and 4Q.  This would account for all of the expected 10% drop we currently project for overall residential investment and would actually be big enough to knock a couple tenths off of overall GDP growth, even though this category only makes up about 0.5% of GDP. 

The economic calendar is very busy in the coming week, with focus on the key run of early data for February - employment on Friday, manufacturing ISM Monday, motor vehicle sales Tuesday, nonmanufacturing ISM Wednesday and chain store sales Thursday.  Other releases due out include personal income and spending and construction spending Monday and revised productivity and factory orders Thursday.

* We forecast a 0.4% rise in January personal income and 0.4% rise in spending.  The employment report pointed to a solid rise in private sector wages and salaries, but the lack of an annual COLA for Social Security benefits (due to the decline in headline CPI) should help to restrain the overall rise in income.  Meanwhile, the retail sales report showed a sharp gain in the key control gauge that feeds directly into the calculation of consumer spending, but there should be some offset from the drop in unit sales of motor vehicles.  The personal savings rate should hold fairly steady in January - a pattern that we expect to continue in the months ahead.  Finally, the CPI data pointed to a modest rise in the headline PCE price index along with a flat reading for the core gauge.  Note that the weight of shelter, which drove the decline in core CPI in January, is much smaller in the core PCE price gauge. 

* We expect the ISM to decline to 57.5 in February.  The results from the various regional surveys point to a bit of deterioration in the ISM on the heels of the impressive gain registered in January (to 58.4).  Of course, the expected result is still quite elevated from an historical standpoint and points to a sustained recovery in the factory sector.  In February, we expect to see a pullback in orders and production being partially offset by a weather-related rise in the vendor delivery component.  The price index is expected to register only a slight downtick (to about 68).

* We look for a 0.1% gain in January construction spending, with some renewed weakness in the nonres category expected to be offset by a modest bounceback in residential activity (as implied by the latest housing starts report) and a bit of a recovery in the public sector.

* We forecast February motor vehicle sales of 10.6 million units annualized, which would be slightly below the January/February average of 11.0 million units.  Widespread safety recalls appear to have restrained activity across the industry - although the Big Three likely captured some market share.  Also, severe winter weather may have temporarily disrupted sales in some parts of the nation.

* The revised GDP and hours data point to an upward revision to 4Q productivity growth to +7.1% from the already lofty +6.2% seen in the original report.  Moreover, compensation was revised down in 4Q (and was revised much lower in 3Q).  So unit labor costs are expected to post a revised 6.0% plunge, an even sharper drop than the 4.4% decline seen in the original report.  And 3Q is expected to be revised all the way from -1.5% to -6.0% or so.  On a year-on-year basis, productivity should be revised up to +5.5%, with unit labor costs running at -4.3%.

* We look for a 2.4% gain in January factory orders.  A sharp jump in the durables category, tied to the volatile aircraft component, is expected to be reinforced by a significant gain in nondurables, which is largely attributable to higher prices for energy-related items. Meanwhile, shipments are expected to edge up a bit while inventories are likely to show a slight dip.

* We forecast a 65,000 decline in February nonfarm payrolls.  Although we believe that labor market conditions are improving on an underlying basis, the jobless claims figures have shown some surprising elevation of late, and unusually severe winter storms hit some parts of the nation right around the time of the February survey. However, we should see a more noticeable positive impact this month tied to new census workers. The bottom line is that we believe weather effects subtracted about 100,000 while net census hiring added about 35,000. Thus, our payroll estimate excluding these special factors is zero.  The BLS will report how many workers were hired for the census, but unfortunately, we will only be able to guess at the weather impact by looking at the performance of the most weather-sensitive industries and movement in the household survey's measure of the number of people missing work because of bad weather.  Meanwhile, we look for a temporary rebound in the unemployment rate reflecting an expected dip in the household survey measure of employment following on the heels of an outsized gain in January. Finally, we believe that the unusually severe winter weather may have shaved 0.1 hours from the average workweek.

United States
Employment Prospects and Policies to Improve Them
March 02, 2010

By Richard Berner | New York

Is another jobless recovery in train?  Where will the jobs be?  And what can policymakers do to overcome obstacles to job growth? 

In our view, the recovery won't be jobless, but gains will be tepid.  We expect annual job growth to average 1% (110,000 monthly) over 2010-11, excluding hires for the decennial census.  Even those modest gains are not a foregone conclusion.  Job losses have abated, and some labor-market indicators have improved, but employment has yet to turn up. 

A long road ahead.  More important, we would need persistently strong economic and job growth over the next few years to regain the 8.4 million payroll jobs lost since December 2007, not to mention the 10.6 million jobs required to restore the employment rate (employment-population ratio) prevailing before the start of the Great Recession.   

Moreover, our unemployment problem has become increasingly chronic.  Two statistics document that fact: The median duration of unemployment has reached 20 weeks, more than twice the peak in the deep 1981-82 recession, and a record 41% of the unemployed have been jobless for six months or longer. 

This note outlines where job gains are likely to be over the next two years and why.  We identify four specific obstacles to hiring.  Each of these hurdles has a cyclical and a structural dimension.  For each, therefore, we discuss policies that might help foster economic growth and job creation both in the immediate future - the cyclical dimension - and for the longer run - the structural part.

Where will the jobs be?  What sectors of the economy are likely to grow in 2010 and 2011, and by how much?  How will employment growth vary in different regions of the country? What will be the likely state of the export market over the next two years, and the resulting impact on employment?

Strong sectors.  Advances in export, infrastructure, capital goods, energy and healthcare related industries likely will account for most of the job gains in the next 18-24 months.  That forecast echoes my views regarding the sources of growth in our economy.  The combination of strong global growth, the lagged effects of fiscal stimulus and improving financial conditions will promote improvement in many of those industries.  And rising demand for healthcare services continues.  In contrast, employment in residential and commercial construction, retailing, and financial services likely will remain soft as those industries continue to restructure.

Strong regions.  Identifying regional strengths and weaknesses is difficult.  For example, industries that likely will benefit from exports and other strong sectors are located in regions hard-hit by regional housing woes.  Conversely, some regions that fared relatively well in the downturn, like the Midwest, are now doing less well.  In our judgment, the Pacific Northwest, parts of the Rockies and Upper Midwest, parts of the Southeast, and parts of the Southwest seem likely to be the strongest regions. 

Export markets and employment.  I expect gains in export volumes of around 10% to be sustained over 2010.  Paced by their domestic demand, growth in many of our major trading partners in Asia and Latin America likely will average 6-7% this year, and Canada probably will expand at a faster pace than the US.  Somewhat slower global growth seems likely in 2011 as the US and overseas policymakers exit from stimulus. 

In manufacturing, some 20% of employment in 2006 was directly or indirectly associated with exports, and I expect that share to grow over the next two years.  Capital equipment and industrial supplies exports likely will continue to do well, while consumer goods will represent a rising share of overseas demand. 

Obstacles to hiring.  Worries about the sustainability of recovery are legitimate and probably are holding hiring back.  Such concerns are characteristic early in recovery, but this time they are worse because of the lingering fallout from the bursting of the housing and credit bubbles.  As a result, it remains essential to pursue policies oriented towards reducing housing imbalances, reducing debt and improving the functioning of financial markets and financial institutions. 

In addition, we think there are four obstacles to hiring that magnify the normal, early-recovery hesitation: Rising benefit costs; mismatches between skills needed and those available; labor immobility resulting from negative equity in housing; and uncertainty around policies in Washington.  Each has both a long-term structural and a shorter-term cyclical element.  For each, we first discuss the problem and the long-term solutions.  Then we turn to what policymakers can do to help the economy and the labor market improve as quickly as possible.

Obstacle 1. Cost of labor resulting from escalation in benefits.  The problem: Thanks to the high ‘fixed' costs of health and other benefits, and of taxes on labor to pay for the social safety net, our labor costs are out of line with other countries when adjusted for living standards.  I say ‘fixed' costs because benefit costs don't vary with hours worked; they are paid on a per-worker basis.  But as employers seek to cut the cost of compensation, these benefit costs drive a growing wedge between total compensation and take-home pay.  Unlike in other countries where healthcare benefits are not directly part of compensation, these rising costs likely have intensified employers' efforts to boost productivity by cutting payrolls.  The recession made the wedge between compensation and wages bigger, as cost-cutting private-sector employers cut take-home pay while leaving benefits intact.  So relative labor costs go up versus other countries while median pay suffers.

Long-term solutions include comprehensive healthcare reform and innovation to boost productivity and labor skills.  Healthcare reform to expand access and control costs will reduce the soaring costs of healthcare for employers and employees alike.  Policies that boost worker productivity will reduce labor costs in what will be a win-win for employers, employees and overall living standards, because real wages will rise. 

Short-run remedies: A refundable payroll tax credit, perhaps for firms that increase their payroll, would be among the most effective short-run remedies.  CBO estimates that a well-designed credit could boost employment by about 9 years of full-time equivalent employment per million dollars of budgetary cost.   

Obstacle 2. Skills mismatch. The problem: For years, employers have complained that they don't find the skills they need in today's workforce.  Worker skills have greatly lagged technical change and tectonic shifts in the structure of our economy.  Immigration restrictions and massive dislocations in several industries in recession have magnified that mismatch as workers who have been trained for one occupation lose their jobs.  And even in healthcare, an oasis of job growth, there is a growing nursing and nursing skills shortage that requires new training facilities.  

Long-term solutions include policies that keep students in school and improve access to education, reorientation of our higher educational system towards specialized and vocational training and community colleges, and immigration reform. 

Short-term remedies: Our current unemployment situation demands income support through unemployment insurance for those seeking but unable to find a job.  Jobless spells degrade worker skills, just when workers need re-training.  One remedy would pair training in basic skills that are needed for work with such income support.  Two other groups seeking employment - newly minted college students and unemployed teachers - could be an ideal nucleus for a Job Training Corps that would empower job seekers with new skills.  As is the case with Teach for America, the Job Training Corps would build a pool of training advocates who then go on to work in other occupations with the perspective and conviction that come from helping others to acquire needed skills.   

Obstacle 3. Labor immobility resulting from the housing bust.  America's workers have always been footloose.  Even in the Great Depression, they looked for work wherever it was.  Today, however, about one in four homeowners is trapped in their house because they owe more than the house is worth, so they can't move to take another job - until they sell or walk away.  Unlike in the Depression, when homeownership was less prevalent, negative equity among a nation of homeowners leads to substantially lower mobility rates.  Owners suffering from negative equity are one-third less mobile according to one study.  That is leading to a wave of ‘strategic defaults', in which borrowers who can otherwise afford to pay decide to walk away.  Whether through foreclosure or default, this process is undermining the economic and social fabric of communities and reducing job opportunities. 

Long-term solutions: Financial and mortgage regulatory reform are essential to restore the health of housing finance.  Significantly improving financial literacy is equally important.   

Short-term remedies:  Local efforts to stabilize communities plagued by foreclosure are essential, but they are not enough.  It is essential to reduce debt, writing off bad loans while not destabilizing the financial system.  Modifying existing mortgages seems appealing, but policies aimed at mitigating foreclosures under the Home Affordable Modification Program (HAMP) have not worked because they attempt to modify mortgage payments and not the amount of debt owed; re-default rates following modification are 50-60%.  Efforts to establish a protocol for short sales and/or principal reduction should be a useful tool in avoiding costly foreclosure and strategic default. 

Obstacle 4. Policy uncertainty is a negative for the economy and markets.  America's long-term challenges - healthcare, budget and tax reform, financial regulatory reform, retirement saving, infrastructure, education, energy and climate change - are not new.  Solving them is imperative.  But while the debates around major initiatives to address them are an important part of the democratic process, the uncertainty that accompanies major policy change is weighing on business and consumer decisions to hire, expand, buy homes and spend. 

Recent work confirms this intuition, underlining how uncertainty produces negative growth shocks.  Nicholas Bloom shows how a rise in uncertainty makes it optimal for firms and consumers to hesitate, which results in a decline in spending, hiring and activity.  In effect, the rise in uncertainty increases the option value of waiting as volatility rises.  Moreover, this line of reasoning suggests that uncertainty reduces the potency of policy stimulus.  That's because the uncertainty can swamp the effects of lower interest rates, transfers or tax cuts.  In effect, uncertainty raises the threshold that must be cleared to make a business choice worthwhile, and as uncertainty declines, the threshold falls with it.  This notion squares with our long-held view that policy traction from easier monetary policy, improving financial conditions and fiscal stimulus was lacking through much of last year, but improved as uncertainty fell. 

Market participants are used to thinking that political gridlock is good, that it prevents politicians from interfering with the marketplace.  The financial crisis clearly exposed the flaws in that reasoning with respect to appropriate financial regulation, whose absence allowed abuses.  Indeed, gridlock today is more likely to be bad for markets, as our long-term economic problems are partly the result of past policies and can only be solved with political action. 

Long-term solutions involve bipartisan leadership to tackle these complex problems one-by-one, in steps that are fair and call for shared sacrifice and benefits.  That means setting priorities, making hard choices, communicating the game plan, and getting buy-in for it in advance.  It is essential to support the work of the National Commission on Fiscal Responsibility and Reform - the deficit reduction commission. 

Short-term remedies:  Reducing policy uncertainty now could be a tonic for growth.  That won't be easy or come quickly, given the political backdrop in this election year.  But even some incremental clarity on policies in any of these areas would offer investors a chance to assess the fundamentals again - fundamentals that we still see as improving.

United States
Fed Stays on Message
March 02, 2010

By David Greenlaw | New York

In his recent testimony to Congress, Fed Chairman Bernanke offered a cautiously upbeat assessment of the economic outlook, but few new clues regarding the future course of Fed policy.

Bernanke reiterated the FOMC's message that "the federal funds rate is likely to remain exceptionally low for an extended period."  In fact, for emphasis, Bernanke repeated the phrase twice.  However, he also indicated that "at some point" the Fed will "need to begin to tighten monetary conditions to prevent the development of inflationary pressures." 

We continue to believe that a sustained economic recovery will lead to a rise in market-based measures of inflation expectations, and this will push the FOMC toward the exit door during the second half of the year.  Also, the more dovish the Fed's message, the more the market will want to test the Fed's inflation-fighting credibility.  For now, though, the message is that improved financial market conditions are leading to Fed to unwind the special liquidity support facilities that had been put in place, but that these actions do not necessarily carry a broader policy signal.

Bernanke repeated much of the exit strategy message that appeared in his Congressional testimony a couple of weeks ago. But there were a couple of new twists.  First, the Fed is apparently still exploring the possibility of using firms other than primary dealers as counterparties in reverse RP's, including money market mutual funds and the GSEs (Fannie Mae and Freddie Mac).  We had thought that this option had been evaluated and rejected, but it appears to still be on the table. Also, Bernanke confirmed that the reverse RPs could include mortgage-backed securities (MBS) collateral.  We had suspected that this would be the case, but the tests conducted until this point had used Treasuries exclusively.  Finally, Bernanke provided a bit more detail on the timeline for the term deposit program, indicating that test operations would likely commence during the second quarter.

We continue to have some doubts about the effectiveness of the interest on reserves (IOR) program.  In fact, we're skeptical that the fed funds rate will respond to a hike in the IOR as the Fed intends.  IOR did not work when it was introduced in the fall of 2008, and it's not clear it is working at present (since the effective fed funds rate has persistently been 12 basis points or so below the IOR).  The Fed is relying on bank arbitrage activity to offset the market impact of the GSEs - who are not subject to IOR - in the funds market.  However, we are skeptical that banks will be willing to devote resources and capital to this type of arbitrage activity.  Thus, we suspect that the funds rate will not respond to a hike in the IOR unless a significant volume of excess reserves is drained from the system. 

The Q&A session was largely focused on issues related to fiscal policy, Fed transparency and regulatory reform but did not break any new ground on these topics.