Euroland
Chewing on Green Shoots
August 06, 2010

By Elga Bartsch & Daniele Antonucci | London

One Swallow Does Not Make a Summer

There is an old adage in the world's most popular forecasting sport - the weather - where the elders keep reminding us that one swallow does not make a summer.  The same holds true in business cycle forecasting: one bumper quarter does not make a robust recovery.  Hence, we would warn investors not to read too much into what likely was a very strong economic performance in Europe during the second quarter.  In our view, the European economy won't be able to keep up the pace it showed in the April to June quarter.

2Q GDP Estimates Still Too Cautious

True, there were clear upside risks to the GDP estimates for the quarter that just ended - both ours and others.  We are raising ours today ahead of next week's data releases for the flash estimates of 2Q GDP.  Given these strong outcomes for 2Q GDP, consensus estimates for European growth will likely be raised in the coming weeks.  Incoming data suggest that our current projections of GDP expanding by a non-annualised rate of 0.9%Q in Germany and 0.6%Q in the euro area are way too conservative.  While we are still waiting for the final data points, notably June industrial production, so that we can close the books on 2Q GDP, it seems that GDP growth could potentially be almost twice as high as our previous official forecast.  As a result, it looks highly likely that Europe has outpaced the US in the April to June quarter.  Whenever this happens, which is rare enough, it is noteworthy because the trend rate of growth in Europe is considerably lower than in the US.  If confirmed by the official data, which will be released over the next few weeks, the stronger 2Q dynamics would push the full-year estimate for real GDP growth to 1.5%Y from 1.2% for 2010 and to 1.3% from 1.1% for 2011. This upgrade does not mark a big shift in our core view that the euro area recovery will be uneven and creditless. 

There are several reasons for the sudden surge in EMU growth. 

•           First, there was a very favourable backdrop from a pick-up in global trade (led by strong EM growth) and a much weaker currency.  Together these two factors caused export growth to skyrocket.  The main beneficiary of the surge in global demand was the manufacturing industry. 

•           Second, in the current cycle, manufacturing companies have managed their inventories very differently from any of the previous cycles.  For starters, they have been cutting their inventories of finished products much more aggressively in the course of the downturn (see Inside the Inventory Cycle, February 23, 2009).  In addition, manufacturers were more cautious in their restocking as the recovery started to take hold because companies continued to be sceptical about the sustainability and the stamina of the upswing.  For five consecutive months now, euro area manufacturers have been positively surprised by the robustness of the recovery.  A record share of manufacturers view their inventories of finished products as insufficient right now. 

•           Third, unusually cold winter weather caused a greater number of construction projects to stop in early 2010.  Hence, the seasonal revival in construction activity in the spring was more pronounced than usual.  In addition, after such big swings as the ones we have seen during the course of the crisis, seasonally adjusting the raw data becomes an art, as it becomes increasingly difficult to distinguish between the underlying trend and the seasonal factor. 

•           Fourth and finally, the unusually hot summer weather and the World Cup seem to have boosted retail spending in July.  While this will not affect 2Q GDP, it could likely provide a solid ramp into 3Q.  So far, we only have retail sales volumes for June.  But July retail surveys suggest a surge in sales in the month. 

None of these factors should have much staying power. Soccer fans have gone back into their summer slumber now that the World Cup is over.  The skies in many European countries are covered by grey clouds again and temperatures have come down to more normal ranges.  Post the catch-up in the spring, the construction industry is once again facing tighter government budgets, falling house prices and difficult mortgage markets in many parts of Europe.  The impact of the restocking process on GDP growth has probably peaked too.  In 1Q, inventories contributed 1.1pp to overall GDP growth and were the only factor supporting growth, as net exports and domestic demand continued to weigh on GDP growth.  Remember, it is the change in the change of inventories that drives GDP growth.  Hence, for an ongoing positive contribution from inventories to headline GDP growth, the pace of restocking needs to pick up quarter after quarter.  Given that the assessment of inventories had corrected for a few months before it bounced back again in July, this does not seem very likely to us.  In addition, manufacturing companies have continued to revise down gradually their output expectations.

Developments increasingly uneven between countries. Closer inspection of the country details shows that much of the euro area strength is entirely driven by Germany and hence unlikely to last.  Take for instance the business survey - the most timely and most robust information we have on economic activity in the euro area.  In July, for output expectations for the next three months, arguably a leading indicator, Germany is the only country among the largest six in which manufacturers are not expecting production to slow.  Germany is also the only country where manufacturers expect production to remain above par.  The other countries are projecting below-trend production growth between July and October.  A similar picture emerges when looking at the assessment of order books.  Only in Germany are the order books above their long-term average.  Elsewhere, order books are climbing but they still remain about 0.75 standard deviations below the long-term average.  When it comes to current production, a key series going into our manufacturing indicator, the July surge seems to have been broadly shared by all countries, except France, which has been reporting stable production for the last four months.  This might change soon though because France was the only country to report a sharp drop in inventories of finished products.  Germany and Belgium saw small declines, while Italy, Spain and the Netherlands reported rises, causing inventories to become less insufficient than before.  To sum up, the recent round of business surveys suggests a strong entry point into 3Q but a moderation in the course of the quarter. 

Several fundamental factors cause us to be cautious on the medium-term growth prospects for the euro area. 

•           First, there can be no mistaking the coming budget cuts.  Spain, Portugal and Greece have phased in measures over the summer.  Other countries will follow suit with their 2011 budget.  On our count, the discretionary austerity measures add up to around 1.2% of euro area GDP for next year (see Euroland Economics: The Mediterranean Diet: Too Harsh for EMU Health? June 7, 2010). 

•           Second, we continue to be concerned about credit constraints caused by weak bank balance sheets.  Our base case remains a creditless recovery (see Credit Crunch versus Creditless Recovery - The Risks, January 11, 2010).  But the unexpected sharp deterioration in credit conditions for corporate loans reported in the recent ECB bank lending survey and a further fall in loans to non-financial corporates found in the June money supply data underscore that the risk of a credit crunch remains in play.  Alas, the bank stress test wasn't the circuit breaker that it could have been and the process of cleaning up bank balance sheets remains painfully slow (see Bank Stress Tests: Transparency & Spanish Stresses Help, Although Lots of Missed Opportunities, July 25, 2010). 

•           In recent weeks, new risk factors have emerged: a re-strengthening of the EUR is not included in our forecasts.  So far, we have assumed that a weaker euro will help to offset the impact of the fiscal tightening on headline GDP growth.  Furthermore, we have seen euro area money market rates, the EONIA overnight rate and the three-month EURIBOR rates moving higher.  But like one swallow does not make a summer, a moderation in growth after an inventory-fuelled bounce does not make a double-dip.

We differ from consensus on the consumer.  While consumer confidence, retail sentiment and labour market conditions are gradually improving, headwinds still lie ahead, we think.  Employment growth will likely be sluggish as companies have not been laying off staff as aggressively as their US counterparts even though the euro area economy shrank more meaningfully than the US.  Wage growth is rather muted, and as many countries are trying to regain competitiveness with the euro area, we don't expect this to change significantly over the forecast horizon.  Only in Germany has a discussion started on higher wage demands.  Further, disposable income will likely be dented by income tax increases and spending cuts (notably on social transfers).  In addition, real purchasing power should be dented by a weaker euro and higher inflation (partially fuelled by indirect taxes).  Finally, the deleveraging process on the part of the consumer has not even begun in the euro area.  In conclusion, we find it difficult to see more than tepid growth in consumer spending. 

Implications for the ECB and its Policy

While the 2Q GDP numbers will also come as a pleasant surprise to the ECB's own forecasting staff, the data are also backward-looking.  In our view, there is little reason to change our fundamental view of a below-par recovery over the forecast horizon.  At the margin, a strong 2Q outturn means a slightly smaller output gap and hence less downward pressure on underlying inflation.  That there might be a little less slack in the economy is also echoed by the stalling unemployment rate, which is now hovering sideways at 10% of the labour force.  On the whole, though, these marginal changes are not big enough and more importantly not sustained enough to change the monetary policy outlook over the policy relevant horizon of 12-18 months.  We therefore continue to expect the ECB to stay on hold until 2H11.  As before, we do see a risk though that a spike in inflation in early 2011 to 2.5% could potentially cause the ECB to become somewhat more concerned about the outlook for price stability.

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United States
How Big a Shock from the Oil Spill?
August 06, 2010

By Morgan Stanley US Economics Team | New York

It has been more than three months since the tragic incident aboard the Deepwater Horizon drilling rig.  While the well has finally been capped, the economic impact of the oil spill continues to affect the Gulf of Mexico.  Prior to installation of the containment cap on July 13, government estimates of the spill rate reached 45,000-60,000 barrels per day, ultimately leaving about 4.9 million barrels of oil in the Gulf.  The flow of oil now appears to have been contained, but the overall situation is far from resolved. 

What will be the economic impact of the spill on the Gulf region and the national economy?  Although clearly a big shock to the regional economy, the spill should have only a tiny impact nationwide.  Despite depressed activity in several industries, increased prices for certain goods, and damage to the regional environment, we estimate the impact of the spill on US GDP will be negligible in both 2010 and 2011.  As outlined below, we believe a number of mitigating factors will offset the negative impact of the oil spill.  Most important, clean-up efforts will provide stimulus to the region that could exceed the losses to output from the spill.  In addition, many tourists who cancel travel to the Gulf likely will go elsewhere, softening the national impact of decreased travel to the region.

Our conclusion that national output should be relatively unchanged does not imply that the consequences of this disaster will be trivial.  GDP is only one of many metrics for measuring economic well-being.  Other barometers - such as living standards, property values, and household wealth - may also be affected. 

Simple analytical framework.  Assessing the impact of the shock is in principle not difficult, but in practice fraught with guesswork and uncertainty. The immediate effects on output and prices will depend on the magnitude and duration of the interruption in affected industries, the regional and industrial scope of these businesses, and the availability of alternative supplies.  Spillover effects to the rest of the economy may also be important.

As a foundation for our analysis, we drew a comparison to the Ixtoc oil spill that occurred off the coast of the Yucatan Peninsula in 1980.  The Ixtoc oil spill totaled 140 million gallons; the government currently estimates that between 94 and 180 million gallons of oil have been spilled in the Deepwater Horizon incident.  Moreover, both spills occurred under similar seasonal conditions, and the affected shoreline lengths were comparable.  Indeed, both spills affected just over 170 miles of shoreline, and similar volumes of oil hit the shores in each instance. 

According to a comprehensive analysis conducted by the Bureau of Land Management, the Ixtoc oil spill caused $700 million (in 1980 dollars) in damages to businesses along the coast of Texas.  That financial drag to economies in the region was an order of magnitude less than the total cost of clean-up, resulting in a net stimulus.  We anticipate that the impact of the Deepwater Horizon event should be similarly limited. 

However, two main differentiating factors are important to note.  First, the Ixtoc spill occurred in water that was both warmer and shallower.  Second, the Deepwater Horizon spill occurred near wetlands - further complicating the clean-up efforts.  Since the two events are not fully comparable, we can only use the Ixtoc spill as a point of reference for our analysis.

Cleaning up the Gulf.  The most visible remaining aspect of the oil spill is the clean-up effort that is still in progress.  To date, over $4 billion (roughly $3.9 billion in private expenditures and $140 million in public funds) has been spent cleaning up the Gulf of Mexico, though this is an upper limit including containment efforts such as the recently installed well cap.  To pay for the clean-up and other punitive claims, BP created a $20 billion claims fund that will be established incrementally over the next 14 quarters.   The clean-up of the spill acts as a stimulus to the local economy and re-utilizes resources that would otherwise remain idle. 

According to Dr. Dagmar Schmidt Etkin, a leading expert in environmental analysis, one must consider several factors in order to account for the cost of an oil spill.  To that end, we adopted a number of assumptions regarding the current situation: 

•           Location: Offshore

•           Oil type: Light crude

•           Shoreline oiling: At least 500 km

•           Clean-up methodology: Combination of dispersants, mechanical, manual, and in-situ burning

•           Spill size: Greater than 34,000 tonnes (or 37,850,000 liters)

Using a revised version of the framework developed by Dr. Etkin, we estimate that the Deepwater clean-up may total $2,983 per barrel.  Based on the estimated 4.9 million barrels of oil that entered the Gulf, the final tab would be around $14.6 billion.  But the cost could easily run to considerably more if the process proves more intractable than we anticipate.

It is critical to note that other forces may have an impact on the clean-up costs.  Oil-eating bacteria are playing a role in removing some of the oil from the Gulf.  In addition, weather will play a significant role in the ultimate outcome of the clean-up efforts.  As witnessed recently with the formation of Hurricane Alex, inclement weather may hinder containment activities.  Conversely, storms could also potentially disperse oil formations and help cleanse the coast.   With the National Oceanic and Atmospheric Administration calling for an 85% chance of an above-normal hurricane season this year, meteorological conditions will certainly bear close monitoring.

Impact on energy sector.  Following the Deepwater Horizon tragedy, the Administration instituted a six-month moratorium on deepwater drilling in the Gulf of Mexico.  As a consequence, Baker Hughes reports that 22 out of 27 deepwater rigs in the Gulf have gone offline so far.  On June 22, 2010, a federal judge voided this ban on the grounds that the Interior Department had presented insufficient rationale for its actions.  The Administration's subsequent appeal failed, but they instituted a new drilling ban set to expire November 30, 2010.  No matter how and when this issue is resolved, drilling companies are working under the assumption that the Minerals Management Service will approve no new drilling projects in this environment of high uncertainty.

A decrease in oil and gas extraction activity will have an impact on US output.  How large might this be?  In the short term, we see a negligible effect on energy production.  For instance, the Federal Reserve's industrial production report for June registered no decline in the data for petroleum and coal products.  Similarly, to date, oil production both regionally and nationally has continued at a steady pace in the aftermath of the Deepwater Horizon incident.  Since there is a lag between the drilling of new wells and the production of oil, there will probably not be a major decline in production until next year. 

Longer term, energy production may be materially impacted by the current ban on the exploration and drilling of new wells.  According to our colleagues in commodities strategy, a 6-18-month moratorium would reduce Gulf of Mexico deepwater production by 64 kb/day in 2010 and 297 kb/day in 2011.   Using current oil prices, these projections would translate into total production losses of $900 million in 2010 and about $9.5 billion in 2011.  In addition, if the moratorium is extended, we will likely see greater declines as losses accelerate.

Impact on commercial fishing.  We estimate the hit to the commercial fishing industry at $2.4-3.0 billion.  We base this calculation on the landings value loss findings of Ewell Smith, head of the Louisiana Seafood Board.  This figure accounts for losses in oysters, shrimp, crab and menhaden in the most heavily hit states: Louisiana, Mississippi and Alabama. 

The Gulf supplies less than 2% of the nation's overall seafood.  Nevertheless, commercial fishing is a big economic driver for the Gulf states; in 2008, the commercial seafood harvest was valued at $661 million.  According to the National Oceanic and Atmospheric Administration (NOAA), the Gulf region was responsible for 73% of total US landings of shrimp, 29.1% of national landings of blue crabs, and 67.0% of US production of oysters in 2008.  

The NOAA has closed between 24% and 35% of federal waters in the Gulf of Mexico since the Deepwater Horizon incident.  These closures have impaired commercial fisheries along the Gulf Coast, especially those in Alabama, Louisiana and Mississippi.  The public perception that the region's seafood is contaminated, as well as the reallocation of labor from fishing activities to clean-up efforts, have contributed to the negative economic effect. 

Gulf production of oysters, shrimp, crab and menhaden is down 60-80% since the oil spill.  Given that commercial seafood landings were valued at $661 million in 2008, we estimate the landings loss for 2010 and 2011 to be $300 million per year.  This translates into a loss of $2.4-3.0 billion during 2010 and 2011 to the broader seafood industry.  We employ multipliers based on consensus and media research to determine the overall impact on the seafood industry.

Impact on tourism.  The tourism industry is one of the industries most affected by the oil spill.  US Travel Association data show that for the states affected, the Gulf Coast accounts for 25% of tourism employment and over $34 billion in annual revenue.  News sources discuss mid-double-digit cancellation rates at hotels, although benefit concerts, clean-up crews and the National Guard have helped to generate some new business.  Still, future bookings have yet to materialize for most hotel operators.  TripAdvisor, the world's largest travel website, whose traffic data provide a leading indicator for tourism, shows large page-view declines of up to 65% for Gulf area destinations, but an increase for beaches on the Atlantic.  This suggests that tourists making other travel arrangements will offset the regional losses on a national level. 

Although there should be no change to US output, our $8.5 billion estimate for regional losses in the first year is material.  We calculated this loss estimate two different ways using two unique sets of data - and the results for each calculation are similar.  First, we used data from the US Travel Association that provides aggregate visitor spending by state for Gulf Congressional Districts in 2008.  Second, we analyzed state GSP data from 2007 (the most recent available), which aggregates expenditures on "arts, entertainment and recreation" and "accommodation and food services", together with total visitors to each state in 2007, to calculate average expenditures per visitor to these states.  Then, using data from various news sources, TripAdvisor page views and recent reports on the impacts of the Gulf oil spill on tourism, we estimated percent losses (for visitor spending and number of visitors) for low and high impact scenarios. 

The greatest impact to tourism will come within the first year following the spill, and we expect the sector to recover almost entirely within three years.  As a comparison, Texas beaches were largely clear within three years of the Ixtoc spill, while New Orleans fully recovered to peak spending levels three years after Katrina.

Impact on recreation.  Given the repercussions of the oil spill on both residents of and visitors to the Gulf of Mexico, we analyzed the potential economic impact on recreational activities in the region.  In its 1982 study of the Ixtoc oil spill, the Bureau of Land Management made a subjective distinction between recreation and tourism.  In their analysis, the authors examined a broad cross-section of businesses in the retail trade and recreational services sectors along the coast of Texas.  Adapting this framework, we focused on these same industries for our investigation of the Deepwater Horizon incident.

According to the most recent Economic Census data, recreational businesses (such as movie theaters, sporting events, casinos and leisure goods retailers) along the Louisiana, Mississippi, Alabama and Florida coasts of the Gulf of Mexico generated over $8.5 billion in revenues in 2007.  However, by nearly all accounts, these industries have experienced minimal disruptions in the aftermath of the oil spill.  For instance, the July 2010 Federal Reserve Beige Book noted that "[m]ost [Atlanta] District merchants [had] noticed a slight increase in traffic and sales in June and early July [and had] reported improved conditions since the beginning of the year".  In addition, anecdotal evidence from our colleagues in equity research has corroborated these accounts.  Likewise, the monthly Philadelphia Fed coincident economic activity indices for Louisiana, Mississippi, Alabama and Florida have continued to rise through June.  Furthermore, in spite of the obstacles posed by the oil spill, leisure and hospitality employment in the Gulf region actually expanded in May and June.

These findings mirror the conclusions drawn by the Bureau of Land Management following the Ixtoc oil spill.  In their 1982 assessment of this tragedy, the authors estimated that the recreation sector lost approximately $3.1 million in gross receipts as a result of the oil spill.  Moreover, the study found that these losses were limited to "a small number of businesses close to the water's edge" and were "offset with additional recreation-related spending elsewhere in the subregions".

Impact on US GDP.  In the short term, the shock to the Gulf region could be significant.  The drilling moratorium is hindering the energy sector, as no new deepwater wells are being drilled for exploration or production.  Moreover, the commercial fishing and tourism industries face decreases in activity and potential losses.  On the other side of the ledger, relief efforts in the Gulf will counterbalance this decline, as BP and the government distribute clean-up funds and legal compensation to the Gulf states.  Although estimates of the ultimate impact of these opposing forces are subject to considerable uncertainty, we believe they will net to essentially no impact to US GDP this year or next.

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Global
Will Food Inflation Bite?
August 06, 2010

By Manoj Pradhan | London

Soaring grain prices are attracting a lot of attention in markets at the moment. Given the strong role that food prices played in emerging markets in the inflation spike of 2007-08, attention naturally centres on the role of food inflation. Is food inflation likely to push headline CPI inflation significantly higher? Are policymakers poised to head off any potential threat from food price inflation aggressively? We asked our EM country economics teams to give us their assessment of the impact of high food prices and how central bankers will approach this issue.

The collective opinion suggests that food prices, despite their large weight in headline inflation, are unlikely to cause a large impact on headline numbers. In addition, central banks are probably willing to overlook food price inflation to ensure further consolidation in growth, with the notable exception of India and a growing risk of monetary intervention in Indonesia. With sufficient domestic stockpiles and a slowing global economy, central banks are unlikely to be aggressive in hiking rates. But slow action could allow food prices to spill over into prices of other items, raising the risk that central banks will have to deal more aggressively with this more general increase in prices further down the road.

This is not the first time in the recent past that food price inflation has grabbed the attention of markets. In the 2007-08 episode, food price inflation was spurred by strong global growth. Even though the Great Recession pushed food prices lower, many of the debates from that time remain relevant today (see Land to Mouth: How to Profit from the Food Chain in Food, Robert Feldman and Hussein Allidina, January 15, 2008, and Buy Chicken!!, Robert Feldman, May 21, 2008). Food prices have been making regional headlines in emerging markets for some time now, as our AXJ and CEEMEA teams have documented (see India EcoView: Food Inflation Concerns Rising, December 22, 2009, and "Is Food Price Inflation Still a Potential Threat?" CEEMEA Macro Monitor, March 1, 2010). Yet central banks seem somewhat removed from the debate as they tend to focus less on volatile items like food and energy.

Central banks use core inflation or trimmed means for policy purposes: Many central banks prefer to focus on core or trimmed measures of inflation for the purposes of monetary policy. The reasoning is simple enough: food price inflation is volatile and affected strongly by factors like weather that have little to do with economic fundamentals. Focusing on a core measure or ignoring both extremely docile and highly volatile items (in the case of trimmed measures) allows central banks to deal with fundamental drivers of inflation more effectively.

Less persuasive for EM economies: This argument works very well for developed economies but is less persuasive for emerging markets. Food prices are just as volatile, if not more so, in emerging markets and the forces driving them can be even more idiosyncratic, given less stable supply chains and transportation facilities. Food price inflation has stayed true to its tarnished reputation, fluctuating with a relatively high mean and showing significant variation on either side of that mean. Positive and high food price inflation has meant a ratcheting effect on the level of food prices.

Importantly, the weight that food prices are assigned in headline CPI is much higher in emerging markets than it is in developed economies. This makes food prices that much more important when it comes to monetary policy. The weights for food prices in CPI inflation for emerging markets fall in a wide range and generally average around 30%. Comparatively, the weights for food prices in the US, euro area and the UK currently stand at 15%, 19% and 11%, respectively.

Lastly, food prices are likely to have larger effects on savings and consumption behaviour and therefore on household utility in emerging markets. Given that emerging markets are likely to have relatively lower personal income levels, food consumption will take up a larger chunk of personal disposable income. Higher food inflation then lowers personal disposable income and could reduce consumption because of the ‘income effect'. Further, the volatility in food price inflation will tend to make households more conservative in their spending in order to compensate for the uncertainty surrounding food prices - the so-called ‘precautionary motive' for savings.

Why central banks tend to leave food prices alone: Given all of these arguments, one would expect central banks to pay closer attention to food price inflation. And they do. However, most central banks are likely to avoid reacting to food prices because the drivers of volatility are not necessarily economic fundamentals, as we discussed earlier. The globalisation of commodity markets and prices gives central banks yet more reason for ambivalence. During the sharp rise in food prices in 2007, most central banks glossed over the spikes in food price inflation. The ability of central banks to respond to such global trends was limited, they argued. However, many, if not most, central banks are adamant that no ‘second round effects' should occur. That is, they would use their policy tools such that there is no transmission into core prices (and inflation expectations).

This time seems to be no different: EM central banks (with the notable exception of India) seem poised to look through food price rises. The list of reasons will likely include all of the above arguments. In addition, a weaker global backdrop and high stockpiles of domestic inventories are likely to further convince monetary policymakers to hold their fire.

Domestic inventories seem to be adequate: Domestic inventories seem to be adequate, with most stockpiles near or even above their historical levels of comfort. While this may not do much to keep the pressure on food price inflation in the very short run, it gives policymakers some reassurance that these stockpiles could be used to put pressure on prices if needed. India and Indonesia, where food inflation is adding to more general pressure on headline CPI, and on the central bank, need particular attention. In India, stocks are sufficient to meet welfare scheme requirements and good monsoons should ease the pressure on prices going forward. In Indonesia, however, stockpiles are relatively lower and the ability of policymakers to manage prices there is therefore lower.

Central banks appear poised to look through the current rise in food inflation: With the notable exception of India (where the RBI is worried about food and non-food price inflation and has already tightened policy), and to a lesser extent Indonesia (where the central bank is yet to raise policy rates), most central banks appear to be satisfied to look through food price shocks to inflation.

In AXJ economies, where growth is closing the output gap the fastest, general pressures on prices appear to be on the radar of the central bank. This is true to a lesser extent in LatAm economies. Brazil's lacklustre performance in 2Q10 should not detract from the stronger-than-expected recovery in many other performers in the region. Even there, inflation has not yet raised sufficient concerns. The main reason for rate hikes in both regions appears to be in order to remove some of the extraordinary easing that was delivered to fend off the Great Recession. Recent concerns about global growth are unlikely to derail the tightening process in most places but will likely slow it down as central banks pay close attention to growth. This is likely to be most evident in China, where the PBoC acted against property speculation with great zeal earlier on. As a result, our China team expects a loosening of the constraints on loans later in the year in order to foster more growth. In other economies where rate hikes have just started or are yet to start, the speed with which central banks raise rates will probably be slower, at least initially.

Complacency would be dangerous: Central banks, however, would be well advised to stay vigilant. Our commodities team still expects some upside to food prices, which could translate into higher CPI prints, given the large weights allocated to food prices. More worrisome are ‘second-round effects'. The positive drift in inflation and the ratcheting up of food prices means that there is a higher risk of spillovers into other ‘core' prices.

Recovery puts EM more at risk: Emerging markets are currently particularly susceptible to such spillovers, given that their economies are recovering and the output gap is closing fast in most countries. The recovery means that domestic demand has recovered strongly in many emerging economies, particularly in Asia and in many Latin American economies. An entrenched recovery and growing domestic demand make it easier for domestic producers to pick up pricing power and for food price inflation to spill over into other non-food items. Central banks could then find that their task is a lot harder further down the road.

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