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UK Property: Concern for the Future
August 13, 2010

By Melanie Baker, CFA, Cath Sleeman | Europe, Johannesburg, London

House Prices: Two-Year Ahead View

 In This Issue
UK Property: Concern for the Future
More Cautious BoE Inflation Report
United States
Growth Pickup Coming, but Fed Exit Postponed
View GEF Archive

 The Global Economics Team
 Melanie Baker
Melanie Baker is senior UK economist. She has been on the UK economics team since 2003. Before this, she worked on the currency economics team. She joined Morgan Stanley in 1999. She graduated in 1998 from the University of Edinburgh with an MA in Economics and Politics and has an MSc from University College London in Economics. She is also a CFA charterholder. Melanie is a member of TheCityUK's Independent Economists Group.
Read about other GEF team members

Stalling Momentum in the Housing Market Recovery

After picking up substantially (from very weak levels), momentum in the recovery of housing activity and prices is showing signs of stalling. House prices have now fallen month on month in four out of the last six months on the Halifax house price indicator.

Demand Likely Not Supportive for House Prices

1.         Household Income Growth Subdued 

Our outlook for disposable income is for subdued growth in 2010 and 2011 and household income expectations - which have a strong contemporaneous relationship with house price inflation - have turned down and seem unlikely to improve much further as the reality of fiscal tightening (public sector job losses and higher taxes) dawns.

In 2009, disposable income growth held up relatively well (3.2%Y nominal after 4.3%Y in 2008), in real terms up about 1.8% despite higher unemployment and very slow wage growth. Sharply lower interest payments on debt have been largely the cause, helped by a lower effective income tax rate and higher benefits payments (as unemployment rose) for example. With increases in taxation, likely interest rate increases in 2011 and potential further net job losses ahead as the public sector contracts, combined with high inflation, we expect real disposable income in 2010 and 2011 to grow, on average, at less than half the pace of 2009.

House price inflation, however, has a particularly strong relationship with household income expectations. We proxy income expectations using a composite indicator based on real post-tax labour income, the percentage of consumer spending on durables and consumer confidence. As the reality of fiscal tightening dawns on UK households, we think that household income expectations are likely to weaken somewhat. 

2.         Mortgage Rates Likely to Rise 

New mortgage rates seem likely to rise over 2011 as market interest rates begin anticipating the start of monetary policy tightening, and assuming still elevated spreads. This should help to dampen any potential increases in house prices and activity. However, what happens to spreads is important here. On balance, we think that mortgage spreads are likely to stay elevated, but are likely to decline only modestly as policy rates rise.

3.         So, Combining Points 1 and 2, Affordability Is Set to Become More Stretched

The burden of debt service for existing borrowers fell dramatically in 2008 and 2009. House prices have also fallen. This implies a significant increase in housing affordability - one factor supporting house prices in 2H09 and 1H10. However, credit conditions are, of course, tighter. If we add in the size of the average deposit, the picture looks very different. The size of the average initial down-payment has increased, offsetting the increases in affordability for the house-buyer in terms of lower interest payments and house prices (at least in terms of first-year costs). 

Moreover, increased affordability as a result of lower interest rates has largely run its course (assuming that mortgage spreads do not substantially contract). We expect the Bank of England to raise rates in 2Q11 (consensus expectations are for a 2Q start), with the balance of risks being towards a later rather than earlier start to rate increases. We expect this, and a concurrent rise in bond yields (including for quoted fixed-term mortgage rates), to gradually raise the average mortgage rate on the stock of debt.

4.         Mortgage Availability Constrained

We expect credit availability to improve gradually, but remain relatively constrained compared to pre-crisis levels. 

Mortgage availability has been improving at the margin, but despite UK banks' view that demand for mortgages has declined over the past couple of quarters, we still see signs that demand is not being met.

Banks face considerable pressure to raise their capital ratios, reduce their short-term wholesale funding and increase their holdings of liquid assets, all of which are likely to weigh on mortgage lending availability. We think a revival of the residential mortgage-backed securities market (RMBS) and the development of a larger covered bond market will ultimately be needed if we are to see a sustainable mortgage market recovery.

5.         Government Policy Changes

Over the recession, various forms of government support and incentives were provided to households and construction companies. Some of these, as well as a degree of the support in place before the recession, seem likely to be reduced in light of government budget pressures. However, it is not clear in which direction house prices might be affected, netting these out. That also applies to the measures announced so far, including:

•           Stamp duty changes: An additional 5% rate of stamp duty for residential transactions > £1 million from April 2011 is planned. The new government will review the effectiveness and value for money of the existing stamp duty tax relief for first-time buyers. Verdict: Lower demand.

•           Lower housing benefit: Housing benefit will be reformed, cutting government spending by an estimated £1.8 billion by 2014-15. This may free up the supply of rental accommodation in expensive areas and increase demand in cheaper areas as well as potentially limit incentives to buy investment property destined for the social rental sector. Verdict: Uncertain.

•           Higher capital gains tax: Although not as big a rise in capital gains tax as many feared, the rise from a maximum 18% to 28% will nonetheless affect the incentives to buy an investment property. Verdict: Lower demand.

•           Changes to the planning system: Verdict: Weak supply recovery.

Valuations Stretched

Most simple valuation metrics suggest that house prices are overvalued. Our house price to income ratio suggests that, to return to a 30-year average (and keeping incomes constant), house prices would need to decline by about 15% (from 2Q10 levels). However, in order to get back to ‘trend', house prices would not need to correct at all. 

Hence, the extent to which one thinks residential housing is overvalued at present partially depends on whether one thinks that the ratio of house prices to incomes ought to have risen over time. We think that there are good reasons why this ratio should have increased, particularly the rise in female labour participation and hence the potential for less volatile household earnings as the business cycle develops. We also think that higher price to income ratios can be explained by lower interest rates and higher loan-to-value ratios (and incomes). So, whether one thinks higher price to income ratios are sustainable also depends on what one thinks the future holds for loan-to-value ratios, etc.

Taking this into account, we still think that valuations look stretched. In our view, we think it makes sense to expect the sustainable house price to income ratio ultimately to decline to somewhere between the trend and the historical average (i.e., to assume that some of the increase in the house price to income ratio is sustainable).

Our own simple econometric approach (which models long-run real house prices as a function of the number of dwellings per capita, real incomes and the yield curve) points to a degree of overvaluation of around 24% in 1Q10 (in both real and nominal terms).

Supply of New Housing Depressed

The supply of new housing relative to (demographic) demand looks set to be somewhat supportive of house prices over the next several years, with the pace of housing starts suggesting that completions may lag ‘underlying' demand for some time.

Our house builders analyst, Michael Watts, thinks the recovery in housing supply will be subdued and that new housing supply is unlikely to reach pre-crisis levels before 2015.

At the current pace, the supply of new homes looks very unlikely to keep up with the expected pace of household formation. By 2011, the DCLG (Department of Communities and Local Government) forecasts that there will be 1.5 million more households in the UK than in 2006. Between end-2006 and 3Q09 there were only 443,000 housing starts, which implies the need for around a million homes to be built over 2010 and 2011, or around 113,000 homes a quarter. The average pace of housing starts in 2009 was around 27,000 a quarter. 

The UK housing market is still prone to booms and busts. That will remain the case while the supply of new housing fails to offset changes in demand. If supply cannot act to balance shifts in demand, then price adjustments will tend to be bigger than they otherwise would be.

House Price Models

Our house price model forecasts around a 5% increase in house prices over the next 12 months, but an 8% correction the 12 months following that. Our house price model uses both demand and supply dynamics, where demand is a function of income per household and a ‘user cost' of owner-occupied housing (including real mortgage rates and house price expectations). Plugging in assumed paths for the main components, our main house price model suggests that prices will rise modestly over the next 12 months and then correct, assuming real mortgage rates follow our forecast for rising average nominal mortgage rates and subdued real disposable income growth. We assume only a modest contraction in mortgage spreads (50bp over the period).

The main drivers of that correction are weak income growth, rising real mortgage rates and a deterioration in backward-looking expectations (we assume that a proportion of expectations are formed in a backward-looking way).

However, the numerical results of the model remain very sensitive to assumptions made. The model is particularly sensitive to the path of real mortgage rates assumed. So, while we now think it is likely that house prices will fall over the next two years, we put a wide confidence interval around the specific projections of the model.

Our Central House Price Forecast

A 7% correction by end-2011: We conclude that there is still some downside risk to house prices, with our new base case being a 0% decline in 2010 and an 7% decline in 2011 (both 4Q/4Q). This is somewhat more downbeat than our house price model suggests, but with consumer confidence declining and given existing overvaluation, we are more comfortable with a flat forecast for house prices by end-2010 4Q/4Q) than a rise. Our bull case is a 3% increase in both years (this effectively assumes that there are no increases in mortgage rates) and bear case is a 6% decline in 2010 and 13% in 2011 (closer to correcting for overvaluation than in the base case). The balance of risks to our central profile is skewed to the downside, particularly given current overvaluation. Importantly, our model is sensitive to assumptions on some of the underlying variables and the correction may take longer to play out than we expect.

Key factors behind our expectation of house price declines: Existing overvaluation and an expected rise in mortgage rates are key drivers of our forecast:

•           Affordability and valuations stretched: Despite falls in house prices over 2008/09, (short-term) affordability for buyers has worsened once tightening in lending terms is taken into account. Valuations, on most of the simple metrics we look at, appear stretched.

•           Weak real disposable income growth: Higher taxes, interest rates and public sector job losses, combined with high inflation, should ensure weak real disposable income growth (contracting in 2010).

•           Mortgage rates likely to rise: With mortgage spreads likely to stay elevated and policy rates rising, on our forecasts, we assume that real mortgage rates rise on average over the next two years.

•           House price expectations deteriorate: We assume that households' expected capital gains from their homes deteriorate since we assume that a proportion of house price expectations are formed in a backward-looking way (that ‘backward look' will gradually take in fewer periods of substantial house price rises and more periods of flat or falling house prices as time moves on).

Further, since we do not think that the UK has worked through fundamental problems with housing supply, the UK remains very vulnerable, in our view, to house price boom and bust. This is another reason for us to be cautious about putting too much weight on our central forecast or the projection of our house price model. 

The biggest risk to our forecast is what happens to the policy rate, in our view. We don't think house price falls in and of themselves would be enough to dissuade the MPC from raising rates. However, the risks to our forecast for a first rate rise in 2Q11 are skewed towards later rather than earlier rate rises. We continue to think that the Bank of England's GDP growth forecasts are too optimistic (see BoE Inflation Report: More Cautious than We'd Expected, August 11, 2010). 

Medium-term outlook for house prices: Over the next 2-5 years, we see scope for significant volatility in the housing market. 1) Supply is likely to recover only weakly, leaving house prices vulnerable to fluctuations in demand. 2) Mortgage spreads may also be volatile as funding pressures rise in 2012/13 (due to several government support programmes rolling off) and later as competitive pressures gradually increase. 3) Real interest rates themselves are also likely to be volatile. In the medium term, we think that inflation pressures will be relatively strong on average, prompting further rate rises from the bank as it tries to get inflation back to target (see The Only Way Is Up? The Potential for Higher Inflation after a Temporary Reprieve, March 31, 2010).

Longer term, demography is likely to have important implications for the UK housing market. However, the direction of the effect will depend on how responsive home builders are/can be to likely significant changes in demand. 

Economic Effects of House Price Falls

Implications for the Economy

We see three main channels for an effect: 1) residential construction; 2) direct effect on consumer spending; and 3) effect on UK banks' willingness and ability to lend.

1) Residential Construction: Effects Limited

Although a further leg-down in house prices is likely to discourage further housing starts, research suggests that UK housing supply is rather unresponsive to changes in house prices compared to other countries. Further, residential construction was only around 3% of UK GDP in 2009. Nevertheless, a further decline in house prices is likely to ensure that residential investment will be a small drag on GDP growth next year (to the tune of 0.1pp, on our central forecast).

2) Direct Effects on Consumer Spending

Changes in house prices and in housing activity should affect consumer spending through several channels, including: a) wealth effect; b) transactions effect (if a slowing in housing transactions accompanies a fall in prices); and c) effect of being in negative equity.

A further decline in house prices should help to ensure very weak consumer spending growth in 2011. Currently, our central forecast is for a significantly below-trend 0.7% growth in real household consumption.

a)         Wealth effect: A fall in house prices depletes the wealth levels of households and reduces the collateral available against which to borrow. We use a midpoint of academic estimates of the wealth effect (that consumers spend around 2.5% of the change in housing wealth) to estimate the impact of the decline in housing wealth on household spending. The decline in housing wealth implied by our base case for a further decline in house prices would imply a dampening effect on consumer spending over two years worth 0.7% of 2009 consumer spending (or around 0.5% of GDP).

b)         Transactions effect: Fewer people moving house means that purchases often linked to home moves, e.g., white goods and soft furnishings, are likely to slow. Housing market activity appears to be showing signs of slowing momentum.

c)         Effect of being in negative equity: We estimate that around 10% of mortgages (i.e., around 1 million), representing around 4% of UK households, are negative equity. This represents just under £100 billion of the £1.25 trillion UK mortgage market. A large proportion of households will also have relatively high loan-to-value ratios on their existing mortgages following house price falls in 2007-09. However, being in negative equity or having a high LTV mortgage does not directly impact people's incomings and outgoings; but it is likely to do so when they want or need to remortgage or to move home. Currently, many customers are reverting to the SVR rather than remortgage. Many of these households may wish to increase their savings and need to do so rapidly in order to lower their mortgage relative to the value of their property (i.e., their LTV ratio), making it easier to obtain a new mortgage or to retain a mortgage on relatively favourable terms. A rise in the number of those needing to move properties might see such capital injections increase.

3) The Effect on UK Banks' Willingness and Ability to Lend

A decline in house prices will likely weigh on the willingness (and ability) of banks to extend further loans. Weak growth in credit supply will, in turn, likely weigh on household spending and total investment.

The link between secured borrowing and consumer spending largely works through housing equity withdrawal. However, the link between housing equity withdrawal and consumer spending appears to have been variable, so it is difficult to draw firm conclusions. UK consumers have needed to borrow to be able to both consume and invest (in fixed assets). 

Credit availability will be important for household (and corporate) spending and saving decisions. Where credit availability continues to be perceived as relatively tight, households will probably want to maintain or build on higher precautionary balances to meet unexpected outlays, for example. It makes sense to pay down debt and increase liquid savings so that existing credit lines and accessible saved funds can provide more of a buffer against any subsequent shocks to income. This should continue to help constrain the strength of any consumer recovery. 

What Does All This Mean for the Consumer Spending Outlook?

We continue to think that GDP growth will slow somewhat in 2H10 and remain relatively weak in 2011. We maintain our below-consensus GDP growth forecasts. A weak consumer spending outlook is a key component of our forecast. We expect significantly below-trend growth in real consumer spending in both 2010 and 2011 on the back of weak disposable income growth and still high incentives to save. Our view that the house price correction will resume in earnest over the next 12 months fits in well with this outlook and is primarily a reason to expect a still elevated savings rate.

For full details, see UK Economics and Banks: UK Property: Concern for the Future, August 12, 2010.

Important Disclosure Information at the end of this Forum

More Cautious BoE Inflation Report
August 13, 2010

By Melanie Baker, CFA, Cath Sleeman | Europe, Johannesburg, London

What stopped the BoE voting for more QE? In light of the weaker central outlook for inflation at the two-year horizon (where its central forecast for inflation is below the 2% target), we wouldn't rule out a member voting for an extension to QE, resulting in a likely three-way split when the vote for the August meeting is revealed with the publication of the Minutes on August 18. In terms of what stopped the majority of the MPC voting to extend QE, that is apparent in the balance of risks it sees to its central forecasts. It sees risks to its central forecast as skewed to the upside. Against the 2% inflation target, at the three-year horizon (even assuming some rate rises ahead), it sees risks to inflation as balanced. On an assumption of unchanged rates, it describes "the risks around the target are broadly balanced by the end of the second year" (our italics).

It also remarks that "the prospects for inflation were highly uncertain and that the Committee stood ready to respond in either direction as the balance of risks evolved".

BoE GDP growth outlook: weaker. The MPC's central forecast for growth is lower compared to its May report (by what looks like more than half a percentage point at the end of the horizon, based on unchanged policy). The change comes partly from incorporating the impact of the Budget (and the faster pace of fiscal consolidation it contained). However, the bank also attributed the change to recent weakening in consumer and business confidence and a slowdown in the recovery of credit conditions.

The revision to its growth outlook is a bit larger than we had anticipated. Despite this, we still think its outlook is too optimistic, appearing to sit well above our own and consensus forecasts.

The MPC noted that the fiscal measures announced in the Budget had eliminated some of the downside risks to its growth outlook, compared to May. On balance, however, the risks to its outlook are still skewed to the downside.

BoE inflation outlook: stronger in near term, weaker further out. The MPC's central forecast for inflation is higher for around the next 18 months compared to its projection in May (based on unchanged policy). Inflation remains above 2% until the end of 2011. Its forecast looks a bit stronger than our own published forecast, although we will get a clearer idea of this when the bank's numerical projections are published next week and there are some increased upside risks to our forecasts following recent movements in commodity prices. The rise in its forecasts over the next 18 months was attributed mainly to the forthcoming VAT hike (which it estimated would add more than 1pp to CPI in 2011). It also reflected higher-than-expected inflation outturns and the likelihood of a rise in domestic gas prices (the MPC expects around a 5% rise in 1H11).

The MPC has lowered its central inflation outlook over the medium term. At the two-year horizon, for example, its central forecast for inflation appears to be further below the inflation target than it was in May (comparing the charts assuming unchanged monetary policy). This presumably comes from a weaker growth outlook feeding through into increased spare capacity. We had anticipated that the MPC would not let a weaker growth outlook feed through mechanically into lower inflation this time, since we thought the starting point for spare capacity might look healthier (i.e., it might assume less current spare capacity than in May). Further, we perceived some serious concerns among some members that overestimating spare capacity or its impact on inflation had led to inflation surprising their forecasts on the upside.

On balance, its near-term risks had increased and remain skewed to the upside as the persistence of high inflation could lead medium-term inflation expectations to rise. Over the second half of the forecast, the MPC considers the risks to be fairly balanced.

Key uncertainties: The key uncertainties for the MPC appear to be the pace of recovery in global demand, the extent to which recent high inflation outturns will raise medium-term inflation expectations, and the impact of the Budget on private demand.

For details, see UK Economics: BoE Inflation Report: More Cautious than We'd Expected, August 11, 2010.

Important Disclosure Information at the end of this Forum

United States
Growth Pickup Coming, but Fed Exit Postponed
August 13, 2010

By Richard Berner, David Greenlaw | New York

Don't extrapolate slower growth.  There's no mistaking the slowing in incoming US economic indicators, ranging from past consumer spending and income to employment and forward-looking orders.  And we are mindful of the downside risks to growth, noted below.  But extrapolating the recent deceleration in the economy into still-slower growth would be a mistake, in our view.  Instead, we see a moderate pickup ahead, with the 2Q downshift marking the transition to a period of unspectacular 3-3.5% growth.

Nonetheless, it's clear that the Fed wants to insure against such risks.  Its decision to roll over maturing MBS into longer-term Treasuries prevents a passive tightening of policy and for now means that 10-year Treasury yields could decline to 2.5% or less, flattening the yield curve.

A lower inflation trajectory carries implications for the Fed and yields next year. As discussed below, we are also lowering our forecast trajectory for inflation; the acceleration we expect next year will likely be slower - to 1.8% for core CPI versus 2% previously.  As a result, we see the Fed waiting until 3Q11 to move.  Previously, we expected a move by the end of 1Q.  And once it starts, the move will be gradual, so the funds rate should end 2011 at 1% instead of 1.75%.  Likewise, for 10-year yields, we see a slower rise than before - to 4.5% instead of 5% by the end of 2011.

Two point four: barely sustainable.  The deceleration in GDP growth from 5% in 4Q09 to 2.4% in 2Q10 has reinforced the consensus outlook for sluggish, below-trend growth.  And many believe that 1-2% growth in 2H is a given.  The 2Q pace is barely on the threshold of sustainability; it is just fast enough to generate the income growth needed for moderate gains in consumer spending.  But it is not fast enough to continue to narrow slack in the economy - key for reducing the tail risk of deflation and maintaining operating leverage for corporate profits.  So, a pickup in demand and output are both critical.

Four factors driving a pickup.  The current deceleration in economic activity, in our view, is largely a reaction to the spring shock from the European sovereign credit crisis.  That shock had a bigger impact on US growth than we thought earlier this year, because it triggered a sudden, temporary tightening in financial conditions and increased uncertainty about the sustainability of global growth. 

In contrast, the easing in financial conditions and three other factors are likely to promote modest improvement in 2H:

1. Financial conditions have eased, with the capital markets opening again and risk appetite returning.  High yield and investment grade corporate spreads widened significantly this spring, but rates have since declined in absolute terms to record lows.  Conventional 30-year mortgage rates have plunged by 70bp.  The dollar on a broad-trade-weighted basis has reversed its spring rally.  And stock prices have improved since their swoon since April. 

2. Global growth is still hearty.  For example, it appears that the Chinese economy has slowed in response to restraints on lending and tighter monetary policy.  But we estimate that it is slowing from 10% this year to 9.5% in 2011 - still strong.  So, while net exports sliced as much as 3.2 percentage points from 2Q US growth, according to revised data, we think they are poised to improve dramatically.  Exports remain strong, rising at a 10.3% annual rate, despite weak agricultural exports.  The drought in Russia and bumper US farm inventories will probably combine to boost farm exports in 2H.  More important, the 35% annualized merchandise import surge in 2Q was a temporary anomaly, in our view.  The jump in oil imports seems to reflect one-time offloading of crude cargoes from ships on the water to tank farms, and the estimated surge in consumer and automotive imports probably will unwind quickly, as it far outpaced the swing in inventories and final sales.

3. Modest but sustainable gains in domestic demand.  A significant slowing in domestic final demand is underway from 2Q's 4.1% clip; indeed, we see it correcting to just over 2% in the second half.  But that lower pace should be more than sustainable.  Among the reasons:

•           Despite tepid July employment data, gains in the work-week and wages seem likely to yield 3% annualized gains in real disposable income in 2H; that is sufficient to sustain both 2-2.5% consumer spending growth and a further rise in the personal saving rate.  Indeed, sharp (2pp) upward revisions to the personal saving rate over the past two years to 6.2% hint that consumers have rebuilt saving and balance sheets by paying and writing down debt by more than previously thought.  Consequently, the headwind to consumer spending from such deleveraging is a smaller risk to the outlook as consumers can spend more of their income in 2H. 

•           The extension of unemployment insurance benefits and aid to state and local governments, restoring $60 billion in temporarily suspended fiscal stimulus, should add to jobs, incomes and confidence.  For example, state and local governments can now use the funds to rehire the 48,000 workers furloughed in July as the fiscal year began.  Moreover, we expect that Congress will agree to extend many, if not all, of the tax provisions that expire on December 31 for one year.  While that could generate medium-term uncertainty about tax policy, it should avoid near-term fiscal drag.

•           Profit margins have yet to peak, providing wherewithal for capital spending, and companies have begun to invest to replace worn-out and obsolete equipment in a sustainable way. 

•           Finally, infrastructure spending, the last part of the fiscal stimulus enacted in 2009, is now gathering steam.  Double-digit spending gains for infrastructure should offset any further weakness in local government hiring.

4. The inventory cycle is not over.  Outsized contributions to output from inventory accumulation are unlikely, but inventories are now lean in relation to sales.  Although just-in-time inventory management techniques promote a secular decline in inventory-sales ratios, if we're close to right that overall final sales (including net exports) run at a 3% rate, inventories will fall too low in some industries unless production steps up in tandem.  As further evidence, the ISM manufacturing customer inventory index at 40 is well below historical norms. 

There continue to be two key risks to our moderately upbeat scenario: Housing.  In addition to the ‘payback' following expiration of the first-time homebuyer tax credit, the downside risks to home prices, mortgage credit availability and housing demand are still present.  Policy/political uncertainty.  We think increased uncertainty around taxes and implementation of healthcare and regulatory reform is one reason why consumer confidence slipped in the last couple of months. 

The case for a gradual rise in inflation.  Firming rents and narrowing slack reinforce our conviction that inflation is bottoming and that the deflation scare is just that - a scare.  Evidence for rising rents began accumulating late in 2009, as apartment vacancies fell.  From January through May, rents climbed 2.8% nationwide, according to Axiometrics, which tracks the national apartment market.  Those increases move through the popular price gauges like the CPI on a six-month moving average basis, so the increases seen in May and June are likely to persist. 

Thanks to hearty gains in output and cutbacks in capacity, moreover, operating rates have jumped 580bp from their trough; shrinking slack has long been a key factor behind our above-consensus inflation call. 

Looking ahead, however, the coming rise in inflation will likely be slower than we had been thinking, courtesy of smaller declines in capacity and thus smaller ‘speed' effects.  The strong gains in capital spending seen since the beginning of the year are offsetting ongoing cuts to industrial capacity, which declined 1.6% since late 2008; capacity just began to level off in 2Q.  As a result, we now see core inflation measured by the Fed's preferred gauge (the PCE price index) at 1.8% in 2011, about 0.4% higher than its pace over the past year but a quarter-point below our earlier forecast.

The Fed: More than a symbolic shift.  In the near term, the deceleration in growth, uncertainty about the fate of the expiring tax cuts and other expiring provisions, and risks of further declines in inflation have spurred the Fed to take out double-dip/deflation insurance.  Adopting a change in the reinvestment policy for its portfolio of MBS, the Fed will reinvest the cash flows associated with principal repayments of MBS and agency debt into longer-term Treasuries instead of letting the portfolio run off. 

Although the Fed's buying program ended in March, its portfolio of MBS has just started to contract because a significant portion of the purchases were for forward settlement.  The settlement of these transactions has just about offset the impact of prepayments, and the Fed's overall MBS holdings have thus remained fairly steady.  However, almost all of the forward trades had settled as of the end of July, so the underlying shrinkage in the principal balance would have started to become more apparent, absent any new action. 

The decision to buy ‘longer-term' Treasuries represents a significant surprise.  We (and others) had thought that the Fed would focus any buying related to a change in its MBS reinvestment policy on short-dated Treasuries.  That's because the program was being advertised by the Fed as a "symbolic" change that did not have much economic significance.  Also, we thought that resistance to the reinvestment change by the hawks on the FOMC would, at best, lead to a compromise in which any buying would be focused in the front end in order to alleviate concerns about an eventual exit strategy.  Instead, the Fed appears to want the program to have somewhat greater economic significance by spreading out its buying across a broader maturity spectrum.  

In fact, it's important to recognize that by using terms like "longer-term" and following up with an indication that the purchases will be concentrated in the "2- to 10-year sector", we believe that the Fed really means that it will buy across the curve.  In fact, this is the same language that the Fed used to announce the $300 billion Treasury purchase program in March 2009.  In that case, the average maturity of the purchases wound up being about eight years.  Keep in mind that there are large sectors of the Treasury market where the Fed is already bumping up against the 35% limit on its ownership share.  So, it will have to pick and choose carefully among outstanding issues.  The Fed's goal will be to hold its SOMA portfolio near the current level of $2.054 trillion.

This change in the Fed's reinvestment policy is more than a symbolic shift because it both avoids a passive shrinkage of the Fed's balance sheet and tees up the markets for a more aggressive asset purchase program at some point down the road if - contrary to our expectations - economic conditions were to deteriorate in a meaningful way.  Also, the Fed buying will take duration out of the market that the shrinking balance sheet would otherwise have added; this should bring down retail mortgage rates.  However, mortgage prepay speeds are slower than would be expected, given the current rate environment, so our trading desk estimates that principal repayments will lead to about a 1.1% per month decline in the Fed's MBS portfolio over the next few months.  On a base of $1.12 trillion of holdings, this amounts to about $12 billion per month.  Add in another $2 billion for agency reinvestments and this totals $14 billion per month (note that this amount could increase in the not-too-distant future if prepay speeds were to rise).  The buying operations will be conducted in a manner very similar to the $300 billion Treasury purchase program that was announced in March 2009.

How do the Fed purchases stack up against new Treasury supply?  Our budget deficit forecast is $1.3 trillion for FY2010 - and a bit less than that for next year.  So, in rough terms, these Fed purchases can be scaled against about $100 billion per month of net new Treasury issuance.  Also, the new coupon issuance has an average maturity of about seven years, which is reasonably close to the expected average maturity of the Fed's purchases.

Resetting the timetable for a reactive Fed.  Looking ahead, with a lower trajectory for inflation next year, we see the Fed - already reactive and wanting to be very sure of sustainable growth and a return of inflation to the comfort zone - waiting until 3Q11 to move rates higher.  Previously, we expected a first move by the end of 1Q.  Once it starts, the move will be gradual, so the funds rate will likely end 2011 at 1% instead of 1.75%.  To be sure, that's not the end of the story.  Our guess is that growth will be stronger and rates will rise more significantly in 2012.

Reactive policy = rising term premiums.  Likewise, for 10-year yields, we also see a slower rise than before - to 4.5% by the end of 2011 instead of 5%.  That's a steep rise from current levels and, for the yield curve, a break from the bull-flattening move that began with the onset of the European sovereign debt crisis and was extended by the deceleration in US growth.  At work will be the combination of a reactive Fed and rising real yields, which suggests that the yield curve will remain comparatively steep even when tightening begins.  With the real funds rate still negative and inflation moving up, a reactive, cautious Fed means that term premiums are likely to rise, and the yield curve will flatten modestly at best.  As the Fed is expected to tighten later and more slowly than before, we think that the yield curve will only flatten slightly and 10-year yields will rise to 4.5%. 

The last point is worth emphasizing: We think that the inflation risk premium will be higher because, unlike in the past, the Fed will be reactive rather than proactive.  That's a critical reason why the curve should stay steep despite rate hikes - a point of differentiation for our call.

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