Roadmap to Stronger, Sustainable Growth
December 16, 2010
By Richard Berner & David Greenlaw | New York
Breakthrough tax deal. We assume Congress will approve the tax/fiscal stimulus deal, which will add about 1pp to growth in 2011 relative to our earlier baseline, pushing our forecast to 4% over the four quarters of next year. Implementation of the deal, which could begin on January 1, will shift the mix of stimulus from monetary to fiscal policy, so that the Fed will likely be less inclined to extend the current LSAP program beyond 2Q11. And it suggests that yields will gradually continue to move higher, to 4% by end-2011.
As widely discussed, the deal will extend the expiring income tax cuts for all taxpayers for two years. In addition to extending several other expiring provisions, it includes three key temporary elements which add new stimulus - a one-year payroll tax holiday for employees, a 13-month extension of emergency unemployment benefits, and full expensing of business investment outlays for 2011. These will boost growth in 2011, partly at the expense of 2012. We estimate that their expiration at end-2011 will net to an offsetting drag of about 0.5pp in 2012. Together with other expiring provisions, the new stimulus amounts to about $400 billion above our December 3 baseline assumptions over 2011-12, or about 1.3% of GDP in each year. We illustrate the estimates of the budget impact of all provisions; these are similar to what we published last week, but refined by the Joint Committee on Taxation and Congressional Budget Office.
Why should this plan have more bang for the buck than ARRA? The fiscal stimulus enacted in the American Recovery and Reinvestment Act (ARRA) of February 2009 (Pub. L. 111-5) did not seem to add much oomph to the economy relative to its size; why should this smaller one produce more results? In our view, there are two reasons. First, the nature of the stimulus matters: Most of the latest stimulus (about 0.7pp) results from the new proposed payroll tax holiday for employees. Such cuts accrue mostly to lower-income, budget-constrained taxpayers and show up quickly in spendable income, so they are more likely to be spent.
In contrast, the Making Work Pay (MWP) tax credit that was a key part of ARRA was disbursed slowly, and some empirical work suggests that taxpayers spent only about 13% of the incremental income, which partly showed up in withheld taxes and partly in rebates when taxes were filed. Similarly, consumers spent about one-third of the one-time tax rebates in the 2008 stimulus package. In addition, the MWP credit at $60 billion was smaller than the proposed payroll tax holiday. Likewise, while ARRA's grants to states and healthcare insurance premium (COBRA) assistance provided a helpful buffer for governments and individuals, these funds tended to be saved rather than spent. Finally, outlays for the famously ‘shovel-ready' infrastructure projects featured in ARRA took as much as a year to show up in spending.
A second reason why the current stimulus is likely to be more potent involves the state of financial conditions affecting households: We believe that liquidity-strapped consumers, suddenly denied access to borrowing in the credit crunch, were more likely in early 2009 to save their tax credits and other forms of stimulus or use them to pay down debt. In contrast, the deleveraging process for households and lenders is far more advanced today.
Indeed, four factors already are promoting sustainable growth. First, balance sheet healing is more advanced and, courtesy of the Fed's new asset-purchase program, financial conditions are gradually becoming easier. Debt-to-income and debt-service-to-income ratios continued to decline in 3Q. The Fed's Senior Loan Officer survey indicated that banks' willingness to lend to consumers has continued to improve and that banks have eased lending standards for consumer loans. The glaring exception is that mortgage credit is still tight; indeed, in 4Q banks signaled tighter standards for mortgage lending. And the ongoing issues around mortgage ‘putbacks' continue to keep origination criteria from loosening.
Second, stronger global growth finally seems to be boosting US output. Following a period in which surging imports overwhelmed domestic demand, and net exports depressed GDP by 3.5 and 1.8pp in 2Q and 3Q, respectively, we expect a sharp reversal in 4Q, with net exports contributing 3.2pp of the estimated 4.3% growth in that quarter. Some of this volatility is statistical, as Dave Greenlaw and Ted Wieseman will demonstrate in a forthcoming note. But much is fundamental, as hearty growth abroad and slower growth in US domestic demand augur a narrower trade gap.
Third, the time-honored cyclical dynamics of recovery, delayed by the credit crunch and the legacy of the financial crisis, are finally promoting the hand-off from rising output to increased hours, employment and income. While November's employment canvass was disappointingly weak in nearly every respect, including a downtick in the workweek, a broader perspective shows that rising hours have supported moderate gains in wage and salary income, and the improvement in a variety of labor market indicators - declines in jobless claims, rising job openings and surveys of hiring plans - points to renewed job gains. Finally, pent-up demand for capital spending is healthy; in the recession, capex slipped well below depreciation expense. Together with the acceleration we expect in economic activity, and the business expensing provisions of the new tax deal, that pent-up demand should spur hearty gains in capex in the coming year. And we think that improving fundamentals will boost capex outlays in 2012 despite the inevitable ‘payback' in outlays after the tax expensing provision expires.
Bottoming in inflation soon, gradual rise coming in 2011. Two factors should promote a bottoming in inflation soon and a gradual rise in inflation over 2011-12: 1) higher inflation expectations courtesy of the Fed, and 2) an acceleration to slightly above-trend growth that narrows slack in the markets for goods, services and housing. The continued slide in core inflation through October to 0.6% in terms of the CPI and 0.9% as measured by the Fed's preferred gauge (the PCE price index) leaves it well below the Fed's comfort zone. While the Fed doubtless welcomes the rise in market-based inflation expectations, it's not sufficient to make officials comfortable with the inflation outlook; indeed, the FOMC's central tendency of only 1.3% core inflation in 2012 and 1.6% in 2013 strongly suggests that it isn't thinking of an exit strategy from the current policy stance any time soon. Taken at face value, the FOMC's inflation outlook implies a ‘tighter' relationship between inflation and slack in the economy than does ours; we expect a faster, albeit gradual rise in core inflation to 1.5% over the course of 2011.
Four downside, two upside risks. Despite these supportive factors, there are four key downside risks to the outlook for growth. Most are familiar. First, housing imbalances remain the most significant single downside risk; a decline in home prices larger than the 10% we expect would disrupt further the supply of credit, menace consumer balance sheets, and thus threaten consumer spending. Second, state and local government finances remain fraught; faced with additional shortfalls, officials might cut spending and employment significantly further, especially as federal grants fade. The good news is that revenues are starting to improve, which should mitigate that risk. Third, if Europe's sovereign crisis were to intensify further, it would (as in the spring) promote renewed risk-aversion and tighter financial conditions. Finally, if China's monetary policy tightening were to go beyond the three additional moves we expect, it could trim market expectations for future growth.
Conversely, two forces might promote upside risks to our still-moderate growth scenario. First, a stronger global economy, especially if it shows up in US exports, could boost growth significantly. Second, a persistently weaker US dollar could accelerate that process - one that we expect will play out in the next two years in any case.
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Polarising Policy Paths
December 16, 2010
By Manoj Pradhan & Joachim Fels | London
Reflation is one of the three key themes - aka the three ‘Rs' - in our 2011 global economic outlook (see Global Forecast Snapshots: 2011 Outlook: Rebalancing, Reflation and Reconciliation, December 8, 2010). It is based on our view that monetary policy will remain expansionary on a global scale next year, which should support the ongoing reflation of the global economy and financial markets. However, underneath the global surface, monetary policy paths are actually diverging, and the divergences look likely to become more accentuated in 2011. While the G3 central banks - the Fed, the ECB and the Bank of Japan - are likely to keep official policy rates at rock-bottom levels through 2011 and will continue to engage in quantitative easing in its various disguises at least for part of the year, other central banks, mostly in EM and in resource-based G10 economies, look set to (continue to) tighten policy in response to rising inflation pressures. In this note, we take a closer look at the divergent policy paths.
Global policy rate up only 50bp or so in 2011: Before delving into the details, it is worth looking at the actual and prospective global stance of monetary policy. While our country economists expect 23 out of the 34 central banks around the world that we are following closely to raise interest rates and only 11 to keep rates on hold, the (GDP-weighted) global policy rate which we routinely publish in our forecast table in The Global Monetary Analyst should only rise by less than 50bp from 2.9% currently to 3.3% by end-2011. One reason why the increase is so moderate is that we expect rates in the three G10 heavyweights - the US, euro area and Japan - to remain unchanged throughout the year. Another reason is that we think most central banks that we expect to raise rates will do so relatively cautiously, in order to prevent too sharp a slowing of the economy and/or excessive exchange rate appreciation.
Real global policy rate still negative, to creep up only slightly: Adjusting the nominal policy rate for inflation, global real short rates remain in negative territory - the nominal rate stands at 2.9%, while global inflation has averaged 3.3% in the current quarter. On our forecasts for inflation and policy rates, the real global policy rate will creep up to around zero by the end of next year - still extremely low compared to global output growth, which we expect to motor along at close to 4.5% in 2011. Thus, the (virtual) global central bank looks unlikely to slam on the brakes next year - it will just press the accelerator less hard, in our view.
A Tale of Two Worlds
One theme that comes through loud and clear from our global monetary policy forecasts is that the monetary policy paths between the big mature economies (essentially the G3) on the one hand and EM economies on the other should diverge even more in 2011, consistent with our ‘tale of two worlds' theme describing the EM versus DM divide. As we discuss in more detail below, inflation is increasingly seen as a problem in some major EM countries, and strong growth in EM means that output gaps are shrinking rapidly in many cases. Conversely, the G3 central banks still worry more about outright deflation (BoJ), undesirably low inflation (Fed) or a fragile financial sector and weak peripheral economies (ECB).
Within the G10, the five central banks that have been raising rates already this year - the Reserve Banks of Australia and New Zealand, the Swedish RIksbank, Norges Bank and the Bank of Canada - are all expected to continue to raise rates this year to varying degrees. Our UK economists expect the Bank of England to join the rate hikers' club this summer as inflation is likely to be entrenched and inflation expectations look set to rise further.
The central banks of the G3 economies, however, are not expected to join this club before 2012. With policy rates still near zero, the burden of monetary policy continues to fall on QE. The Fed's enhanced QE2 programme is scheduled to run through 2Q11 and our US economics team now expects no further enhancements to this programme because of the new fiscal package that is making its way through Congress. The stimulus from the fiscal package is expected to add about 1% to GDP growth next year, making further asset purchases to stimulate the economy unnecessary. The BoJ recently announced a more modest enhancement of its own QE programme, which extended the range of assets it was going to buy. The ECB, by contrast, has kept up the purchases of peripheral bonds through its SMP programme (though it has sterilised all such purchases) and has retained unlimited three-month tenders to support to liquidity requirements for the euro-zone's banking system. The risk here is that the ECB may have to engage in more aggressive action if the problems from the euro-zone periphery are transmitted to the core countries. Should such a contagion occur, the ECB might be forced to then extend its own operations to a Fed-style programme of large-scale asset purchases. At present, the ECB appears to be in no mood to pursue any such strategy, asking governments instead to find a sensible solution to sovereign problems while it provides stability to the financial sector through its liquidity programmes. In a nutshell, all three major central banks remain focused on their ongoing QE programmes, and an exit from these programmes does not appear to be in sight for the foreseeable future.
Worlds Apart: EM Central Banks Forge Ahead
Policy-makers in the EM world, on the other hand, have been setting monetary policy playing three balancing acts: i) balancing off weakness in G10 growth versus strong domestic growth; ii) balancing off the domestic output gap and inflation risks; and iii) balancing off constraints of the trilemma against currency appreciation. Anaemic growth in the G10, the absence of the ‘worrisome' kind of inflation and fear of inviting even more currency appreciation due to the trilemma have all kept policy-makers from tightening monetary policy aggressively in the EM world. There now appear to be risks that the first two balancing acts may prompt policy-makers to abandon their ultra-cautious stance and force them to take away more monetary accommodation, but stop short of an outright restrictive monetary stance.
Balancing Act #1: External versus Internal Demand
For all their economic outperformance, EM economies are not yet at the stage where they can ignore developments in the DM world. As long as the advanced economies slowly eke out a recovery, the EM world can use its monetary policy to propel domestic growth further. Policy-makers have taken heed of this delicate balancing act as they kept one watchful eye on anaemic G10 growth and another on strong domestic growth. The net result has been that monetary tightening has been far more subdued than would have been the case if both external demand from the G10 countries and domestic demand had been robust.
Policy-makers in AXJ and LatAm economies with their strong ties to US markets, and in the CEEMEA economies with their ties to the European markets, have remained watchful. In the AXJ region, for example, India has been the only economy to tighten rates aggressively, and this was in response to an inflation problem which now seems to be under control. Monetary measures in China have been mostly restricted to liquidity management and RRR hikes. However, our China economics team expects that China's policy machine will follow through on its commitment to tackle inflation this year with three rate hikes by mid-2011, continued currency appreciation (with USD/CNY to reach 6.20 by end-2011) as well as a modest tightening of the lending quota for 2011. Rate hikes elsewhere have been measured. Despite the fact that the output gaps in Korea and Taiwan are now estimated to be closed, central banks there are not expected to hike rates aggressively. A similar story can be seen in Indonesia, where domestic demand has played a strong role in the economic recovery.
To a lesser extent, this story is also playing out in Latin America. Rates were cut to historically low levels in many cases in response to the slowdown in the US. Much of this unprecedented easing has now been removed. But the frenetic pace of rate hikes also slowed down some time ago as it became clear around mid-year that the G10 recovery was going to be slower than had previously been anticipated. A similar balance is also evident in the CEEMEA economies. These economies have much stronger ties to the European economies, and the problems with the euro area peripheral countries have kept many CEEMEA central banks from raising policy rates.
Importantly, in EM countries where policy is likely to tighten, it is likely to be aimed at tapping on the brakes in order to cap growth and inflation where they are rather than engineer a meaningful downturn in either.
Balancing Act #2: Domestic Demand versus EMflation
Inflation concerns have prompted China to embark on a broad-based policy tightening, and similar fears are playing up in other parts the EM world, particularly in economies that have recovered quickly through robust domestic demand growth. There are two bits of good news here: i) not all EM economies have inflation concerns; and (ii) only a handful of countries have the kind of inflation problem that is likely to invite a relatively strong response from monetary policy-makers.
Just about half of the countries in our EM universe have inflation concerns. However, in PPP GDP-weighted terms, these economies account for over 75% of EM GDP. However, with the notable exception of Argentina, Brazil, Indonesia and Saudi Arabia, countries where inflation is a concern are facing a relatively benign type of inflation problem so far. Inflation in these countries has been confined to food/energy prices and core measures have been quite stable and uncontaminated by food and energy inflation. The concern, however, is that unfettered growth of domestic demand when there is little or no slack left in the economy is an invitation for food/energy inflation to slip into core measures, which would then become a serious inflation problem. In order to prevent this very eventuality, there is likely to be further monetary tightening in 2011.
17 of the 23 interest rate-setting EM economies under our coverage are expected to hike rates in 2011. At one extreme, six are likely to keep rates on hold. However, three of these (Hong Kong, UAE and Saudi Arabia) have pegs to the US dollar, which makes them move in lock-step with the Fed. But three others (Malaysia, Colombia and Mexico) will not raise rates in 2011, in our view, Malaysia having raised rates in 2010, and Colombia and Mexico expected to raise rates only in 2012. At the other extreme, the central bank of Chile is expected to raise policy rates by 225bp over 2011, the central bank of Brazil by 175bp and the central banks of Turkey and Israel by 150bp each. All the others will likely raise rates by 50-100bp next year.
On our count, 13 out of the 18 EM central banks who have raised rates in 2010 or are expected to raise rates in 2011 will have larger rate increases in 2011 than they did in 2010. The notable exceptions are mostly the early hikers like India, Malaysia, Brazil, Chile and Peru. Having already moved policy rates meaningfully higher in 2010, these central banks can now slow down the pace of monetary tightening and take rates a little less slowly in the direction of neutral.
Balancing Act #3: The Trilemma and Currency Appreciation
Besides balancing off external and internal demand, and internal demand and inflation, policy-makers have also been reluctant to hike policy rates aggressively through fear of attracting even more capital inflows, leading to further currency appreciation. The two-track global recovery and the ultra-expansionary AAA monetary regimes in the major economies have all made capital flows into EM economies inevitable.
Depending on their circumstances and preferences, different EM economies have chosen to deal with these capital flows differently. Intervention in FX markets has been employed in many economies overtly, with Colombia, Turkey and Israel as the prominent ones on this front. Besides that, mild capital controls have been put in place as another tool to deal with capital flows. However, these are unlikely to stem the tide. FX intervention is difficult to conduct on a consistent basis unless policy-makers are also willing to follow through with the costly sterilisation of these purchases (costly since EM rates are typically higher than DM rates, making the cost of carry negative). Further, capital controls are tools that can effectively change the composition of inflows but are not very good at reducing the overall level of these inflows.
Thus, EM economies really only have two choices to make to deal with capital inflows: allow currency appreciation or prevent it. In general, economies where output gaps are closed and inflation is a concern will find it relatively safer to allow their currency to appreciate. China, India, Korea, Taiwan and Singapore from the AXJ region and Brazil, Argentina and Peru from Latin America fall into this broad category (though Brazil will likely resist currency appreciation going forward). The appreciation in turn should keep growth and inflation from rising further.
On the other hand, where growth is welcome, policy-makers may take aggressive steps to curb currency strength. The SARB has already cut policy rates by 100bp order to keep the currency from strengthening. In addition, our Turkey economist, Tevfik Aksoy, now believes that there is a 30-40% probability that the CBT may also follow this lead with 50bp of cuts to the policy rate.
Polling our EM economics teams, a combination of rate hikes and FX appreciation is likely in most countries. Notable exceptions to this trend are the economies of Brazil, Hungary, India and Thailand, where FX appreciation is unlikely. With some of the rate hikes already out of the way in Brazil and India, there should be less pressure on their currencies to appreciate; however, the risk of appreciation is likely to remain to the upside, given their growth performance. The picture in other economies is mixed. Clearly, the stand-out economy here seems to be China, where both higher rate hikes and a stronger currency are highly likely. It is important to note that this does not imply that the rate hikes or currency appreciation need be particularly aggressive.
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