Are EMs the New DMs?
May 06, 2011
By Manoj Pradhan | London & Alan Taylor | New York
Introduction
In today's world economy, many old certainties have been swept aside. The adjectives ‘fragile' and ‘robust' have been switched between developed market (DM) economies and emerging market (EM) economies. Remarkably, the EM economies have contributed over 70% of global growth during the recent cyclical recovery and have done so without any hiccups from macro fundamentals or markets. Effectively, the title of this study is a question about whether EM economies can be the next long-term drivers of global growth and about the convergence of standards of living around the world. In this first of two notes, we examine this question from a high level of aggregation, splitting the world into DM and EM economies (see the Appendix for the list of countries). In a companion note, we will discuss the same issues at the country level.
Is the EM-DM reversal of fortune really so stark, and is it durable? Depending on whether it is EM stock markets or European peripheral spreads soaring on the day, the phrases "EMs are the new DMs" or "DMs are the new EMs" can be heard quite commonly in the financial world. Though the latter phrase is used almost as dark humour, there is bright conviction about the former. We think that the broad structural story behind EM growth includes a variety of supports, many stronger now than in past decades - catch-up potential, favourable demographics, low debt burdens, sounder policies/institutions, better social capabilities and ‘self-insurance' from sizeable FX reserves. But where exactly are the EM economies in their drive to become DMs?
Are EMs the New DMs?
Our short and simple answer to that question... is yes, but the transformation is not yet complete.
The longer and not-so-simple answer... In terms of growth, EMs have significantly outperformed DMs in almost every respect. Yet, EMs have yet to catch up in terms of levels. However, the fact that there is this gap between EM and DM economies also means there is scope for improvement, and therefore for sustained EM growth. There are risks to this convergence, however, from the DM and the EM side, which will likely take serious effort and considerable time to correct.
The Good, the Bad and the Ugly of the EM-DM Divide
We divide our analysis of the EM-DM divide into ‘narrow' (one based on more or less standard macroeconomic metrics such as growth, inflation, debt, etc.) and ‘broad' (based on socio-economic and political economy considerations) buckets. Our key conclusions on the EM-DM divide are as follows.
The (really) good... The quality of growth in EM economies has been staggeringly better of late. While DM economies have actually regressed, with lower and more volatile growth, EM growth has improved dramatically and on a steadier trend than in the past. In fact, macro-stability has improved in general. On the inflation, indebtedness and self-insurance fronts, for example, the success of EM economies has been remarkable.
More interestingly, and in our opinion more importantly as well, EM economies have narrowed the gap between themselves and DM economies on many of the ‘deep' social indicators that are important for sustained growth. The deep determinants of longer-term growth such as life expectancy, schooling and economic and political freedom have improved in EM as well as DM economies, but by a much greater degree in the EM economies.
...the bad (well, not so good)... Even though the variability of GDP growth has not improved and the variability of inflation has continued to fall, in level terms, there is still clear daylight between EM and DM economies. A similar story exists for the deep parameters, like the political and economic freedoms and social indicators. But there is actually a silver lining here. With plenty of scope for improvement, the medium-term picture for EM growth remains well supported if reforms and investments continue.
...and the ugly: Despite all of the achievements we have outlined above, inequality in EM economies has actually worsened during a golden era of resilient development and income growth. Unless the rising tide eventually starts to lift most boats, there is a risk that a significant fraction of the EM world's population ends up being excluded from the benefits of growth and convergence. As we know from history, such a trend could pose a political and economic threat to the case for a sustained structural EM advantage.
For the DM economies, the list of ‘ugly' issues is much longer than it was half a decade ago. The risks to sustainable growth, a razor-thin margin for manoeuvre for policy-makers, adverse demography and high debt burdens mean that it may be the DM economies that pose the biggest threat to global and EM growth.
Mind the gap: Overall, EM economies have narrowed the gap between themselves and DM economies dramatically, but the emphasis on improving the quality of growth needs to be pressed further. Maintaining that pace may not be as easy or smooth going forward, but EM economies certainly have the momentum in their favour.
What Are ‘Emerging Markets'?
That the EM world could survive intact the largest economic and financial crisis that investors have witnessed in their lifetime, and then go on to power global economic growth in a time of continued strain, speaks volumes for the EM success story. It is safe to say that, ex ante, such an unusual reversal of fortune had not been widely anticipated, and even ex post it remains a challenge to fully explain it. This, in turn, begs the broader question as to what it means to still refer to emerging and developed economies as two distinct groups.
‘Emerging markets' may be defined as economies in transition towards a high standard of living.
In a narrow sense, they will have demonstrated the ability to generate rapid growth in potential output. EM economies typically have a low starting point in terms of how efficiently they allocate and use the resources available to them. They may also have a scarcity of resources per person, for example, physical or human capital. It is the reallocation of the factors of production and the increase in their efficiency, combined with further capital accumulation, which can allow for the rapid growth of potential output in the future.
How can this come about? In a broader sense, the EM economy in question must also have some claims to have put in place the deeper, fundamental political and legal reforms (such as enhanced rule of law, stronger property rights, lower corruption, better governance, etc.) or socio-economic reforms (such as health and education improvements, monetary and fiscal stability measures, better infrastructure, removal of trade barriers, etc.) needed to bring about a permanent upshift in its long-run development trajectory.
Are DMs the New EMs?
The proposition may seem darkly humourous, or at least cheeky, rather than a serious question; but even so it is not hard to find investors who believe that some DM economies are now worse prospects than many EM economies. While they have a valid point on the growth prospects of these economies, the absolute standard of living in DM countries is still high enough to keep them from slipping into the EM bucket. In a subset of DM economies, to be sure, adverse fundamentals (e.g., demographics and debt) may put medium-term growth at risk, and there the difference between them and the upper echelon of EM economies could then fade faster than anticipated.
A Gradated Scale
Clearly, neither EMs nor DMs are what they used to be. The EM-DM divide is thus perhaps not as stark as we once thought. Korea and Chile are already part of the OECD, and a clutch of others might be knocking on the door relatively soon. In contrast, Europe's periphery is stuck in reverse gear. DM economies have been losing ground, relatively speaking, to EM economies for a while now. Recently, however, some DM economies have lost ground even on an absolute basis, thereby speeding up the EM-DM convergence.
On a gradated scale, DM economies that have emerged from the Great Recession relatively unscathed and are already plugged into EM growth in some way are likely at the top of the heap. Those that have lost significant ground with relatively weak prospects for the medium term would likely come next. Close behind would be EM economies that have raised their standard of living to a high level and whose growth prospects are strong, with some catching up still to go. Following in their footsteps are the high-growth EM economies that are still a couple of notches lower in terms of the level of their development. And finally, and worryingly, is a category of developing countries that would have hoped to ‘emerge' in much the same way as some of the EM success stories, but will now have to find a new strategy for growth, given the decline of the DM consumer.
‘Models' no more: In terms of economic philosophy, an important development is that DM economies are no longer seen as ‘targets' or ‘models' to aspire to. Their recently proven fallibility means that EM economies are trying to chart their own sustainable path forward, using the DM model more as a ‘reference' but not blindly following the same development path recipes.
Growth and Macro-Stability: A ‘Narrow' Look at the EM-DM Divide
The Really Good
There are many reasons to wax lyrical about EM economies, but less to say about DM economies here. Better growth and inflation, lower indebtedness as well as higher FX reserves bringing about an improved outlook for sovereigns, and better demographics all argue for continued outperformance of EM economies in their quest to mature into developed markets. The historical performance and our economics team's outlook that we discuss below support this thesis. We start with the areas where the relative economic strengths of the EM world seem most apparent.
Its all about the quality of growth: Looking at GDP growth versus its standard deviation on a 10-year rolling basis, aggregated using PPP GDP weights, the remarkable ‘U-turn' that EMs have achieved from the 1980s contrasts sharply with the ‘one-way' traffic in DM growth which has been falling the 1980s. Around 1980 (just before its ‘lost decade'), the EM world offered higher growth but higher variance than the DM world. From a risk/reward standpoint, this advantage was tempting to some. But in the 1980s and early 1990s this advantage evaporated. DM growth slowed, but EM growth collapsed and became more volatile. Slowly, by the late 1990s and 2000s, the EM turnaround began. And now, after the crisis, it is the EM world's turn to post stronger growth, just as DM volatility has mounted. In relative terms, the risk/reward picture now appears to strongly favour EM again, even more starkly than it did in the 1970s.
Based on our economics team's forecast, EM economies look well set to outperform DM economies in the medium term, thanks to not just strong performance from EM economies but also from weak and uncertain growth from many major DM economies (see Global Forecast Snapshots: The Global Economy in One Place: Global Resilience, April 6, 2011).
The taming of inflation: Perhaps the central theme of recent macroeconomic history has been the taming of inflation. The eruption of price instability in the 1970s following the end of the Bretton Woods system saw inflation in DM world peak at around 10-20% per year. In the EM world, however, it was not uncommon to see inflation rates running higher, sometimes by several orders of magnitude and at hyperinflationary levels.
DM economies made serious progress in the fight against inflation by bringing inflation down from roughly 10% to close to 2% while also lowering the volatility of inflation. After the challenging 1970s and the debilitating 1980s, the EMs made rapid progress. By the late 2000s, the EM group had all but converged to DM performance in terms of inflation metrics, with mean and standard deviation of inflation both in single digits. Thus, although the inflation beast was gradually slain worldwide, the fight was certainly fiercer in the EM world than in the DM world, and the ultimate triumph therefore all the more remarkable. And too much can sometimes be made of the DM ‘advantage' of low inflation. Indeed, an entrenched low inflation regime may have been too much of a good thing as fears of destabilising deflation came to the fore, over many years in the case of Japan, and then in many other DMs during the crisis; EMs have avoided this trap.
The engine of EM growth: exports: The more outward-looking export strategy of the EM world as compared to the the DMs can be seen clearly through a much more rapid increase in the export to GDP ratio for EMs. More interestingly, the concentration of EM and DM export baskets has converged since the 1990s. After a sharp move towards diversification in the early 1990s, EM economies have reduced their export concentration to about 2-3 times the level of the DM economies - a big decline from about 4-5 times in 1990.
It should be kept in mind, however, that the course of economic development does not necessarily entail a shift towards ever more diverse and stable production structures. Indeed, there is evidence that richer countries eventually have a tendency to reverse this trend, specialising into narrow product lines as their development proceeds towards high income levels; in contrast, middle-income countries can be at a different stage where they become more diversified as they start to industrialise in new sectors.
The Not-Quite-So-Good
Is this story of an EM-DM reversal in fortune for real? While we can demonstrate the spectacular macro improvement in EM economies, it is still the case that the mean and volatility around GDP growth and inflation in the EM world are all still a significant level above their DM equivalents. Higher levels of inflation usually bring along higher inflation volatility. Reducing inflation while growth stays high is difficult for at least two reasons. First, fluctuations in growth will drive fluctuations in inflation.
Second, it is reasonable to think that the ‘sacrifice ratio' (how much growth will have to be hurt to lower inflation by 1%) becomes more penalising at low levels of inflation than at high levels of inflation. Policy-makers may be quite unwilling to hurt growth significantly at the moment (see Emerging Issues: A Macro Trinity Grips as the Impossible Trinity Ebbs, March 16, 2011) and more willing to tolerate higher volatility in the medium term as long as it also brings higher growth. This does imply, however, that uncertainty will remain high even with strong performance in the EM world.
Finally, strong export orientation could be a risk for EM economies if DM growth or EM domestic demand fail to come through in a reliable and sustainable way.
Debt, reserves and sovereign risk perception: However, in one key macro area we see signs of continued progress underway, but with still some distance to go until EMs lower macro risk to DM levels. (Or, alternatively, and more pessimistically, until DMs backslide toward EM risk levels.) And that is in the area of fiscal prudence.
We looked at the evolution of public debt relative to GDP, based on simple country averages, from 1990 to 2009. The DM group has an average level of debt higher than the EM group throughout, though, as is well known, EMs are generally more fiscally fragile than DMs (prone to default crises) even at the same public debt ratio. But the fluctuations in these levels are revealing.
The picture shows that the EM world has decoupled from DM in another favourable way, the ability to achieve a more benign fiscal stance, running down debt during booms, and thus being better placed to absorb shocks during downturns. Chastised by the debt crises of the 1980s and late 1990s, EM economies made a concerted effort to work down their debt burdens while stockpiling FX reserves as a means of self-insurance. The DM experience of the 2000s, in contrast, was of a fairly steady debt level followed by a cataclysmic increase during the Great Recession, with some DMs suffering capital market penalties (high spreads) or even denial of market access (some European peripherals). Now, looking forward to adverse DM debt levels and trends for many years, it is far from clear that DM economies will all be considered safe sovereigns by investors.
A powerful summary of changing investor perceptions about the relative fiscal soundness of the DM and EM worlds is shown in Exhibit 9 of our full report, which displays the S&P sovereign ratings in numerical form (+1 for each notch below AAA) for each country group from the mid-1990s until the present. The average DM rating remained remarkably steady at about 1.4, and with declining cross-sectional variation, until the crisis. Since then, the mean rating has started to climb towards 2 (AA+) and the variance has also risen (from 1 to 1.6), reflecting the downgrades of some once impeccable DM sovereigns. Meanwhile, in the EM world, sovereign ratings have been headed in the opposite direction since 2000. Prior to that, in the years of EM crises, the mean EM rating fell from BBB- in 1995 to as low as BB+ in 1999. Then, in the last ten years of progress towards macro-stability, the mean EM rating rose as far as A-/BBB+ in 2011, with variance sharply declining too.
The Ugly
Most of the news here is on the DM side, and since these issues are well understood, we only list them here. However, we do emphasise that, despite this brief treatment, we remain cognisant that these issues are easily the most worrisome for the global economy now and even in the medium term.
Sustainable growth, policy errors on either side (too loose for too long pushing up inflation and asset prices, or too tight, too soon like Japan in the 1990s) and a poor handling of the debt situation in the G4 economies all threaten the outlook for global growth. Sustainable growth is still far from assured in any of the G4 countries in what was predicted to be a BBB (Bumpy, Below Par, Brittle) recovery (see Global Forecast Snapshots: The Global Economy in One Place: 2010 Outlook: From Exit to Exit, December 9, 2009).
The ECB's earlier-than-expected move and the Fed's likely later start to the hiking cycle have still not resolved the debate about which one holds fewer risks for their respective economies and for the global economy as well. Finally, worries not just in peripheral Europe but in the US, Japan and the UK are all very much on the frontline of the risk frontier for the global economy. We do not expect most of these issues to be tackled in the next few months, which means that the uncertainty confronting policy-makers and markets will likely persist for a while.
Increasing the Quality of Growth by Rebalancing
In past notes, we have argued that the process of global rebalancing has been underway for the better part of a decade now (see Emerging Issues: The Great Rebalancing, February 16, 2011) and that there is a possibility that it proceeds in a benign but bumpy way for the global economy. An integral part of the rebalancing process entails an increase in real yields globally (but by more so in the EM world) as well as real appreciation of EM currencies (but more through nominal appreciation than via EM inflation being higher by a constant spread over DM inflation in the future). Indeed, the process of rebalancing via EM real exchange rate adjustment is already underway. If the process of global rebalancing proceeds as we expect, the nominal and real appreciation of EM currencies and the rise in real yields globally could put EM economies on a more sustainable growth trajectory while giving DM economies better access to positive spillovers from continued EM growth.
Higher real interest rates spurred by higher investment relative to savings should raise the return on capital, particularly in the EM world. The appreciation of EM currencies in nominal terms that we expect should not only boost consumption there but also raise the competitiveness of DM exports. Rebalancing should thus help EM economies generate the more domestic demand-oriented sustainable growth they need and desire while incentivising DM exporters to tap into EM growth.
If the outperformance of EM economies is successfully fuelled in part by a more domestic demand-led growth strategy, there is also likely to be a large boom in intra-EM exports. The basket of products produced by EM economies may be subject to change again. While an absolute advantage relative to DM economies may have prompted EM exporters to spread their cost advantage to a range of products, catering to other labour-abundant EM economies may mean that EM exports become more specialised, focusing on comparative advantage instead.
Deep Parameters: A Broader Look at the EM-DM Divide
Many investors would naturally focus on our ‘narrow' evaluation of the relative performance of EM and DM economies, if only because it might suggest short-horizon tradable implications for asset markets. However, we would argue that the socio-economic and politico-legal comparisons we employ below provide even stronger implications for asset markets in the medium and long term, supplying insights which may offer additional support for investments today.
In this part of the analysis, we consider political and economic freedom, life expectancy and education, and the trends in average well-being versus inequality in both EMs and DMs. For a change, there is plenty of ‘good' news for both EM and DM economies to cheer about. But in another change, the EM economies chalk up a significant issue in the ‘ugly' column here.
The Really Good
Economists identify investments in public goods like education and health as being instrumental in supporting economic development. To focus on these social indicators, we plotted simple cross-country averages of a health proxy (life expectancy) and an education proxy (years of schooling) in the EM and DM worlds. Although such measures are crude, and may focus more on quantity than on hard-to-gauge quality, the comparative trends are still suggestive. It is here that both the EM and DM worlds have made significant progress. However, as has been the pattern so far, EMs have outperformed here.
Starting from a point where DM health and education levels were nowhere in sight, by 2005 EM life expectancy was already at the level achieved by the DM world in 1970 and EM education had progressed even further to 1985 DM levels! Provided that the same quality as well as quantity outcomes can be assured as in the 1970s/1980s era DMs, then the EMs appear to have built a good platform in the areas of health and education to make convergence to DM levels going forwards a feasible goal.
One very deep set of fundamentals for development that is emphasised in research on institutional foundations concerns freedom, both economic and political. We show both the ‘democracy score' (from the Polity IV project) and a composite measure of economic freedom (covering areas such as corruption, instability, rule of law, etc.) from the Economic Freedom of the World database, and show that EM economies have converged strikingly towards the DM world since the 1980s.
As one would have guessed, the DM world was essentially politically free by 1980 (close to the maximum score of 10); but economic reforms in the 1980s increased economic freedom in the DM world to a substantially higher level as measured by this index. The EM world initially lagged far below the DM world on both counts. Then, first via an improvement in EM political freedoms and, later, through enhanced economic freedoms, EM economies began to catch up the DM economies.
By now, looking at these two types of freedom, the advantages of the DM world are no longer what they used to be. More than half of the ‘institutional gap' between EMs and DMs has been closed in the last 30 years. However, there is still a way to go before EM economies enjoy the same freedoms that DM citizens take for granted.
Surprisingly, the adverse impact of the EM growth surge on the environment also appears to have turned the corner. After a worrying rise in the adverse impact of growth on the environment, the early 1990s have seen the beginning of a much more benign outcome for CO2 emissions in low and middle-income economies. Again, EM economies have outperformed DMs since the beginning of the 1990s, even though they lag DMs in terms of the level.
A final hit to the EM-DM spread comes from the favourable dynamics that the EM world should continue to enjoy for a while more. This is especially the case when the economics of aging and the retirement of the baby-boomers and its effect on DM social security and debt are considered. We show the advantage that the DM economies clearly enjoyed in the post-war period through very favourable demographics (in particularly, an extremely low dependency ratio, which means that the workforce was a large segment of the population, and the very young and the aged a smaller proportion). Since the 1980s, EM economies got ‘younger' while DM economies began to age. At this moment, the dependency ratio has actually switched and now favours EM growth. It appears likely to stay that way for a very long time, giving EM economies a generous window of time to use this precious factor of production to its advantage.
The Not-So-Good
The story here is quite similar to that of the ‘not-so-good' aspects of our ‘narrow' analysis in the first part of this study. While EM economies have really narrowed the gap with respect to the DM economies, there is still quite a distance between the two in terms of the standard of living and its deep determinants.
However, this gap has a silver lining for EM economies. The fact that there is so much scope for improvement on various dimensions suggests that the EM economies can deliver strong growth over the medium term, if reforms and investment in key areas can be pushed forward.
The Ugly
The bad news here is from... the EM world! EM economic outperformance has not been good for inequality. And this has been in spite of expectations that the integration of the EM world's unskilled work force into the global economy would raise this cadre's relative wages, in line with standard trade theory. Rather, contrarian forces, such as outsourcing, labour matching or skill-biased technological change, may have limited and reversed any such equalising dynamic.
This is one crucial aspect of development and political economy, since an unequal distribution of income can create political tensions and fray the social contract. For example, inequality may also perpetuate low provision of key public goods like health and education in some cases, and lead to the exclusion of the less privileged from political voice. This is as true in DMs as in EMs, but it is interesting to note that while both groups of countries have faced a challenge on this dimension, it is one notable area where the EM economies have strongly and worryingly underperformed.
DM income inequality has remained virtually flat. In the EM world, however, steady levels of inequality in the 1980s gave way to a reversal and signs of rising inequality in the post-1990 period. This all came at a time when both the EM and DM world have tripled their per capita incomes over two-and-a-half decades.
Thus, if there is one area of concern in our summary evidence, it concerns the ability of rapidly growing EMs to share the fruits of economic growth across society. According to Simon Kuznets' conjecture, some of this increasing inequality may be an unavoidable by-product of rapid industrialisation and structural transformation, and thus unremarkable from an economic standpoint. But from a political standpoint, attention to distributional issues could be an essential part of a stable social contract which can support development in these countries going forward.
Summary
Our analysis here suggests that EM economies are primed to take over the next leg of global growth, driven by the need to generate a better standard of living, financed by stronger growth. On most metrics, the EM-DM divide has reduced dramatically. On our ‘narrow' definition of relatively higher frequency and bread-and-butter macroeconomic indicators, the EM world is firmly in the driver's seat. For most broader measures of development too, EM performance has been remarkable and remains promising. The biggest risks to the global economy at this moment are from the well-known macroeconomic risks from the DM world and less obvious risks to social and political structures from rising inequality in the EM world. The balance of risks certainly points heavily towards leading EM economies taking up their rightful place in the DM world before too long, with other hopefuls not too far behind. Are EMs the new DMs? Yes. The transformation is not yet complete but is coming along very nicely!
Appendix
List of EM countries and ISO codes: Taiwan (TWN), India (IND), Indonesia (IDN), Korea (KOR), Malaysia (MYS), China (CHN), Singapore (SGP), Hong Kong (HKG), Thailand (THA), Brazil (BRA), Mexico (MEX), Peru (PER), Colombia (COL), Argentina (ARG), Venezuela (VEN), Chile (CHL), Russia (RUS), Poland (POL), Czech Republic (CZE), Hungary (HUN), Romania (ROU), Ukraine (UKR), Turkey (TUR), Israel (ISR), SA (ZAF).
List of DM countries and ISO codes: United States of America (USA), Germany (DEU), France (FRA), Italy (ITA), Spain (ESP), Japan (JPN), United Kingdom (GBR), Canada (CAN), Sweden (SWE), Australia (AUS), New Zealand (NZL), Austria (AUT), Belgium (BEL), Denmark (DNK), Finland (FIN), Greece (GRC), Iceland (ISL), Ireland (IRL), Luxemburg (LUX), Netherlands (NLD), Norway (NOR), Portugal (PRT), Switzerland (CHE).
For the accompanying charts and tables, see Emerging Issues: Are EMs the New DMs? May 4, 2011.
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Policy Challenges for the EM-DM Convergence
May 06, 2011
By Manoj Pradhan | London & Alan Taylor | New York
Policy-makers have played an important role in the remarkable ongoing transition that is propelling EM economies closer to their DM counterparts. But generating and maintaining such rapid rates of growth brings its own challenges. In the early days of this process, EM economies were almost lucky to be viewed as high-risk economies, giving policy-makers some room for error. With EM economies now firm favourites to be the engine of global growth for the foreseeable future, that margin seems to have shrunk awfully quickly. EM policy-makers will now have to factor in not just the domestic and global economic conditions, but also global rebalancing and the structural shift of their economies from ‘emerging' to ‘developed'.
Are EMs the New DMs?
The challenges that policy-makers face as part of this transition depend on how far along the transition path EM economies are. Clearly most EMs do not enjoy the same standard of living that DMs do, but does the evidence suggest they have the potential to catch-up with the DMs? In a detailed accompanying note (Are EMs the New DMs?), we deal precisely with this issue.
Our short answer is "Yes, EMs are the new DMs...but the transformation is not yet complete."
The slightly longer answer is that the evidence we present suggests that EMs have sliced away a huge part of the gap between themselves and DM economies. Progress on socio-economic factors has allowed strong growth to become entrenched. Somewhat counter-intuitively, the fact that EMs still lag behind DMs in terms of the level of economic freedom, education and life expectancy also suggests scope for further improvement, and therefore for sustained growth.
The good, the bad, and the ugly of EM-DM convergence: A relatively ‘narrow' view (one based on standard macroeconomic metrics) shows that EM performance in the last two decades has far outstripped DM performance and the distance between the two has narrowed dramatically (PPP weights and contribution to growth). Indeed, arguably the major risk to the world economy on this measure comes now from the fragile condition of the DM economies.
On a ‘broader' perspective (based on socio-economic and political economy considerations), both EM and DM economies have plenty to cheer about even though the extent of EM improvement is remarkable even here. There is, however, one important caveat to the sustainability of EM growth. Inequality in the EM world has worsened even as it has continued to record strong growth after the EM crises of the 1980s and the late 1990s up to now.
Policy challenges: Against the backdrop of our key results, we draw out the following implications for EM policy-makers:
•§ EM central banks will likely remain more tolerant of moderate inflation and inflation volatility, but within limits.
•§ The export orientation of EM economies could be seen as a risk to growth. Policy-makers could favour a more domestic demand-oriented growth strategy and also look to diversify exports more.
•§ Real exchange rate appreciation is an important part of the internal and external rebalancing of EM economies - but policy-makers need to be careful not to allow inflation expectations and inflation to gradually drift higher. This could eat into the hard-won macro-stability gains of EM economies. Currency moves will likely serve as a buffer.
•§ Given rising inequality in the EM world, EM policy-makers will need to be careful to consider the redistributive impact of their policies.
Tolerance for inflation and inflation volatility: EM policy-makers have tamed inflation from extremely high levels, even as recently as a decade ago, to within sight of DM inflation levels. High levels of inflation usually reflect low credibility and poor macroeconomic policies. Lowering inflation from those levels through better policies therefore does not mean that growth suffers. Rather, growth can be boosted even as inflation falls. In other words, the ‘sacrifice ratio' at very high levels of inflation is quite low. At lower levels of inflation, when most of the obvious improvements have already been made, the ‘sacrifice ratio' is significantly more adverse. EM policy-makers now have to be willing to hurt growth meaningfully if they want to foster strongly anchored inflation expectations. In our opinion, this trade-off is not one that most EM policy-makers will choose.
On the growth front, we expect the gap between EM and DM economies, particularly in terms of socio-economic indicators, to propel EM growth at a rapid pace for the foreseeable future. It is unlikely that such rapid growth can be achieved without fluctuations and volatility, which implies that inflation is likely to be volatile too. Finally, until productivity growth subsides and per capita incomes in the EM world come close to their DM counterparts, real EM exchange rate appreciation (where we expect nominal exchange rates to contribute to a greater extent but not overwhelmingly) implies continued upside risk to EM inflation (see The Global Monetary Analyst: The Great Rebalancing, February 16, 2011).
Real exchange rate appreciation as part of global rebalancing and EM outperformance: Continued EM growth outperformance, sustained by EM outperformance on the ‘deeper' social and institutional parameters, would imply that the EM real exchange rate will also continue to appreciate. In an ideal world, the real exchange rate appreciation should be in line with the productivity differential between the EM and the DM world.
In the medium term, however, it is entirely possible that real exchange rate appreciation falls short of what is needed for global rebalancing, or exceeds it. The appreciation of the EM real exchange rate has been ongoing for the better part of a decade now, first through nominal exchange rate appreciation but more recently through EM inflation running higher than DM inflation. If EM inflation expectations and consequently inflation are allowed to ratchet up relative to DM inflation, it is possible for the EM real exchange to appreciate ‘excessively', and so damage the EM's precious macro-stability gains. Policy-makers will therefore have to take the lead in guiding EM real exchange rate appreciation as close as possible to a carefully calibrated ‘optimal' path, while finding the right mix of nominal exchange rate appreciation and EM inflation running higher than DM inflation.
Export orientation versus domestic demand growth: The export-oriented, outward-looking strategy of EM economies of the last few decades certainly helped to deliver rapid growth. The same export orientation, however, could prove to be a risk to EM growth. With a post-crisis shock to ‘permanent income' - and very likely also to trend growth - in DM economies, DM consumers are unlikely to produce the kind of demand for goods that rapid credit growth helped to generate before the financial crisis. EM policy-makers are keenly aware of the need to generate enough domestic demand to insulate their economies from external reliance. The risk, however, is that this internal rebalancing towards a domestic demand-oriented model comes later rather than sooner. The question is whether the rebalancing towards a more domestic demand-oriented growth strategy can be kick-started by policy-makers. This does not mean abandoning exports, however, as export infrastructure in the EM world could form the basis of a boom in intra-EM trade in gross terms, even as EM-DM trade wanes.
Dealing with rising inequality: The ‘ugly' side of EM growth has been the rising inequality even as EM economies have outperformed on virtually every other measure that we consider. This is a serious problem, given that political and economic freedoms in the EM world are still well shy of their DM counterparts. Rising public discontent has already shown its might in recent tensions in the Middle East, and EM policy-makers will have to work hard to keep inequalities from rising further. In the short term, they might need to mitigate adverse distributional trends due to adjustment/rebalancing policies. Monetary policy tightening, for example, can affect the credit-constrained households and firms the most. If these turn out to be lower-income households, then fiscal support for these households could act as a subsidy that reduces the distributional effect. However, there is also a risk that policy-makers go too far in the other direction and ‘over'-subsidise incomes, thereby reducing the incentives to generate labour income.
But EM-DM Convergence Also Has Plenty of Good News for EM Policy-Makers
For one, potential output growth, thanks to ongoing deep socio-economic development, will be a huge help. Given the uncertainty surrounding the estimates of potential output growth, it can be difficult to know whether rapid growth will turn inflationary. If the experience of the past is anything to go by, improvement in socio-economic indicators will boost productivity and potential output growth. This should reassure policy-makers that they can maintain reasonably strong growth without forcing runaway inflation.
A second source of structural relief on the inflation front could come from nominal exchange rate appreciation as part of external rebalancing. While nominal exchange rate appreciation is not expected to singularly bear the burden of nominal exchange rate appreciation, it has done very little on an EM-wide basis in the recent past. An improvement on that will alleviate some of the pressure on EM inflation to do more of the rebalancing.
Finally, the EM convergence towards the DM world should also mean that financial markets become deeper and cover a large part of the cash flows in EM economies. This will have profound implications for the economy and for policy-makers. For starters, more developed financial markets should mean better allocation of capital. Second, the information content of financial markets should provide policy-makers important clues about the economy's health. It should also make monetary policy more effective. Finally, it could provide EM reserves managers a reasonable alternative to investing their funds almost exclusively in DM financial markets.
Summary: The EM-DM convergence story has been nothing short of remarkable. On virtually every metric, narrow or broad, EM economies are hot on the heels of DM economies in their move to join the DM club. While the deeper parameters of development still show that EMs have some way to go before they can actually become members, this very gap can provide the impetus for future sustained growth. The transition to DM status is not going to be automatic, but EMs have shown quite convincingly that they can navigate the course very well. Are EMs the new DMs? Yes, but we believe that the transformation is not yet complete and policy-makers will play an important role in seeing it through.
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Why the UK May Not Be Such a ‘Safe Haven'
May 06, 2011
By Melanie Baker & Cath Sleeman | London
Fixed income markets have been behaving as if the UK is a relative safe haven. Indeed, since the General Election last May, 10y gilt yields have outperformed Bunds by 90bp and UK 5y CDS has outperformed Germany by 30bp as investors sought the safety of gilts from the turmoil in the European periphery.
There are several reasons why we think investors tend to attribute something of a ‘safe haven' status to the UK, including that the gilt market was ‘tested' in 2010 and came through in one piece. We outline some of these reasons below (Safe Haven Reasons #1 to #6). In each case, we then take a preliminary look at a few ways in which this ‘safe haven' status of the UK could come to be tarnished and explain why/where we think these arguments are vulnerable. Clearly there is a relative story here too, and any perceived safe haven status could suffer because the perception of other markets/ economies improves. However, for simplicity, we restrict our remarks in this note to looking at things from a purely UK angle.
Safe Haven Reason #1: The UK Can ‘Print or Inflate its Way Out of Trouble
The UK, with its own currency and central bank, always has the option of ‘printing money' (or, more practically, creating reserves). There are two circumstances where this option might be helpful:
•§ Liquidity crisis: If there were a serious risk of a ‘buyers' strike' in gilt markets, the BoE could step in and buy gilts.
•§ Solvency crisis: The government and BoE could decide openly (or more furtively) to try to raise inflation expectations (e.g., by raising the inflation target), wage growth and actual inflation, thereby raising nominal fiscal revenues and nominal GDP (the denominator for key fiscal sustainability measures) and eroding the UK's debt stock in real terms.
Why We Aren't So Convinced
On the surface, high inflation looks potentially helpful. It should boost nominal GDP and, by boosting tax revenues, it can also help to lower the primary deficit. However, there are (at least) two important reasons why we think the effect of higher inflation will not be as beneficial as some think and several circumstances where higher inflation could be positively harmful to any ‘safe haven' status:
•§ Inflation-linked debt: The UK has a high proportion of inflation-linked government debt.
•§ Many items of government expenditure are explicitly linked to inflation: Government spending would also rise since higher inflation would raise benefits/pensions payments via indexation (and assuming that the government doesn't ‘change the rules'). From 2011-12, the CPI measure of inflation will be used to up-rate benefits. Broadly grouping together the bits of expenditure that are directly inflation-linked (benefits, tax credits, the basic state pension, public service pensions and interest payments) amounts to some 32% of total government spending, on our calculation.
•§ Wages fail to keep pace with inflation: If wages fail to keep pace with consumer price inflation, that can worsen deficit projections further. Income taxes are the single largest chunk of UK tax revenues. In the absence of higher wage growth, income tax revenues would fall (as CPI inflation drove income tax brackets higher though indexation). Consumers would likely buy fewer goods, given the squeeze on real incomes (so there might not be any offset from higher VAT receipts). Lower real incomes and input price rises would also likely lead to downgrades of real GDP growth prospects. In the OBR's latest set of forecasts, it raised its CPI inflation forecasts significantly for the next two years but lowered slightly its wage growth forecasts. That resulted in a worsening of its deficit forecast. A cumulative ~1.7pp upward revision to its CPI forecast over 2011-12 and 2012-13 (similar for RPI) led to a £3.7 billion worsening in its forecast deficit by 2013-14.
•§ Favourable circumstances for a sharp deterioration in BoE credibility: Elevated inflation matched by a sharp pick-up in wage growth and inflation expectations would risk the MPC being seen to be keep monetary policy ‘too loose for too long' (prioritising the health of the real economy, financial stability or fiscal sustainability over its own inflation-targeting credibility).
Conditions are arguably currently favourable for a credibility loss in light of the MPC's recent record: 1) CPI inflation has been above the 2% target for 18 of the last 24 months and 1pp or more above the target for 15 of those months. 2) Drawing a simple trend line through CPI inflation starting in December 2003 would suggest that it is on an upward trend.
A sharp deterioration in credibility could lead to a fast rise in bond yields and sterling weakness - a loss of ‘safe haven status' irrespective of any positive benefit on deficit as a % of GDP from a period of high nominal GDP growth.
Safe Haven Reason #2: Sovereign Has A Very Long Average Maturity Debt
The average maturity of traded debt outstanding is higher for the UK government than for any other major economy. This provides a two-fold ‘safe haven advantage':
•§ Lower liquidity requirements: In any given quarter, the UK will have less maturing debt stock to refinance than it would otherwise.
•§ Makes it easier to ‘inflate your way out': If inflation expectations rise substantially, nominal bond yields should rise too. This could potentially worsen fiscal sustainability. However, if you have a long average maturity debt, this effect will be less (all else equal, you will be refinancing less).
Why We Aren't So Convinced
Looking beyond the direct liabilities of the sovereign, UK banks have very large refinancing needs over the next couple of years, not least as they roll off government support plans. This matters for the sovereign's ‘safe haven' status since two of the UK's largest banks are officially classified as being part of the public sector and since the banking sector is still very large relative to the size of the economy. Our Banks team calculated in a recent note that the top five UK banks have assets worth some 345% of GDP on an IFRS basis. Although this compares favourably to Switzerland, it compares to 198% for Spain for the same statistic, 325% for France and is similar to Ireland (at 360% for the top six).
In addition, the benefits in terms of refinancing requirements are clearly offset if a country is running a high deficit (as the UK is). The government expects gross gilt issuance of £167.5 billion in 2011-12 alone.
Safe Haven Reason #3: Gilt Market Is Highly Liquid with High Domestic Ownership
A higher percentage of domestic market ownership than many other economies and high levels of domestic participation reduce the chances of a mass exodus from the market in times of crisis. Given the size of the gilt market, there will be limits (at least in the short to medium term) as to how far investors can choose not to be invested in gilts.
Why We Aren't So Convinced
As seen with the euro periphery, the effective status of a government bond can easily change from riskless to something far from riskless. In late 2009, UK CDS (versus Germany) widened some 30bp in three months. Second, the level of domestic ownership in the UK is exaggerated by the large-scale asset purchases of the Bank of England (as part of quantitative easing). We assume that these will be sold down gradually starting from mid-to-late 2012. Third, focusing on flows, the UK is still highly dependent on overseas demand. Over the six months from September 2010 to February 2011, we calculate that the overseas sector has net purchased nearly £27 billion of gilts. This is £20 billion lower than the previous six-month period, with overseas accounts actually being net sellers of gilts in January when yields rose. This suggests that demand may wane if yields rose materially due to a change in perception of gilts' ‘safe haven' status.
Safe Haven Reason #4: Political Cohesion
The UK's political system arguably results in a relatively high ability for the governing party (or coalition in the current case) to ‘get things done'. The UK's structure of government is relatively centralised; the second house has limited powers (the House of Lords cannot block or amend finance bills for example); there is less of a separation between the executive and the legislature than in some other economies and the head of state (the Queen) has exceedingly limited powers; the UK system of governance tends to generate single-party majority governments; and fixed-term parliament legislation should enhance political stability.
Why We Aren't So Convinced
•§ The current system resulted in a coalition: We continue to assume in our forecasts that coalition relations remain such that there is no significant danger of the fiscal tightening programme being reversed. However, there are potential flashpoints ahead, including the prospect of further fallout from the AV referendum and a likely disappointing performance of the economy (our forecasts for GDP growth are below the OBR's).
•§ Fixed-term parliament legislation doesn't preclude an early election: Under the new legislation, for an early election motion to pass, it would need the support of two-thirds of the House of Commons (the coalition control only 55%). However, if a motion of no confidence is passed (where a two-thirds majority is not required), and no alternative government is found, an early election would result. The coalition could try to ‘engineer' a no-confidence vote, although this would be controversial.
Safe Haven Reason #5: The UK Has Committed to Significant Deficit Reduction
The UK deficit-reduction plan is ambitious in terms of both timing and scale. It is already well underway and there has been no significant back-tracking on planned tax rises or spending cuts.
Why We Aren't So Convinced
We would rather the government committed to a sharp deficit reduction than not, given the scale of the deficit. However, we think that the plans will be a significant drag on growth this year and next and will help leave the UK vulnerable to judgements that the economy cannot generate sufficient growth to meet its fiscal targets:
•§ We still think that OBR real GDP growth forecasts are too optimistic for the next couple of years... We remain at the low end of consensus on growth. We expect fiscal tightening in 2011-12 alone to subtract around 1pp from GDP growth over the next year or two; we continue to think that real consumer spending growth will be very weak as public sector jobs are lost, inflation remains relatively high and wage growth fails to keep pace. We expect the legacy of the financial crisis (a lack of business confidence in the continuing availability of bank credit) to help constrain investment growth. Our forecasts for real GDP growth are now 0.5pp below the OBR's for 2011 (1.2% versus 1.7%). As a very rough indication of what that might mean for the deficit (and issuance), the OBR's ready-reckoner would be consistent with this adding around £5 billion to the deficit . Our 2012 real GDP growth forecast is now 0.7pp below the OBR's, potentially implying an additional add of more than £5 billion to the deficit.
•§ ...but that is probably the case for the following few years too: In The Gilt Edge, April 6, 2011 (page 5), we already discussed how the financial crisis has likely helped to lower the UK's potential growth rate (e.g., the rebalancing of the economy implying transition costs/temporarily lower productivity). We plan to do more work in quantifying some of these effects in a later edition. Beyond 2013, the OBR assumes potential output growth of 2.1% a year and actual output growth averaging 2.9% between 2013 and 2015. Both assumptions look on the optimistic side to us.
•§ Much will also depend on the OBR's interpretation of the growth outlook: As discussed in detail in the previous edition, it matters whether the OBR judges any projected worsening in the deficit, as a result of a lower growth assumption/outcomes, as structural or cyclical. In the March Budget, the OBR judged that the government still had a greater than 50% probability of eliminating the structural deficit by 2015-16. Hence, the government was judged as still on track to meet its mandate and no further planned fiscal tightening was necessary. Weak incoming growth that led to an upward assessment of the structural deficit and a judgement that more deficit reduction action was needed to ‘plug the gap' could prove politically divisive and bring into question the mandate itself.
•§ The amount of UK government debt is arguably higher than it appears: There exists a broad range of liabilities that are debt, yet are not captured in national accounts. This is true for economies other than the UK and has been discussed in detail by Arnaud Marès (see Sovereign Subjects: Ask Not Whether Governments Will Default, but How, August 25, 2010). We plan to develop this theme in a future Gilt Edge, but it is worth noting that the UK may gain more attention than elsewhere when the OBR publishes its Fiscal Sustainability Report (July 13).
Safe Haven Reason #6: UK Banks Recapitalised Early
The UK authorities' response to financial crisis in the UK was relatively early and decisive. The UK banks are now relatively well capitalised in comparison to some of the major banks in the euro-zone. UK banks are also reducing their reliance on government funding (e.g., paying down the SLS ahead of schedule). Hence, there is currently less concern in the UK about an ‘adverse feedback loop' developing between perceptions of sovereign and bank vulnerability.
Why We Aren't So Convinced
Our central case is that no significant problems emerge that would adversely impact perceptions of the ‘safety' of gilts. However, the scale of bank assets relative to the economy is very large and channels of vulnerability for the UK banking sector and hence risks to the sovereign remain:
Weak pre-provision profit growth: Clearly, proposed changes in UK banking sector structure and capital ratios are partly designed to ultimately protect the sovereign from the banks. However, the transition to this new regime is likely to be costly. According to our UK Banks team, UK bank profits are likely to struggle for some time. Funding costs are likely to remain high as: i) reshaping of the sector progresses (the cost of proposed ‘ring-fencing' is uncertain, but the ICB lists reduced bank profitability as one of the outcomes); and ii) Banks may face stricter capital and liquidity requirements. Meanwhile, revenues are likely to remain challenging in a post-financial crisis environment of slow loan growth/deleveraging.
•§ ‘Peripheral Europe' exposure is large: Exposure to peripheral economies is large against the book value of the major UK banks. However, according to our UK Banks team, much of this is well provisioned for, and even assuming further sizeable falls in these assets does not raise serious concerns for UK bank balance sheets.
•§ Vulnerability to UK house price declines and rate rises: We still expect a 7% further correction in UK house prices. Our Banks team thinks that the UK banks are well placed to cope, so long as the ability of customers to service those mortgages does not substantially deteriorate. We expect the policy rate to rise by 150bp to 2% by end-2012. Assuming full pass-through, we calculate that 100bp of BoE rate rises would result in around a 10% increase in mortgage payments. A survey commissioned for a recent Retail team note suggested that only 6% of mortgage holders would expect a 10% increase in mortgage payments to place them in serious financial difficulties. But, in the case of a 40% increase in mortgage payments (requiring about 375bp of rate rises and likely accompanied by a much larger fall in house prices), more than half would.
•§ Large exposures to commercial property: In the Financial Stability Report, the BoE notes that for the major UK banks, commercial real estate makes up around a third of lending to companies worldwide.
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Why We Still Expect the MPC to Raise Rates in August
May 06, 2011
By Cath Sleeman & Melanie Baker | London
We expect the first rate rise in August: We continue to expect the MPC to make its first rate rise in August. While the consensus among economists is also for 3Q, markets appear to be expecting a slightly later start, with only 20bp expected by the December MPC meeting.
Our expectation for an August rate hike is driven by two factors. First, we expect to see further signs that inflation is becoming entrenched in expectations. Specifically, we anticipate a significant rise in wage growth and a further uptick in inflation expectations over the coming months. Second, although we anticipate weak growth (and weaker than the MPC's central forecast), we anticipate positive GDP growth in 2Q, released just ahead of the August rate meeting (0.3%Q).
A significant increase in wage growth and a further uptick in inflation expectations: The MPC's key upside risk is that persistently high inflation becomes entrenched in expectations, making it more difficult to return inflation to target. We expect regular pay growth (currently 2.2%Y, 3-month moving average) to rise over the coming months, increasing this concern for the MPC. We expect regular pay growth to reach 2.9%Y by year-end:
a) Persistently high inflation: RPI inflation plays a key role in many wage negotiations, and we expect the RPI measure to stay above 5%Y until November. Indications from settlement data suggest that rewards have picked up since the start of the year, due in part to inflation. According to data from the IDS, three-quarters of firms have awarded higher increases so far this year: the median award is 3%, compared to 1.3% by the same organisations in 2010.
b) Public sector wage growth unlikely to hit zero despite freeze: Not all public sector workers will face a pay freeze. Groups excluded from the freeze include those earning below £21,000 (28% of public sector workers), banks in the public sector, and those subject to existing multi-year pay deals (e.g., school teachers get 2.3% until September and police officers 2.6%).
c) Large rise in wage growth not necessary to make higher inflation appear ‘entrenched': Labour productivity growth is low, which lowers the level of wage growth consistent with meeting the inflation target. The MPC noted this in its most recent Minutes, observing that "the sustainable rate of wage growth consistent with meeting the inflation target depended upon the growth rate of labour productivity, which had also remained weak in the latest data".
d) High unemployment may not exert much downward pressure on wage growth: First, the number of long-term unemployed continues to rise. Those unemployed for longer periods exert less downward pressure on wages (they are less attractive to employers and are less likely to search for a job). Second, there appears to have been a small decline in the efficiency of the labour market, with increases in both the unemployment rate and the vacancy rate. One explanation is a temporary skill mismatch between the positions available and those seeking work. Alternatively, the downturn in the housing market may have restricted labour mobility.
Continued GDP growth: We expect the MPC's worst fears on growth to moderate. After the sharp fall in output over 4Q10, many members (voting to keep policy on hold) voiced concern that this fall may be a harbinger of sustained economic weakness. While we expect growth to disappoint the MPC, we anticipate positive GDP growth in 2Q (0.3%Q) and we expect surveys to indicate stable (or improving) momentum.
Risks skewed towards a later first rate rise: The risks to our call for a first rate rise in August are skewed towards a later move. In particular, we highlight two key risks.
Recovery in wage growth may come later: To date, wage growth has picked up more slowly than we had forecast and a normalisation in average earnings growth could be stalled by spare capacity in the labour market. A key indicator for assessing the severity of this risk will be wage settlement data. In its March release, the IDS noted that an early look at April suggested that wage growth may be picking up, with most of the deals recorded so far at 3% or higher.
Bumpy nature of the recovery may make the MPC hesitant about raising rates in August: Although we only expect 0.3%Q GDP growth in 2Q (released shortly before the August meeting), growth may be dampened further by the late timing of Easter and the additional Royal Wedding bank holiday.
A similar event occurred in 2002. The Queen's Golden Jubilee involved moving the late May bank holiday to June 3 and creating an additional holiday on June 4. The ONS adjusted its statistics for the first holiday (as the bank holiday is a regular seasonal event), but did not adjust for the additional holiday (as it was a ‘one-off'). In December 2002, the ONS estimated that quarterly GDP growth (calculated at the time to be 0.6%Q) would have been between 0.2-0.7pp higher absent the Jubilee. However, it also estimated that 3Q GDP growth would have been 0.4-0.7pp lower.
The effect on 2Q11 GDP growth could be smaller than for the Jubilee because the extra holiday occurred in the first month of the quarter (April) and so some of any decline in production will be made up within the quarter. However, the proximity of Easter and subsequent closeness of the two ‘four-day weekends' may have encouraged a greater number of people to take longer vacations than usual for this time of year, leading to a larger fall in production.
Low risk of a rise in May: In our view there is only a very low risk that the BoE raises rates tomorrow. Since the MPC's April decision, there has not been sufficient evidence, in our view, to suggest that the risk of inflation becoming entrenched has risen. On activity, the news since April has broadly been mixed. The MPC will have been disappointed by 1Q GDP growth (0.5%Q), at least relative to its February forecasts (although the April minutes suggested that the MPC had revised down its expectations). However, the MPC may downplay the figure as it noted in April that weakness in construction and energy (which dragged down growth) was "unlikely to be repeated". There has been positive news on trade, with a second large improvement in the trade deficit, but a further deterioration in consumer confidence, and indicators of retail spending have remained weak. Finally, consensus expects ‘no change' and we note that the MPC has become much less likely to surprise consensus in recent years (see page 7 of The Gilt Edge, April 6, 2011).
Our expectations for the May Inflation Report: We don't expect to see major changes to the inflation fan charts in the critical second half of the forecast horizon. Both the March and April Minutes implied there had been no major changes to the MPC's view on the balance of risks. To support our call for an August rate rise, however, we would ideally like to see its median projection for inflation higher, and above 2%, in two years' time, since the ‘market profile' on which the projections are based will likely show a first rate rise only in 4Q.
1. Inflation fan chart (based on market interest rate expectations; see Chart 1 in Exhibit 2 of our full report). This chart shows the MPC's projection for CPI inflation if the policy rate was moved in line with market interest rate expectations.
a) What did the chart show in February? The darkest band (which contains the mode - the most likely outcome) was below target in the second half of the forecast period (1.6% in 1Q13). But the risks were skewed to the upside, so the median was actually ~2%. From the Inflation Report: "Taking that skew into account, the Committee's best collective judgment is that the chances of inflation being either above or below the 2% inflation target in the medium term are broadly equal".
b) What is the chart likely to show in May? In the near term, we expect the fan chart to be shifted slightly higher. The April Minutes said that "Despite the fall in CPI inflation in March, recent developments in the prices of energy, imported commodities and other goods indicated that the most likely near-term path of inflation would be higher than the Committee had thought at the time of the February Inflation Report."
Over the second half of the forecast period, we may see a small upward shift in the darkest band because the market interest rate profile will likely be lower. For the February Inflation Report, the market interest rate profile looked similar to our own rate forecast, with two rate rises in 2011 and four in 2012 (see Chart 3). For May, we expect the market rate profile to show only one rate rise in 2011 (though still four rate rises in 2012). We don't expect the skew to have shifted, as both the March and April Minutes hinted that there have not been any significant changes in the balance of risks.
c) What would look consistent with an August rate rise? The darkest band in the fan chart moves closer to 2% in the second half of the forecast period.
2. Swathes chart (see Chart 2). This chart shows the probability of CPI inflation being above target if the policy rate was moved in line with market expectations.
a) What did the chart show in February? In February, the probability of inflation being above target was around 50% in two years' time. This suggested that the MPC's median forecast was close to 2% at that point. So, if the MPC turned out to be broadly right on the economy), then the market arguably ‘had it about right' on the outlook for interest rates.
b) What is the chart likely to show in May? Given our expectation that the ‘market profile' will contain one less hike this year, we would expect that the probability of inflation being above target will be judged fractionally higher than 50% in two years' time, implying that the median forecast was now above 2% at that horizon. However: 1) this may be hard to see visually in the chart; and 2) the Committee may judge there to be greater downside risk around its growth outlook than in February, given disappointing GDP and consumer-related data since February.
c) What would look consistent with an August rate rise? That at two years ahead and beyond, the ‘swathe' is above 50%. This would suggest that the ‘market rate profile' (with only one interest rate rise in 2011) does not have enough priced in for rates.
3. Inflation fan chart (based on constant interest rates and unchanged QE; see Chart 4) This chart shows the BoE's projection for CPI inflation if the bank rate was held constant and stock of QE kept unchanged.
a) What did the chart show in February? The darkest band in the fan chart (which contains the mode) was around the target in two years' time. Because the balance of risks was to the upside, the median and mean were both higher (at 2.4% and 2.5%, respectively). This implied that interest rates would need to rise if the BoE were to ‘hit' the inflation target in the medium term. However, these numbers are not available until a week after the Inflation Report is published.
b) What is the chart likely to show in May? We don't expect to see any major changes to this chart in the second half of the forecast horizon.
c) What would look consistent with an August rate rise? A ‘no change' in this chart could still be consistent with two rate increases by year-end. In February, market expectations (which contained two rate increases) looked broadly appropriate for offsetting the amount of inflationary pressure shown in this chart. However, to confirm whether or not there is ‘no change', we will probably need to wait another week for the numerical projections.
Uncertainty around the timing of the BoE's first move is likely to remain high over the next couple of months: The May Inflation Report and even the Minutes may not narrow the spread of views among consensus on whether or not the MPC will raise rates this year at all:
Small changes in view among individual MPC members have become increasingly important in recent months in analysing the likely path for rates: 1) over the last few monetary policy meetings, no less than four different monetary policy options have been preferred by different MPC members; and 2) it would take only two members changing their vote to trigger a rate rise.
However, because there is such a range of views, it is difficult to interpret how movements in the collective view (as represented in the Inflation Report) reflect changes in individual views. Further, in June, Andrew Sentance (who has been voting for a 50bp increase) will be replaced by Ben Broadbent on the committee. In addition, Weale or Dale (who have been voting for a 25bp rate rise) could change their vote if GDP growth, as we expect, continues to disappoint. Dale has said "If growth turns out to be materially weaker than I anticipate or other medium-term pressures on inflation ease unexpectedly, I will reverse my decision".
Making matters trickier, since the start of the year, interpreting activity indicators has become more difficult owing to several one-off factors (the VAT rise and poor weather). This difficulty may persist over the next few months with the much later timing of Easter and the additional April bank holiday.
For the accompanying charts, see The Gilt Edge, May 4, 2011.
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