The Deep Divide
June 03, 2011
By Spyros Andreopoulos | London
We have expressed worries in the past about the combination of super-expansionary DM monetary policies and US dollar quasi-pegs in EM creating upside risks to inflation (see The Global Monetary Analyst: The Inflation Merry-Go-Round, January 26, 2011). Here, we sketch out some thoughts about longer-term inflation risks.
Import price tailwinds... Developed economies have been benefiting from a positive cost shock that has lasted for an entire generation. Imported goods have been getting cheaper, in real terms, for about 30 years now. Broadly speaking, this can mainly be attributed to the benefits of globalisation. The increased integration of countries with an abundance of cheap labour into the global economy - China, India and others - has meant that developed economies have been able to obtain a large proportion of their manufactured goods consumption cheaply from abroad.
...may be turning into headwinds - courtesy of Global Rebalancing... This trend may be about to reverse because of Global Rebalancing (GR). GR ultimately means that goods from China (and other savings surplus EM economies) will have to become more expensive in real terms in the countries that now have a substantial trade deficit vis-à-vis these economies (that is, their price in importing economies' currency will have to rise faster than the general price level). This will occur through a combination of nominal exchange rate appreciation and cost increases in the exporting economies (more accurately: cost increases in the exporting economies that exceed the cost increases in the importing economies). Given the very high import penetration of Chinese goods in the G10 economies, a sustained rise in the cost of Chinese goods could generate meaningful imported inflation.
Note that China's role is likely much larger than the direct evidence suggests. The fact that other countries' exporters have to compete with China for market share means that they themselves have had to keep the prices of their exports down. Higher Chinese prices could thus lead to price increases in the imports from other economies, too.
To be sure, it is very difficult to tell when the trend will reverse. As the costs of imported goods from China rise, production of manufactured goods will move to cheaper places within China - the interior, where labour costs are substantially lower - and to other economies such as India, Vietnam and so on. However, anecdotal evidence suggests that these may be long-run solutions only. Small economies such as Vietnam may not be able to generate the scale of operations required, while the interior of China as well as India do not (yet?) have the infrastructure. In summary, finding cheaper producers will take time - while of course in the long term, GR will bring about a shrinking in China's market share and import penetration as Chinese goods become more expensive.
...while real commodity prices could continue their upward trend. We profess no strong conviction over the path of real commodity prices. Yet, continued strong growth in commodity-intensive EM economies in the medium term and scarcity of raw materials in the long term could well mean that the trend of rising real commodity prices, in place since the early noughties, could persist.
This would add to the imported price pressures. (Of course, higher commodity prices are themselves part of the reason why imports from EM are becoming more expensive - that is, the two sources of higher import prices interact.)
In short: advanced economies could face a double-whammy of adverse long-term cost shocks. What does this mean for overall inflation?
Imported inflation is neither necessary nor sufficient for overall inflation. The existence of imported inflation pressures is, however, not sufficient for overall inflation - as measured by broad price indices like the CPI - to emerge. Neither, in fact, is it necessary. Given imported inflation, what matters for the path of prices broadly is the evolution of domestic prices - what some central banks call Domestically Generated Inflation (DGI). Indeed, this is the component of prices that central banks have the most control over in the medium term. Overall inflation can be low even when import price inflation runs high if DGI is sufficiently subdued; conversely, overall inflation can be high even with low import price inflation if DGI is strong. Put differently, what happens to overall inflation depends on how much DGI the central bank allows.
The market question - "where will inflation be high and where less so?" - therefore boils down to which central bank will allow more DGI and which less. Note that this is a long-term question. If we are right in our assessment, higher import price inflation could prove a structural characteristic for many advanced economies - in the sense that the timeframe over which this phenomenon will likely play out is similar to the timeframe required for Global Imbalances to unwind (Global Rebalancing to take place): perhaps a decade or so. In turn, the question of which central bank will allow more inflation and which one less is essentially a question of central bank preferences - what weight they attach to the goals of growth/unemployment and of inflation.
We think that the Fed would likely allow higher inflation than the ECB in the long run... That is, the Great Policy Divide (see The Global Monetary Analyst: The Great Policy Divide, March 9, 2011) between the Fed and ECB manifests itself not just on the question of how to handle inflation at this (or any) particular stage of the cycle. As long as core inflation is within its comfort zone, the Fed is prepared to see through a headline inflation overshoot due to imported cost shocks. The ECB's focus on headline, rather than core, inflation implies that it would push DGI below 2% in response to imported inflation.
Yet the divide is deeper than this: in a democracy, even formally independent institutions like central banks ultimately reflect the preferences of their societies. In the case of the Fed and ECB, the preferences of the underlying societies differ meaningfully, we think. Some of these factors are ‘soft' but, in our view, no less relevant.
• The US is a debtor economy, as evidenced by decades of current account deficits and a highly levered household sector. Debtors are less averse to inflation. More fundamentally, ‘the American Dream' is predicated on growth - personal, for each citizen and, by extension, economic for the whole society.
• In the case of the ECB, of course, it may seem oversimplified to speak of ‘societal' preferences since the euro area consists of widely disparate societies. But for all practical purposes, we think that German preferences dominate: EMU would be unthinkable without Germany, Europe's largest economy; from an institutional perspective the ECB is modelled closely on the Bundesbank; and German preferences are shared to a greater or lesser extent by several other euro area countries - frequently called the ‘hard core' of Europe. What do these have in common? They are essentially societies of savers, as evidenced by years, sometimes decades, of current account surpluses (as well as low levels of private sector leverage). Savers value ‘stability' - i.e., low inflation. In addition, Germany's traumatic 1920s hyperinflation is very much part of the collective subconscious and is likely to have shaped attitudes towards inflation meaningfully.
...as has been the case in the past. Finally, as the proof of every pudding is in the eating, long-term inflation performance is telling, we think. Since 1970, headline CPI inflation in the US has been higher than Germany's 78% of the time on quarterly data (US headline CPI inflation has averaged 4.4% compared to Germany's 2.9%). Since 1990, it has been higher 74% of the time (with US headline CPI inflation averaging 2.6% against Germany's 2.0%) while it has been higher 68% of the time for the euro area as a whole (average euro area inflation was 2.3%).
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A More Pronounced Slowdown Lies Ahead
June 03, 2011
By Elga Bartsche, Daniele Antonucci, Olivier Bizimana, Anselm Karitter & Tomasz Pietrzak | London
Raising Our 2011 GDP Growth Forecasts Once Again
On the back of the stronger-than-expected growth outturn in 1Q11, we again revise up our full-year real GDP forecasts for the euro area. Instead of the 1.7% previously forecast, we now expect the euro area to expand by 2% this year. Alas, the good times are water under the bridge, and at this stage we see little reason to change our forecast profile for the quarters that lie ahead. In fact, the start to 2Q in the core countries was decidedly on the soft side, especially when it comes to consumer indicators out of Germany and France. Consequently, our 2012 estimate remains unchanged at 1.2% and continues to sit well below the market consensus of 1.7%. We had first lowered our 2012 forecast back in April and continue to be one of the most bearish houses on the street (see European Economics: Clouds Gathering at the Horizon, April 6, 2011).
Clouds Are Gathering over the Euro Area
We continue to think that some serious headwinds lie ahead for euro area growth in the remainder of this year. These headwinds consist of: 1) elevated commodity prices, which our commodity team expects to rise again; 2) a seriously overvalued euro, which our FX strategy team forecasts to appreciate further; 3) rising short rates on the back of an early start to the ECB's tightening campaign; and 4) ongoing tensions in euro area government bond markets, which are going to push up funding costs for banks and cost of capital for corporates. Taken together, these four factors are likely to shave about half a percentage point off quarterly GDP growth later this year. In addition, the political uncertainty about the end-game in the euro area periphery could cause households and companies to hold back on larger purchases and investments.
Passing a Turning Point in the Business Cycle
We see increasing evidence that the euro area business cycle has reached a turning-point. This verdict comes very clearly from our Surprise Gap Index, which plunged deep into negative territory in May. Our Surprise Gap Index is our long-standing favourite proprietary indicator to pick out the turning points in the euro area business cycle. Contrary to other indicators with a similar name, ours does not track whether the data flow has come in better or worse than market expectations. Because we believe that such data surprises would already be reflected in financial markets, our Surprise Gap Index measures whether manufacturing companies are positively or negatively surprised on how their business developed compared to their own projections three months ago. In our view, tracking these surprises helps us to understand what companies are likely to do next in terms of adjusting their production levels. When manufacturers are experiencing sizeable negative surprises, as they do now, they are more likely than not to cut back on their production volumes, we think. Going forward, we would expect forecasters to follow the lead from companies and abandon the idea that the euro area recovery could gain momentum into next year.
All Our Metrics Point to a Slowdown
All our proprietary indicators now point towards a moderation in euro area GDP growth in 2Q11. Both our bottom-up and top-down indicator predict a slowdown in 2Q growth to 0.6%Q from 0.8%Q in 1Q, slightly above our official forecast of 0.5%Q. For 3Q, our preliminary model estimates vary between 0.4%Q and 0.5%Q, indicating some upside risk to our forecast of 0.3%Q in 3Q. These estimates are likely to come down as the quarter progresses though, if our conjecture proves to be accurate that business sentiment is likely to correct further in the coming months.
Order Books Are Shrinking, Inventories Broadly Stable
Survey data indicate that companies are still seeing their inventory levels as very insufficient. But with the assessment on inventories hovering sideways, if not deteriorating at the margin, we don't expect the inventory cycle to be a driver of the euro area business cycle, especially not after order demand started to ease in May. While the gap between producers' assessment of demand and assessment of inventory levels remains unusually wide in this recovery, it looks increasingly unlikely that order demand will converge towards the more upbeat assessment of inventories.
Output Plans and Current Production Being Scaled Back
Producers' output plans for the next three months have declined meaningfully over the last two months. This was mainly driven by a weakening in France and Spain, but also by some first visible declines in Germany, but still remaining above their long-term average in Germany and the Netherlands. They have declined below the long-term average consistent with trend growth in Spain, Belgium and Italy though. In France, a sharp decline has brought output expectations back to its long-term average recently. Companies' assessment of current production - a key indicator going into our manufacturing indicator and our survey-based GDP indicator - already peaked in February.
Intra-Euro Area Growth Discrepancies to Remain Wide
In our view, the coming slowdown will be particularly marked in the industrial powerhouses such as Germany, Austria or Finland. This is because they experienced a sharper bounce-back in activity after the deep recession, which hit them harder than others. The speed of this jump-start in activity in the early phase of the recovery is unlikely to be sustainable, we think. Hence, these countries will experience a marked slowdown, even if the growth rate still stays above the euro area average due to the sounder fundamentals there. At the same time, we think that most of the periphery will remain in a severe situation over the forecast horizon, notably Portugal and Greece. We would highlight though that even in these countries the economic environment should likely improve in 2012, provided that no major additional austerity measures become necessary. In terms of the overall euro area growth picture, we should not lose sight of the fact that the three smallest peripheral countries in focus at the moment - Greece, Portugal and Ireland - together account for around 5% of euro area GDP.
HICP Inflation to Stay above 2% in 2011
Euroland HICP inflation surged in the first four months of 2011, reaching 2.8%Y in April and easing slightly to 2.7%Y in May. This acceleration in headline inflation is primarily due to the strong rise in energy costs and food prices. On balance, however, the peak in inflation might already be behind us. Looking ahead, we project inflation to fall further but to stay above 2%Y in the remainder of the year. However, thanks to base effects, the annual pace of headline consumer price inflation should ease progressively. Yet, the risks to our headline forecasts are probably skewed to the upside as our commodity team believes that oil prices should rise again going forward (see Crude Oil: Big Draws to Push Prices Higher, May 24, 2011). In order to be comparable with the forecast being produced by central banks, our own forecasts are based on oil futures. Core inflation, by contrast, is projected to rise in the months ahead as a result of the normal pass-through process. Overall, core inflation pressures are likely to remain moderate though, given the slack that still exists in the euro area economy, where unemployment remains elevated and capacity utilisation subdued.
ECB to Hike Gradually Up to 2%, then Pause for a While
We continue to see the ECB hiking two more times in the remainder of this year (in July and in October), bringing the refi rate to 1.75% by year-end. After that, we expect one more rate hike in early 2012, followed by an extended holding operation. In our view, it might not be before 2013 that the ECB will resume its tightening campaign. The reason for putting the tightening on hold in early 2012 is a combination of subdued growth (at 1.2%, around potential but below the historical trend) and inflation easing back below the price stability threshold. Over recent weeks, the money markets have repriced the path for future ECB policy rates considerably, taking out more than 60bp of tightening in 2012. As a result, money market expectations are now close to our own forecasts. If anything, however, the upward revision to our 2011 growth and inflation estimates would suggest that the risks are starting to tilt towards additional tightening by the ECB over and above our forecast.
Liquidity Likely to Stay Unlimited for Now
The upcoming June ECB Governing Council meeting will see the release of a fresh set of staff projections. These should show a marked upward revision of the 2011 growth and inflation estimates and, possibly, also of the 2012 inflation forecasts. We would expect these upward revisions to provide the backdrop for pre-announcing a rate hike in July by altering its posture beyond "monitoring very closely" to one of "strong vigilance". In addition to a new set of staff projections and hints at a move in July, the ECB will need to announce the terms of its tender operations during 3Q. Against a backdrop of marked tensions in the peripheral government bond markets and of some banking systems still heavily relying on the ECB's liquidity provisions, we expect the ECB Governing Council to reluctantly extend the fixed-rate, full-allotment procedure for another three months on June 9. As far as the ECB's SMP is concerned, we regard this programme as effectively being closed to new purchases of peripheral government bonds.
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