In Search of the Natural Rate of Interest (Part I)
Feb 14, 2006
Joachim Fels (London) and Manoj Pradhan (London)
Introduction and summary
What stance on US monetary policy has Ben Bernanke, the new Chairman of the Federal Reserve, inherited from his predecessor? This is an important question for the Chairman and his fellow policy-makers, as well as for financial market participants. We know that the Fed funds rate stands at 4.5% since Alan Greenspan’s valedictory FOMC meeting on January 31, 2006. However, we do not know whether the 4.5% level represents an expansionary, a restrictive, or a neutral policy stance. To answer this question, we need a benchmark against which we can judge the policy stance. One such benchmark is the ‘natural’ rate of interest, which is sometimes called the ‘neutral’ or ‘equilibrium’ interest rate. Put simply, the natural rate is the level of the real Fed funds rate that keeps actual output at potential output, and inflation stable in the medium term. The problem is that the natural rate cannot be observed; it has to be estimated. Moreover, it is likely to vary over time. In this note, we present our estimate of the natural rate, based on a simple model of the economy and a less simple statistical filtering technique called the Kalman filter. To be clear, our goal is to develop a benchmark against which the stance of monetary policy can be judged, not to make a call on the Fed — our US economists are much better at this. Judged against our estimate of the natural rate, which should currently be around 2 1/4% in inflation-adjusted terms, Ben Bernanke inherits a monetary policy stance that is already slightly restrictive. Thus, if our estimate is anything to go by, and if the Fed pushes rates further into restrictive territory in the coming months, both the economy and inflation should slow over the medium term. Wicksell’s widget Swedish economist Knut Wicksell first introduced the concept of the natural rate in 1898, and it has enjoyed a renaissance in economic mainstream thinking in recent years. He defined the natural rate as follows: “There is a certain rate of interest on loans, which is neutral in respect to commodity prices, and tends neither to raise nor to lower them.” To clarify, a glance at the original 1898 German language version of Wicksell’s book shows that “commodity prices” stands for the price of goods or the general price level. Wicksell saw deviations of the ‘money’ rate of interest rate, which is set by the central bank, from the natural rate, as the main cause of business cycles and fluctuations in the price level. An interest rate below the natural rate — a negative real rate gap — would lead to an acceleration in bank credit, because the return that could be earned in the real economy — the natural rate — would exceed the cost of credit. Hence, the economy would expand and prices would rise. Conversely, an interest rate in excess of the natural rate — a positive real rate gap — would lead to a contraction of bank credit, a slowing economy and falling prices. Thus to keep the economy on an even keel, the central bank would have to keep the interest rate at or at least close to the natural rate. Importantly, Wicksell’s natural rate is not a constant, but varies over time, reflecting fluctuations in the productivity of capital in response to changes in technology, or shifts in private households’ consumption and savings decisions. Thus, a central bank that uses an estimate of the natural rate as a benchmark for its monetary policy actions will have to take into account that the natural rate can be a moving target. Taylor’s trick The natural rate of interest is also an important component of the popular Taylor rule, introduced by Stanford economist John Taylor almost a century after Wicksell’s original analysis. The Taylor rule can be seen as both a description of a central bank’s actual rate-setting behaviour and a prescription or guideline for policy makers. It postulates that the central bank does (or should) set its policy rate in response to the deviations of actual from potential output (the output gap), and the deviations of actual inflation from its target (the inflation gap). In Taylor’s simple version of his rule, which was meant to describe the Fed’s policy actions, he assigned an equal weight to the output gap and the inflation gap. According to the Taylor rule, if the output gap is zero and inflation is on target, the policy rate should equal the ‘equilibrium’ rate. Of course, this equilibrium rate is nothing else but the natural rate — the rate that keeps output at potential and inflation stable. In his simple example, Taylor assumed that the natural rate was a constant, equal to the long-run average of the actual real interest rate. Even now, most versions of the Taylor rule treat the natural rate as a constant. However, both Wicksell’s analysis and basic economic reasoning would suggest that the natural rate varies over time and should be treated as such in any kind of Taylor rule analysis. The problem: the natural rate is unobservable While the general concept of a natural rate is intuitive, the practical problem that central bankers, economists and financial market participants face is that the natural rate cannot be observed — is it neither released by a statistical office, nor can it be looked up on Bloomberg. It has to be estimated, which is what we do in this note. An additional complication is that the natural rate is defined with reference to yet another unobservable variable: potential output, which is needed to calculate the output gap. A simple way to estimate both the natural rate and potential output is to use long-term averages (as Taylor did for the natural rate) or smooth trends of actual interest rates and actual output. However, the results from this are imprecise and ignore economic theory, which would normally guide us in making a more educated guess about both unobservable variables. In fact, the natural rate and potential output growth should be related in some form as both are influenced by a common factor — productivity growth, which in turn is driven by technological change. Therefore, we employ a small and fairly rudimentary model of how the economy works that allows us to estimate the natural rate and potential output jointly, and which takes into account that the two unobservable variables are driven by a common factor, such as productivity. Our basic model of the natural rate This section provides a brief verbal description of the model we employ to estimate the natural rate. Those readers who are interested in a more detailed formal description should refer to the Appendix of our full report and those who are interested only in the results of the estimation will find it on tomorrow’s version of this Forum. Our model consists of (i) a Phillips curve equation that describes the interaction between inflation and the output gap and (ii) an equation describing the relationship between the output gap and the real interest rate gap. The output gap is defined as the deviation of actual output from potential output. The real interest rate gap is the difference between the actual real interest rate and the natural rate. Thus, the output gap and the real interest rate gap each have a component that is unobservable: potential output and the natural rate, respectively. In the first equation, inflation responds to changes in the output gap in the previous quarter, and to past inflation. We would expect inflation to rise when the output gap is positive and to fall when the output gap is negative. This is the classic Phillips curve relationship. Once estimated, our system in fact confirms the expected relationship. Note that, while this is a highly simplified model of the inflation process, it is consistent with the conventional wisdom that the output gap is the main driver of the cyclical ups and down in inflation. Now that we have established that inflation is driven by the output gap in our model, we need to determine what drives the output gap itself. Our second equation models the output gap as a function of composite cyclical factors and the real interest rate gap. The real interest rate gap itself reflects the stance of monetary policy — a positive gap suggesting a restrictive stance, since the real interest rate is above the natural rate. If the real interest rate exceeds its natural level, the interest rate exceeds the inherent return on investment in the economy and causes a decline in spending, just as in Wicksell’s original model. Our estimation results indeed confirm this negative relationship between the interest rate gap and the output gap. An increase in the real interest rate will put downward pressure on the output gap, which in turn will push inflation lower, each step proceeding after a one-period lag. This is in line with the empirical observation that monetary policy affects output faster than it does inflation. Note, however, that changes in the real interest rate gap are not only determined by monetary policy actions, but can also occur due to fluctuations in the natural rate. As the natural rate only changes glacially, though, it is still approximately right to say that the real rate gap is determined by monetary policy actions, at the least in the short run. As we want to allow both the natural rate and the growth rate of potential output to vary over time, their behaviour also needs to be explicitly modelled. Thus, we need to specify two more equations in our model. In order to bring economic meaning to these equations, they should be guided by economic theory. We use two broad economic postulates. First, economic factors such as physical capital, productivity and human capital affect not just how quickly potential output grows, but also the rate of return that these factors earn. Second, the behaviour of the time-varying natural rate of interest we estimate should be consistent with long-run conditions put forth by benchmark growth models. In keeping with the first assumption, the equations for potential output, as well as the natural rate of return, have a common factor that affects them both. According to the second assumption, the behaviour of the natural rate of interest is based on long-run conditions from growth models. Readers interested in more detail on the model and the estimation technique should refer to the Appendix of our full report (available on Morgan Stanley’s Client Link or from the authors upon request). Our simple model requires only three data series for the estimation: real GDP as a measure for real output; the core personal consumer expenditures (PCE) deflator as a measure of inflation; and the Federal funds rate target as the nominal short-term interest rate. The real Fed fund rate is thus defined as the nominal Fed fund rate minus the year-on-year increase in the core PCE deflator (which is the Fed’s preferred inflation measure). Both the output gap and the natural rate are then estimated within the model, using the assumptions described above and a statistical technique called the Kalman filter, which is also described in more detail in the Appendix of the full report. We estimate the model using quarterly data for the three series from 1962 through 2005. Tune in again tomorrow for the results of our estimation
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Modest Improvement in Current Year Financing Pressures
Feb 14, 2006
Ted Wieseman (New York)
Note: The following is an excerpt from Government Funding Watch: Moderation Amid Diverging Trends, February 10, 2006, by Vincenzo Guzzo, David Miles, Takehiro Sato, and Ted Wieseman. Please see the full report for associated tables and graphs. Modest recent improvement in the financing outlook. Since the November edition of the Government Funding Watch, the FY2006 (September) funding needs of the US federal government have improved modestly. Continued significant strength in tax revenues after the biggest gain in 24 years in FY2005 — driven by both a continuation of the two-year surge in corporate receipts and, increasingly, accelerating growth in individual withheld taxes as job and income gains have picked up — has led us to reduce our FY2006 budget deficit estimate from $410 billion to $375 billion. On the other hand, the record-smashing flood of non-marketable debt issuance in 2005 that sharply depressed funding needs well beyond the already significant improvement in the budget gap (to $318 billion from $413 billion in FY2004) seems to have finally come to an end. The Treasury Department predicts a net pay-down of non-marketable debt in 1Q for the first time in six quarters, and no rebound in future quarters seems likely according to our municipal debt desk, so we have reduced our estimates for nonmarket sources of financing. Combining our lower budget deficit forecast with our lower non-marketable assumptions, we estimate that Treasury’s net marketable borrowing need in the current fiscal year will total $354 billion, still up sharply from the $216 billion borrowed in the market in FY2005, but down a bit from the $370 billion we estimated in November. Treasury has already begun to fill this financing gap with increases in shorter-dated coupon sizes, the revival of the long bond, and a swing back to significant net bill issuance after the surprising — and unplanned — pay-down in 2005. We expect that a continued gradual move higher in coupon sizes as well as sizable net bill issuance (with still, of course, the normal seasonal gyrations, including the typical 2Q bill pay-down) will continue through the course of the fiscal year. Budget outlook for 2006 improving. The budget deficit narrowed sharply in FY2005 to $318 billion (2.6% of GDP) from $413 billion (3.6%) in FY2004, as a nearly 15% surge in tax revenues — the largest since 1981 — significantly outpaced elevated spending growth of 8%. The President requested, and Congress passed, very tight limits on non-defense discretionary budget authority in both the FY2005 and FY2006 budgets — roughly 2% increases in each year, a decline in real terms. However, the carryover of budget authorizations from the free-spending early years of the Bush Administration, additional emergency discretionary spending for hurricanes in 2004 (much larger outlays for the more damaging 2005 hurricane season loom in FY2006) and other disaster recovery efforts, and high, but slowing, defense outlay growth kept overall spending growth elevated in 2005. Total discretionary spending surged 8.1% in FY2005, even as growth in defense outlays slowed to +8.7% from annualized increases of 14% in the first three years following 9/11. Offsetting the defense slowdown was an acceleration in nondefense discretionary spending to +7.5%, bringing the annualized growth in nondefense discretionary outlays in the first five years of the Bush Administration to +7.8%, nearly double the +4.1% annualized growth during the eight years of the Clinton Administration, when the partisan gridlock between the White House and Congress helped keep spending well under control. Many Republicans were displeased with this level of spending, and the Administration responded with very restrained budget requests for 2005 and 2006 — and again in the just-released 2007 budget — which Congress stuck to quite closely in the final budgets that were passed. Along with an ongoing topping-out in defense spending, it had initially appeared that a notable slowing in discretionary spending was finally on tap for 2006. But the response to the devastation from Hurricane Katrina and other storms will put that off for another year. The Congressional Budget Office (CBO) estimates that hurricane recovery spending, including both direct rebuilding and heavy outlays by the federal flood insurance program, will cost nearly $50 billion in FY2006. In addition, the beginning of the Medicare prescription drug plan in January is estimated by the CBO to cost about $30 billion net in FY2006, boosting mandatory outlays notably. As a result of these two big boosts, we look for a second straight year of spending growth near 8%. On the positive side, we expect limited growth in defense outlays this year. In the first quarter of the current fiscal year, defense spending (adjusted for an accounting shift involving Medicare eligible retirees) was up only 1% year on year, and troop deployments continue to fall, with both the total number of troops in Iraq and the number of national guard troops and reservists on active duty down about 15% since the beginning of the fiscal year in October. Excluding the emergency Katrina-related spending, growth in underlying non-defense discretionary spending should slow sharply this year as the near-freezes in budget authority passed for FY2005 and FY2006 start to take hold. While the boost from Katrina and Medicare spending is likely to make for another year of sharply elevated spending growth in FY2006, revenues have continued to surprise on the upside, leading us to cut our budget deficit estimate. Our initial forecast for the FY2006 budget deficit was $410 billion. We trimmed this to $400 billion following stronger-than-expected revenue growth in 4Q. And having tallied up the results for January, which showed another month of very strong tax revenue growth led by individual withheld income and payroll taxes as job and wage gains have accelerated, we have reduced this further to $375 billion. We now project a 6.4% gain in overall revenues in FY2006, the leading component of which we estimate to be a 6.6% gain in individual withheld income and payroll taxes. This would be the largest rise for this category since FY2000 and would offset some flattening out in corporate and individual non-withheld receipts after the near-record surges these two categories saw in 2005. We expect renewed improvement in FY2007. Our preliminary estimate for the FY2007 deficit is $325 billion, which at 2.3% of GDP would be the smallest on this basis since 2002 and right in line with the average over the past 40 years. We forecast a 4.2% gain in spending, which would be the lowest of the Bush Administration and compares with estimated average annual gains of near 7% over its first six years; and we project a 7.0% gain in revenues. On the spending side, CBO estimates that hurricane recovery-related spending will be cut in half from around $50 billion to near $25 billion. The incremental increase in spending on the Medicare drug program will be a bit smaller — $53 billion in FY2007 versus $30 billion in FY2006, according to CBO projections. So the net of these two special factors, which are expected to be responsible for much of the spending growth in 2006, should be about zero growth in 2007. Non-emergency non-defense discretionary spending should show little growth in 2007. There was no growth in real budget authority passed in the FY2005 and FY2006 and something similarly tight is expected in FY2007 if Congress sticks more or less to the White House’s proposals, as it did in the prior two years. We expect defense spending to continue flattening out, though at a high level, more than 70% above than the pre-9/11 spending level of FY2000. On the revenue side, job and income growth are accelerating, a trend we expect to continue to gather steam, leading us to project strong gains in total personal income and the wage and salary component in FY2007 (see Betting on Sustainable Growth, February 6, by Richard Berner and David Greenlaw for details of our economic outlook). We forecast total personal income growth of 7.5% in FY2007, and growth in wages and salaries of 6.7%, which we expect to translate into 8.5% growth in individual income tax collections (building in the typical real bracket creep) and 6.7% growth in social insurance taxes. Budget looking better, but other means of financing looking worse. The sharp narrowing in the budget deficit in FY2005 was only one contributor to Treasury’s sharply reduced marketable borrowing needs. Nearly as important was a record-smashing flood of non-market means of financing, both issuance of non-marketable debt — primarily State and Local Government Series (SLGS) securities issued directly to municipalities engaged in pre-refunding transactions — and a sharp rise in cash from “other means of financing”, which includes changes in student loans balances, balances with the IMF and other government-guaranteed loans. Combined sources of non-market financing spiked to a record $102 billion in FY2005, meaning that, even with a budget deficit of $318 billion, the Treasury only had to borrow $216 billion in the market — nearly the same as in FY2002 when the deficit was less than half as big, at $158 billion. The largest contributor to this surge in non-market financing was record issuance of SLGS, as municipal governments rushed en masse to pre-refund outstanding debt at the ‘conundrum’-like interest rates prevailing through the year. Total net SLGS issuance came to a record $67 billion in FY2005, including a run of three straight record-breaking months from March to May. Through the first quarter of FY2006, SLGS issuance remained relatively strong, totalling about $10 billion from October to December, and we were starting to wonder if this gravy train would ever stop. Suddenly, in January, it did, as there was a net pay-down of SLGS for the first time in 14 months. And in the details of its 1Q borrowing projections made ahead of the February refunding announcement, the Treasury indicated that it expected this to continue, estimating an $8 billion pay-down of non-marketable debt in 1Q. Our municipal debt desk agrees, expecting municipal refunding activity to plummet to around $85-95 billion in 2006 from $155 billion in 2005 and $110 billion in 2004. As a result, we expect overall non-marketable debt issuance in FY2006 to be near zero. Combined with some flattening out in “other means of financing” after an unusual spike last year, we project overall non-market sources of financing in FY2006 will plunge to +$20 billion from +$102 billion in FY2005. As a result, we estimate that the $57 billion increase in the deficit we project in FY2006 will require $138 billion in additional marketable borrowing — $354 billion vs. $216 billion last year. Filling the financing gap. Based on our budget deficit and non-marketable financing forecasts, we estimate that, as of the beginning of FY2006, the Treasury had a $186 billion financing gap at then-current coupon sizes (the financing gap being the amount of additional money that needed to be raised through a combination of larger coupon sizes or new issues and net bill issuance). The combination of the reintroduction of the bond — which we now estimate will total $24 billion this year, with a $10 billion reopening in August of the $14 billion new issue auctioned in February — along with recent increases in the sizes of the 2-year (to $22 billion in January from $20 billion) and 3-year (to $21 billion in February from $18 billion) filled about one-third of this. At current coupon sizes, we estimate a remaining financing gap in the current fiscal year of $125 billion. We expect that this will mostly be filled by net bill issuance, but we also look for a continued gradual move higher in coupon sizes. By the end of the fiscal year, we predict that the 2-year will have been raised to $24 billion, the 3-year to $23 billion, the 5-year to $16 billion (from the current $13 billion), and the 10-year to $15 billion new issue and $10 billion reopening (from the current $13 billion/$8 billion). These adjustments and an estimated $100 billion in net bill issuance for the fiscal year would, we estimate, fill the remaining financing gap this year. Note that, while the $100 billion in net bill issuance we estimate may seem large, it should be viewed in the context of the net pay-down of nearly $50 billion that occurred in FY2005. This pay-down was almost certainly neither planned nor welcomed by the Treasury. Instead it was a forced response to the much stronger-than-expected revenue inflows during the 2005 tax season, the extremely strong growth of corporate taxes in September 2005, and the flood of SLGS issuance through the year. The unexpected pay-down last year caused some severe dislocations in the bill market at times and resulted in a sharp decline in the share of the outstanding marketable debt made up of bills (to approximately 19% from 22% by our calculations) to a level that we believe is below where the Treasury would like it to be. So we think this year’s significant expected net bill issuance should be viewed as partly a catch-up and reversal of what happened in FY2005. By our calculations, current issuance patterns should easily be able to deal with any reasonably likely outcome for the budget deficit this year with relatively minor adjustments to coupon sizes and bills, so we see no need for any near-term adjustments to the current auction structure. And this should remain the case for the next couple years. Looking a bit further down the road, however, recall that 5-year issuance returned to a monthly schedule in FY2004, so the amount of maturing debt will rise sharply in FY2009, potentially forcing some more significant adjustments by the Treasury, if the budget deficit remains near current levels. Return of the bond. The 30-year bond made a triumphant return at the February 9 auction, the first bond auction since August 2001. The security, already expensive-looking when issued and trading about 12 basis points rich to the prior long bond (February 2031 maturity) just ahead of the auction, still managed to surpass expectations thanks to extraordinarily high demand from final investors relative to prior norms. The $14 billion new issue was awarded at 4.53%, 4 basis points stronger than pre-auction levels, which left it, at least in the initial post-auction shake-out, inverted to every other benchmark coupon — the 2-year, 3-year, 5-year, and 10-year — and even to the Fed funds target. Any doubts about whether there was really enough underlying demand for duration by investors to absorb such a large issue at such an expensive level were assuaged by the extraordinarily strong demand from final investors at the auction relative to prior norms. The detailed bidding statistics provided by the Treasury showed that primary dealers were apparently scared off by the richness of the security, bidding a measly $16 billion for the $14 billion issue. In contrast ‘indirect bidders’, a category that includes bids placed by primary dealers on behalf of customers and the New York Fed on behalf of central banks (note, though, that at least historically, central banks have not been meaningful participants in long-end auctions in contrast to their predominance at short maturities) bid a huge $11 billion — 80% more than they bid for the $13 billion 10-year auction a day before. Of the competitively awarded amount, indirect bidders received 65.4%, a share that has only been exceeded once at any coupon auction in the three years these data have been published. Primary dealers received 34%, which compares with an average of 68% at the new issue 30-year auctions from 1998 through 2001. Depending on how this apparently sizable demand for duration affects the market in the months ahead, it could influence the Treasury’s financing decisions in 2007. At the February refunding announcement, Treasury officials affirmed that there would be no changes to the previously announced 30-year schedule in 2006 — a new issue in February followed by a reopening in August. But the debt managers said they were sensitive to potential issues in the STRIPS market if they stuck to this schedule going forward and indicated they would make an announcement at the August refunding on what, if anything, they plan to do in 2007 to rotate in a May/November schedule. To do so, they could rotate next year to a May new issue/November reopening pattern. They could stick to the February/August auction schedule, but make the February issue a 30 1/4-year with a May 2037 maturity. Or they could issue two new bonds per year starting in 2007, with new issues in February and August and reopenings in May and November. In our view, the second of these options is the most likely. But the very strong reception this initial revived 30-year bond received could affect the decision. The Treasury has always been very clear that it does not try to “time the market” in making financing decisions. But the debt managers operate under a mandate to seek the lowest-cost funding of the debt over time, balanced against a desire to maintain flexibility and contain rollover risk. If the initially strong demand for the new 30-year were to intensify in the months ahead, and it appeared that the sort of structural curve inversion seen in the UK were occurring here, the debt managers might consider making a shift to relatively greater long bond issuance in 2007 when they announce their plans in August.
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Growth Matters
Feb 14, 2006
Vincenzo Guzzo (London)
Note: The following is an excerpt from Government Funding Watch: Moderation Amid Diverging Trends, February 10, by Vincenzo Guzzo, David Miles, Takehiro Sato, and Ted Wieseman. Please see the full report for associated tables and graphs. Another downward revision. On the back of a second consecutive downward revision, we now see euro area government funding falling in 2006, in both gross and net terms in the context of broadly stable redemptions. On our estimates, total gross issuance of government bonds for the four largest markets in the euro area — Italy, Germany, France and Spain — should ease to €474 billion this year from €493 billion in 2005. This amount is well below the €520 billion peak recorded in 2003-4 and is the lowest in four years. It is also substantially lower than the €508 billion we forecast in our previous quarterly assessment in November (see V. Guzzo, D. Miles, T. Sato and T. Wieseman, Government Funding Watch, The Fiscal Divide Widens, November 15, 2005). Four factors support light gross issuance in 2006. First, we expect stronger growth in 2006. Second, while we do see fiscal policy turning expansionary for the first time in four years, the size of the stimulus is likely to be marginal. Third, redemptions should be a bit lower than we previously expected. Finally, the share of bond funding on overall borrowing requirement keeps edging down, as some issuers rely on a growing share of non-market instrument and other means to finance their deficits. Each of these elements should play an important role in driving government bond supply lower than the peaks of the past few years, extending a trend already apparent towards the end of last year. We estimate that stronger growth explains at least 40% of the downward revision to 2006 government funding, the other three factors each contributing around 20%. The first key takeaway — growth matters. It is a consensus view among economists and financial market participants that Europe ran into a fiscal relapse in the early part of this decade. Evidence does not support this conventional wisdom. The overall slippage in the euro area aggregate budget deficit from its trough of 0.9% of GDP in 2000 (stripping out UMTS receipts) to its peak 3% in 2003 was just above two percentage points. Both the US and the UK saw their positions swing from a surplus to a deficit over the same period, with cumulative deteriorations in excess of six percentage points. We estimate that automatic stabilisers accounted for nearly 90% of the rise in the euro area deficit in 2001-05 (Exhibit 9). After a sizeable discretionary stimulus at the peak of the cycle in 2000-01, fiscal policy turned, if anything, moderately restrictive over the next three years. It should be no surprise then that, as soon as the recovery gains steam, deficits start falling and so does government funding. No spending frenzy despite the electoral cycle. A second longstanding view, to which we have also subscribed in the past, is that important electoral deadlines in most continental European countries — Germany last September, Italy in April, France next year — lead to a synchronized fiscal relapse, as politicians lure voters with higher spending and lower taxes. While it is probably too early to draw conclusions about the presence of a spending frenzy in Europe, our current estimates point to exactly the opposite: only a marginal stimulus in 2006 after a moderate tightening in 2005, and prospects of further restrictions for next year. Should growth move steadily above potential, governments might find it hard to resist the pressure of spending the extra receipts rather than using them for deficit reduction; but we are obviously not there. The current business cycle upswing is still too hesitant for us to anticipate a resurgence of the loose and pro-cyclical policies last seen in 2000-01. The bottom line is that the current cautious policy stance supports once again the case for light borrowing needs. Buybacks have led to redemption cutbacks. Stronger economic growth and better tax receipts feed through into lower 2006 government funding through a second dimension: buybacks. When we first assessed government bond redemptions for 2006, around a year ago, we estimated that €363 billion of bonds would have reached maturity in the year ahead. In November, we trimmed this projection down to €357 billion. It now stands at €350 billion. This means that the pick-up in tax receipts observed during the second half of 2005 did not feed entirely into lower funding last year, but part of the proceeds might have spilled over into 2006. In other words, as borrowing needs trended down, issuers preferred to buy back some of the heavy issues due for redemptions in the year ahead, rather then trigger a total dearth of supply. If growth holds, as we think, the same may happen again in 2007. Still relatively high share of non-market funding. When borrowing requirements picked up significantly in 2003-04, several euro issuers increasingly diversified their funding strategy away from traditional euro-denominated government bonds. Euroland’s finance agencies, on average, ran down their cash positions, increased the stock of short-term bills, and relied more and more on foreign currency denominated issues, non-market instruments, and other means. The share of other funding means remains higher than we originally anticipated. We estimate that domestic government bond issuance currently covers only 80% of Germany’s overall borrowing requirement, while this share is even lower for Italy. At last, heavy supply in the long end. The country breakdown of funding projections reveals that the bulk of our downward revision affected Italy. This may sound surprising to many, considering the country’s poor economic performance and the high budget deficit. Yet a better than expected cash deficit position in 2005, lower redemptions this year, and a continued low share of market funding explain the discrepancy. As for the maturity split, lighter supply will likely be spread along the curve, with the noticeable exception of long-dated bonds. At last finance agencies are locking in heavy amounts of supply at historically low yields. On our calculations, a sizeable supply of 15-year bonds in Italy, 30-year across the continent, and, to a lesser extent, 50-year in France, might push overall issuance for the over 10-year segment close to €27 billion in the first quarter. Euroland’s finance agencies appeared more timid in issuing inflation-linked bonds. We think the supply of linkers may pick up later in the year.
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An End to Excess Liquidity?
Feb 14, 2006
Takehiro Sato (Tokyo)
Investors start to fret about excess liquidity drying up Market sentiment, which had been positive up until recently on prospects for a BoJ end to quantitative easing (QE) as a sign of an end to deflation, has started to change. Overseas investors have started to slow their purchases of Japanese equities, after buying a net of more than ¥1 trillion per month for the past seven months. Contributing factors include high valuations as well as a growing uncertainty on monetary policy both in Japan and in the US and broadening concerns about the excess liquidity worldwide drying up due to the end of Japan’s QE. Amid expectations in Japan of the core CPI rate staying further in positive territory after turning positive in late 2005, the expected timeframe for a rate hike has moved up, to no later than year-end. In the US, investors have become increasingly sensitive to policy risks, in light of strong labor market conditions, accelerating wage increases, and the big event such as the replacement of the Fed chairman. Overseas investors are keenly interested in how the BoJ, which is looking to end its unprecedented QE stance, absorbs surplus funds and how the move affects financial institutions and the global economy. Three doubts about global liquidity drying up We think a decline in liquidity would be limited to Japan and be temporary, and the ongoing weakness in stocks, bonds, and USD/JPY presents buying opportunities for several reasons. First, we do not have strong doubt that a BoJ move away from QE would reduce some of the excess liquidity in Japan, but we doubt whether the policy has stimulated asset markets on a global basis. Investors are concerned that Japan’s higher interest rates will lead to an unwinding of yen carry trades. However, Japanese banks are no longer major suppliers of yen funds for yen carry trades of the large hedge funds, as they were in the late 1990s, because their creditworthiness has improved substantially and they have little need to make currency swap transactions to raise foreign currency. In other words, we doubt that the surplus of funds stemming from the BoJ’s QE has been a major factor behind the worldwide excess of liquidity, and the impact would be limited to the specific area. Second, the savings glut in developing countries, a major force behind the global excess liquidity, is not likely to decline immediately even if the BoJ and the Fed slightly raise rates. The real source of the savings glut has been asset inflation in the US, which has given rise to funds with substantial risk leeway that have benefited prices of oil and other commodities. In turn, the savings glut that developing countries and oil producing countries have amassed has been recycled into the US bond market. This mechanism is unlikely to be unravelled, even if the Fed funds rate goes up to 5%. This cycle of developing countries’ excess savings holding down long-term yields in the US, which in turn further increases developing countries’ excess savings, is likely to sustain itself. Third, even if the BoJ moves away from QE, it remains to be seen whether it can smoothly raise rates by year-end. In other words, the core CPI may not strengthen in F2006 as the BoJ expects, because deregulation and cutbacks in government expenditures continue to weigh on prices. We think the core CPI will hover around 0% in the latter half of F2006, even after an end to QE. In this case, political pressures for inflation targeting will almost certainly increase. Economic impact: not nil, but negligible For much the same reasons, we think an end to QE and an unwinding of global carry trades are unlikely to threaten economic growth in Japan or worldwide, the way that the 1998 hedge fund crisis stemming from Russia’s default did. To be sure, QE has started to show some of the originally intended effects on the economy and financial markets, with the growth in bank lending from the middle of last year. When the BoJ first adopted the policy in 2001, these effects were known as portfolio rebalancing effects. This mechanism was not clearly apparent no matter how much the BoJ increased the amount of surplus funds, as banks’ financial intermediary function failed in 2001-03, but has started to result in one of the originally intended effects, loan growth. The effects have been unexpectedly strong because of a decline in real rates as deflation has eased. We accordingly think a move away from QE would affect this virtuous cycle only slightly. In other words, the impacts of a BoJ tightening of the supply of surplus funds and a BoJ loosening of the same may be asymmetric. We are also doubtful about the existence of carry trades, however, for all the concerns that they will be unwound if the BoJ ends QE. BoJ Governor Fukui has said that short-term rates will remain around 0% even after QE ends — that is, the BoJ will continue to provide the minimum amount of liquidity needed to keep short-term rates near 0%. Money market rates are likely to rise from 0% to around 0.1% in response to fund supply and demand after the end of QE. This increase would not be long lived, but investors would probably become even more sensitive to interest rate trends if the overnight call rate rises, even temporarily. Based on the above outlook for prices, we see little urgency for a rate hike, however, and think short-term rates will stay close to 0% for unexpectedly longer time. Appendix: Responding to FAQs Since last week we have a number of questions from investors on the methodology of the termination of QE, likely market impact, and the influences on the BoJ’s balance sheet. The following supplements are our responses to these FAQs. Supplement 1: Outlook for the money market after the end of QE The BoJ has officially said in its Outlook Report that money market rates will remain very low (close to 0%) after the end of QE. However, it remains to be seen whether they will decline to the ultra-low levels of the ZIRP (zero interest rate policy) days and stay pegged there. As liquidity risk re-emerges in the money market with the retreat of the Bank’s presence in the money market, short-term rates could unexpectedly hover between 0% and the Lombard rate for several reasons. (1) Revenge on the part of Japanese banks. Deposit-to-loan ratios of the major banks rose after the reimposition of deposit insurance caps during the QE in the last five years led to a shift of deposits from financially weak banks to financially sound ones and thereby corrected the disproportionate amount of funds in the banking system. However, it is unclear whether major banks are lenders in the call market after the normalization of the call market, as regional banks and shinkin banks were. City banks are unlikely to provide substantial amounts of funds to the call market to try to get a very narrow rate spread. Restrictions on their allocation of capital have become much tougher as their risk management has strengthened. As a result, supply-demand conditions in the call market will likely be tight as major banks hold on to funds and even if the BoJ lowers its target for current account balances to ¥15-20 trillion. The ones that would be hurt the most by such a rise in money market rates would be foreign banks and securities companies, which regularly need yen for the domestic lending business and bidding on the JGB auctions. (2) Concerns about the Lombard facility. A Lombard-type lending facility was established in 2001 with the aim of enhancing liquidity in the money market. Rates on loans extended through this facility are the same as the official discount rate (0.1%) and the overnight call rate will be theoretically capped, even if the unsecured overnight call rate rises. However, in practice, the facility has not caught on because private-sector banks are reluctant to borrow from the central bank. Hence, even with the Lombard facility in place, short-term rates are likely to break through 0.1% on a temporary basis. Lombard loans are fundamentally different from special BoJ loans extended to bankrupt financial institutions to help keep the financial system stable. Nevertheless, private-sector financial institutions seem to be concerned about the reputation risks associated with Lombard loans. (3) Increase in amount of settlements. The money market has been somewhat complacent about the liquidity risks associated with rising settlements amounts because the BoJ instituted QE shortly after RTGS (real time gross settlement) started in 2001. However, if it becomes difficult to count on a supply of excess reserves well above the required amount, then intraday liquidity measures would probably be needed. This factor would unexpectedly make intraday supply-demand conditions in the money market more volatile. (4) Japan Post’s balance of current accounts could be destabilizing. Japan Post’s balance of current accounts at the BoJ has been at ¥2.5-3.0 trillion. These are technically not reserve deposits; what they are is vague. Also, it is still somewhat unclear whether Japan Post is fully functioning as a giant lender in the money market. If the institution were to hold onto the funds in its current account at the BoJ and supply-demand conditions in the money market would likely tighten, although the BoJ’s stance on market operations would have an impact as well. Supplement 2: Impact on the BoJ's balance sheet The BoJ’s balance sheet, which ballooned to more than ¥150 trillion on February 10, would probably shrink gradually with an end to QE, but the BoJ has not clearly indicated how, perhaps out of concern that might limit its policy leeway. We think its basic strategy is to wait for current account balances to decline on their own when terms of the current liquidity supply operations expire. In this case, the BoJ’s liabilities and assets would both decline. The BoJ also has the choice of accelerating the pace at which funds are absorbed by resorting to operations to absorb funds. In this case, it would likely sell bills or issue bills-sold, but the result of the latter case would only be replacements to the liabilities side of the balance sheet and no change in the size of the balance sheet. Some investors think the BoJ may reduce the value of the outright buying operations or sell JGBs outright as a way to absorb funds and shrink its balance sheet, but a reduction in outright purchases would be more difficult than reducing the target for current account balances or subsequently raising rates due to political reason. Also, the outright selling operations are very unlikely because the BoJ’s holding of the JGB is assumed to hold until maturity.
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Abundance is Just Beginning
Feb 14, 2006
Gray Newman (New York)
With no signs of the abundance of inflows letting up, Brazil has decided to use its strong dollar inflows to buy back up to $20 billion in external debt coming due between now and 2010. The move follows the central bank’s aggressive buying spree, which has enabled it to double its net international reserves and to use derivative instruments known as reverse currency swaps to offset all remaining dollar-linked domestic instruments (see “Brazil: The Central Bank’s Buying Spree” in GEF, January 18, 2006). The move to buy back debt, first announced late on February 9, has been met with near universal praise. Following the announcement, there was renewed talk of an imminent ratings upgrade on Brazil’s external debt which is currently three notches below investment grade status. The Brazilian real reached its strongest levels in nearly five years on Friday, February 10 and Brazilian external debt instruments posted new records. Aside from investors who had decided to short Brazilian external debt in recent weeks, it was hard to find much grumbling. The optimism is understandable. After all, the contrast in just three years could hardly be greater. In February 2003, there were still concerns that Brazil might default on its debt. Now, its external debt looks like it is closer to extinction than to default. Voices of caution I did hear a few voices of caution after the debt buyback announcement, but they were a minute minority of Brazil watchers. The cautious camp argues that the finance ministry is moving too quickly and should instead sequence the external debt changes only after providing for a greater opening of Brazil’s domestic debt market, which remains largely off limits to foreigners. Expand fixed-rate domestic instruments and then move to provide more longer-dated fixed-rate instruments, they argue, instead of relying on the strength of the currency to transform Brazil’s external debt stock. The fanfare of the public announcement, they worry, is likely to simply fuel market expectations and run the risk that asset prices move ahead of Brazil’s fundamentals. There is some validity in the concerns of the voices of caution. The announcement of the debt buyback, viewed in isolation, tell us very little. After all, there have been spectacular cases in the past, such as the Bolivian buyback debacle in the late 1980s, where debt buybacks have appeared to be successful in reducing the nominal value of the debt but have accomplished very little to reduce the total market value of the debt stock. Four stages In the case of Brazil, however, I am optimistic that the authorities are viewing the debt buyback within a much larger game plan. As I see it, Brazil’s strategy has four stages: the first, the decision to accumulate reserves, is related to the second, the debt buyback. In the coming days, we expect to hear more details of stage two as well as stage three, the move to reduce the market segmentation that has plagued Brazil’s domestic debt markets and left it largely off bounds for most foreign investors. Stage four, in many ways the most important, involves how the fiscal authorities will use the benefits of lower real yields (thanks to lower inflation and improved ratings). Brazil needs to take advantage of the resources freed up thanks to lower debt servicing costs to both boost public investment spending as well as to reduce its tax burden. An attempt to provide greater clarity on stage four was aborted late last year and will likely have to wait until after the elections slated for October. The decision to buy back the short-dated external debt is really just the flipside of what the central bank has been already been doing. By aggressively accumulating reserves, Brazil’s central bank has managed to shrink the public sector’s net external debt (net of reserves) so that by the end of 2005 it was near $22 billion — less than half the level at which it stood at the end of 2004. The other way to reduce the net public external debt is to buy back external debt, which is what the finance ministry announced last week that it had already begun would continue to do as market conditions permitted during the remainder of this year. Of course, the shift away from external debt will turn the spotlight to Brazil’s domestic debt, which now represents nearly 95% of Brazil’s net public debt. While the authorities have been successful in eliminating all dollar-linked swaps and have offset all remaining dollar-linked instruments (roughly $11 billion are set to mature by 2009) by issuing reverse swaps, Brazil’s debt stock is still dangerously vulnerable to overnight interest rates. More than half of Brazil’s $408 billion net domestic debt stock is linked to overnight interest rates. The emergence of fixed rate and longer-dated paper should get a major boost in the coming months when the authorities announce measures to better open the domestic market to foreign investors who have shown significant appetite for duration. Only through the coordinated effort of the central bank to control inflation and strengthen its credibility, along with measures to designed to open Brazil’s domestic markets, will Brazil be able to benefit from lower real yields. Both the efforts announced to date by the central bank and the finance ministry, as well as measures expected shortly, should help lower Brazil’s debt servicing costs sharply. We estimate that the savings could reach 4–6% of estimated public revenues in 2006 (see “Brazil: Plan B Redux” in This Week in Latin America, November 22, 2005). Of course, the process is dynamic: the improved fiscal and debt picture is likely to trigger a series of upgrades to Brazil’s credit standing, reducing debt servicing costs further. Ultimately however, the challenge for Brazil is how to use the resources freed up from lower debt servicing costs. The glaring mismatch between private investment in Brazil and public investment needs to be addressed, as does a series of distortionary taxes. Stage four, however, will likely have to wait until after the elections and either the second term of the current administration or the new term of the next administration in January 2007. End of intervention nears In the meantime, the Brazilian real should remain strong. While some have argued that the finance ministry’s announcement will keep the real from strengthening, given its aim of buying up to $16–20 billion dollars to buy back debt, I suspect the move will strengthen the currency. The medium-term prospects are positive as external vulnerability is reduced, but I would argue that the near term prospects are also real positive. With net public external debt (external debt net of reserves) already near $20 billion, or slightly lower given the announcement that the authorities have already bought back $2.3 billion so far this year, the day that it goes to zero thanks to central bank accumulation of reserves or the finance ministry’s buyback has most likely been brought forward. Brazil can, if it chooses, to be long dollars. But I suspect that such a move would only serve to attract more flows to bet on further real strengthening, especially given the dramatic carry trade that works against a long dollar position. We continue to expect to see the real test and likely break through 2.0 in the coming months, even as we acknowledge that there could be some turbulence late in the year as a new cabinet or second-term cabinet is named. Bottom Line There is not much of a debate these days over whether the abundance that Brazil and many emerging market economies are enjoying is here to stay or is merely the result of a temporary terms-of-trade shock about to turn the other way. More and more investors with only limited understanding of the dynamics of Brazil’s trade, fiscal and debt accounts are increasing their exposure to Brazil. That concerns me. But the good news from Brazil is that the authorities are using the current abundance to eliminate their net external obligations both by building up reserves and buying back external debt. Along the way, Brazil is also extending the duration and maturity of its domestic debt and using monetary policy to help squeeze out residual inflationary expectations and thus paving the way for substantially lower real yields. For Brazil’s fiscal authorities, the abundance is just beginning. How they deal with the abundance will be Brazil’s ultimate test.
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The Case for Investment Grade
Feb 14, 2006
Serhan Cevik (London)
Turkey, once an investment-grade country, is steadily moving towards a better status. The analysis of historical figures, albeit providing a fundamental basis to our understanding of what happens in economies and financial markets, is not sufficient to identify turning points and emerging trends. We need a multi-layer forward-looking analytical approach to study structural shifts and to estimate the probability of sovereign default. Turkey’s institutional transformation presents a challenging, but rewarding case. A simple extrapolation of past business cycles would suggest an impending bust — indeed, an argument put forward by some analysts in the last three years. However, despite numerous shocks such as the Iraq war and monetary tightening in developed markets, Turkey’s macroeconomic fundamentals have continued to improve even beyond our optimistic expectations. And now, with the start of EU accession process, institutional reforms — improving stability, predictability and transparency of political institutions — will strengthen the country’s economic performance and reduce its vulnerability to oscillations in global financial conditions (see Fat Lady Slimming, October 4, 2005). In other words, we expect the steady convergence of nominal and real economic variables towards European standards to raise Turkey’s credit rating to the investment-grade status in the next two years. Macroeconomic improvements support our call for higher credit ratings. Turkey was an investment-grade country before political instability and policy mistakes led to a devastating crisis in 1994. Unfortunately, the persistence of fragmented politics, even after such a shock, had not allowed the implementation of prudent policies and structural reforms and consequently trapped Turkey in a bad, unsustainable equilibrium until another destructive crisis hit the economy and financial markets in 2001. But this unavoidable result of decades of instability turned out to be a wake-up call encouraging voters to do what politicians failed to pull off: the consolidation and rationalisation of politics. As the 2002 elections put a single-party government in power, a coordinated set of far-sighted macroeconomic policies and structural reforms has set the stage for strong, non-inflationary growth. Turkey’s real GDP increased 32%, on a cumulative basis, and inflation declined from an average of 77.5% in the 1990s to less than 8% in the post-crisis period. In our view, this impressive macroeconomic performance, though benefiting from favourable global liquidity conditions, is mainly a result of structural changes in the economy that also support our call for higher credit ratings. The productivity renaissance is the key factor in shaping Turkey’s new economy. There are numerous measures of progress, but we believe that the best gauge to assess the depth and sustainability of economic change is productivity. The normalisation of Turkey’s political and macroeconomic landscapes has functioned like a ‘technological innovation’ that boosts labour (as well as multi-factor) productivity growth (see Stabilisation as Innovation, May 9, 2005). For example, the 36.6% cumulative increase in output per hour worked in the post-crisis period has led to an unprecedented 40.5% drop in unit labour costs. Furthermore, the growth rate of total factor productivity accelerated from a disappointing 0.5% per year in the 1990s to 4.8% in the last four years. Thanks to these underlying improvements, the Turkish economy has maintained an above-trend growth momentum and, at the same time, disinflated below the 10% mark. In our opinion, structural adjustments and the resulting moderation of macroeconomic volatility will keep reducing the probability of negative output shocks and support robust output expansion and progress towards price stability (see Breaking the Curse of Sisyphus, December 15, 2005). Prudent regulations and improving capital structures have rejuvenated the banking sector. The strength of the real economy and the country’s credit quality cannot improve on a sustainable basis, without a vibrant, structurally-sound financial system. Turkey’s banking sector — one of the original sources of underlying fragilities that led to financial catastrophes in the past — has become an agent of progress in the post-crisis era. For example, the average capital adequacy ratio in the banking sector increased from 13.4% in 2000 to the peak of 30.9% in 2003 and now stands at 23.8%. Moreover, irresponsible risk taking, measured by the amount of short foreign currency position that declined from US$5.4 billion in 2000 to a mere US$41 million last year, no longer represents a systemic risk to financial stability. With improving macroeconomic conditions, Turkish banks have moved away from speculative positions to providing proper financial intermediation. In turn, the rise in credit availability — from 19.8% of assets in 2001 to 38.5% last year — supports economic activity as well as the central bank’s efforts to implement inflation targeting. Looking forward, the emergence of a highly competitive, technologically advanced and well regulated banking sector will play a crucial role in moderating business-cycle volatility and addressing structural inefficiencies that constrain productivity growth. The key determinant of credit quality is the state and projected path of public finances. Turkey has come a long way from the crisis period when the Treasury was paying real interest rates in excess of 30% on lira-denominated bonds and market participants — and even the authorities — used to contemplate the possibility of debt restructuring. In order to break the vicious circle of fiscal imbalances and market expectations, the authorities have implemented a rigorous fiscal consolidation strategy using large primary surpluses as the key instrument. In the past six years, the central government budget has produced an average primary surplus of 6.1% of GDP per year — an exceptional performance, which actually increased to 7.2% of GDP last year. Thanks to such prudent fiscal policies and a credible commitment to disinflation, the cost of borrowing eased from an average of 62.7% in 2002 to 24.7% in 2004 and 16.5% last year. With the compression of forward-looking real interest rates from 28.5% in 2002 to 9.2% last year, the Treasury’s interest payments declined from a terrifying 23.3% of GDP in 2001 to 13.7% in 2004 and then 9.4% in 2005. As a result, the budget deficit narrowed from the peak of 16.5% of GDP in 2001 to 1.9% last year — well below the 3% threshold of the Maastricht criteria (see The End of Fiscal Dominance, November 8, 2005). The diminishing public-sector borrowing requirement (PSBR) improves debt dynamics. The PSBR declined from an average of 9.4% in the 1990s and the peak of 16.4% of GDP in 2001 to 0.8% last year. As a result, the public sector’s gross and net debt-to-GDP ratios improved from 107.5% and 90.5%, respectively, in 2001 to 69.8% and 56.5% last year. This is an outstanding correction, in our view, but there is more to come. First, with the diminishing PSBR, the Treasury is becoming a net debt payer and reducing its rollover ratio in the domestic debt market from 89.4% last year (and 92.8% in 2003) to no more than 77.1% this year. Second, the increase in the average borrowing maturity in the domestic debt market — from nine months in 2002 to 27.7 months last year — is moderating the Treasury’s exposure to interest rate fluctuations. Third, the decline in the share of foreign exchange-denominated and -linked instruments — from 57.3% in 2001 to 38.9% last year — is lessening the sensitivity of debt dynamics to exchange rate fluctuations. All in all, we believe that multi-year fiscal programming and structural reforms will continue strengthening the Treasury’s future debt-service capacity and thus credit quality. External imbalances may be a rating constraint, but forward-looking analysis supports our call. Catastrophists have argued that Turkey is on the verge of a balance-of-payments crisis because of the widening in the current account deficit to 6.2% of GDP last year. Although such an imbalance may be a rating constraint, we need to identify the causes and the future path. Given Turkey’s oil dependency, it should not be surprising to see a worsening, especially when the economy has expanded at an above-trend pace. As we have argued in previous reports, structural adjustments in the economy and in residents’ portfolio allocations drive today’s external imbalances (see Big Picture, December 7, 2005). Moreover, with the decline in net public-sector external debt from 37.8% of GDP in 2001 to 13.2% last year, the quality of financing has improved both in terms of non-debt creating capital inflows and within the category of debt-creating inflows. Therefore, we expect the forthcoming correction in Turkey’s balance of payments to support higher credit ratings. Turkeyhas overcome macroeconomic instability and is now out of the debt trap. Though Turkey still faces a number of long-term challenges (such as the rationalisation of the archaic tax system, dealing with the mounting pension deficit and lengthening debt maturity), it is moving towards meeting the Maastricht criteria. Given the consensus on the need to address structural shortcomings, we are of the view that vibrant economic growth and institutional improvements, strengthening the resiliency of Turkey’s economy and financial markets, warrant multiple rating upgrades.
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