From Beijing to Dubai
Mar 24, 2006
Stephen Roach (from Dubai)
My travel schedule is planned months in advance. It was only by happenstance that I found myself in both Beijing and Dubai this past week -- two of the more recent flashpoints in a US-led pushback against globalization. What I found in both cities unsettled me -- disappointment and frustration over America’s attitude toward two of its major providers of foreign capital. The United States has been having a good deal of trouble with its overseas image in recent years. The feedback from Beijing and Dubai is that this image is going rapidly from bad to worse -- something a saving-short US economy can ill afford.
China is deeply troubled over the outright hostility from an increasingly xenophobic US Congress. The senior officials I spoke with this week in Beijing protested on two counts -- China’s fragility and America’s penchant for scapegoating (see my 21 March dispatch, “Inside the China Debate”). On the first count, the Chinese don’t believe that US politicians appreciate the potential risks that still lurk in this transitional economy. Instead, they are pressuring China as if it were operating from a position of much greater strength. China remains very much a tale of two economies -- a booming coastal region and a lagging interior. Most in Washington view China from the lenses of Beijing and Shanghai, and conclude that these two thriving metropolises personify the emergence of a powerful and mighty nation. What they don’t realize is that only 100 km away from either city lurks a China that has changed very little in the past thousand years. Yes, 560 million Chinese now live in urban centers around the country, although probably less than half these city dwellers have seen meaningful improvement in their standard of living over the past 30 years. Meanwhile, the rural population of some 745 million Chinese still tries to get by on $1-2 per day. At the same time, despite 25 years of 9.5% real GDP growth, serious vulnerabilities continue to plague the macro structure of the Chinese economy. The financial system has only just begun the long march toward liberalization and development. Growth continues to draw the bulk of its support from external demand (i.e., exports) and autonomous internal demand (fixed asset investment). Self-sustaining growth from the Chinese consumer is deficient, reflecting a pervasive sense of job and income insecurity that stems from ongoing reform-induced headcount reductions. Far from letting the invisible hand of market-based capitalism drive price-setting, the visible hand of administrative fiat still plays a major role in the determination of prices of goods and services in the real economy, as well as interest rates, the currency, and the prices of many other assets in the financial economy. All this speaks of a Chinese strain of market-based socialism that is still far too fragile to stand on its own. China also feels that it is being victimized for America’s structural problems. Premier Wen Jiabao was crystal clear on that point when he ended the recent China Development Forum by stating, “It is unfair to make China a scapegoat for structural problems facing the US economy.” There’s no dark secret what he was referring to -- China’s important role as a provider of goods and financial capital to a saving-short US economy. As long as America has a serious saving problem -- and, of course, the US net national saving rate plunged into negative territory for the first time in history in late 2005 -- trade deficits are a given in order to attract the foreign capital to fill the void. If the Schumer-Graham bill closes down US trade with China through the imposition of steep tariffs, a saving-short US economy will simply have to divert a significant portion of its multilateral trade deficit elsewhere. Undoubtedly, that means a higher-cost producer would have to take China’s place as a low-cost provider of capital to the US -- imposing the functional equivalent of a tax hike on the American consumer. When I pointed this out to Senators Graham, Coburn, and Schumer in Beijing, Senator Schumer said, “I understand the structural point, but China still has to give.” The editorialist in me says, if Washington -- or for that matter, beleaguered US manufacturers -- really wants China to give, then it needs to make that argument from a position of a macro strength and boost America’s national saving rate. Until, or unless, that happens, US-led China bashing is nothing short of political hypocrisy. In the meantime, Washington could well be about to compound one of America’s most serious structural problems -- at considerable expense both to the US and Chinese economies. These are the “lose-lose” outcomes of globalization that can only end in tears. In Dubai, I was met by a similar sense of consternation. Fresh from the wounds of the rejected Dubai Ports World transaction, several major private equity investors in the UAE were blunt in expressing their sudden loss of appetite for US assets. As one seasoned investor in US companies and properties put it to me, “As practitioners, as investors, we have become very shy of the US -- we just turned down a recent deal for that very reason.” Another added, “For us, foreign direct investment into the US has become far less palatable due to recent developments. The bulk of our dedicated offshore money is now going elsewhere.” The comment that unnerved me the most took this exasperation to an even deeper level. One investor asked, “What can we do to push back, to send a signal?” I certainly don’t want to make too much out of an unscientific survey of a few private equity investors in Dubai. But up until recently, this was one of the Middle East’s most pro-American investment communities. The individuals I met with this week are seasoned participants of many a cross-border transaction into the US. For them, the political shock wave from Washington has come from out of the blue, and they now see little reason to go back to the same well -- especially given the wide menu of less contentious alternatives available elsewhere in the world. In the broad scheme of things, Dubai is a small player in the world of international finance. But to the extent that the Dubai backlash is emblematic of similar distaste from other Middle East investors -- hardly idle conjecture, in my view -- the repercussion cannot be minimized. Net foreign direct investment into the United States hit $128 billion in 2005 -- an increase of $22 billion from the inflows of 2004. If that trend now starts to reverse course, America’s already daunting current-account financing problem will only get worse. From Beijing to Dubai, there is a growing undercurrent of economic anti-Americanism. The irony of it all is truly extraordinary: The US has the greatest external deficit in the history of the world, and is now sending increasingly negative signals to two of its most generous providers of foreign capital -- China and the Middle East. The United States has been extraordinarily lucky to finance its massive current account deficit on extremely attractive terms. If its lenders now start to push back, those terms could change quickly -- with adverse consequences for the dollar, real long-term US interest rates, and overly indebted American consumers. The slope is getting slipperier, and Washington could care less.
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Are Structural Drags Holding Down Real Yields?
Mar 24, 2006
Richard Berner (New York)
Despite their recent increase, the level of real interest rates remains low by historical standards. For example, 10-year TIPs yields now stand at 2¼% and the real Federal funds rate is roughly 2½% (comparing nominal yields with core inflation). In my view, low real yields have in the past and still do reflect low “term premiums” — the compensation investors require for holding longer-term securities rather than rolling over a series of shorter notes (see “The Term-Premium Case for Higher Yields,” Global Economic Forum, January 20, 2006). The recent backup in yields in the face of benign inflation news, in my view, is the product of two factors. Investors have recently reassessed the prospects for global growth and monetary policy at home and abroad; the end of quantitative easing in Japan and more hawkish talk from central bankers in Japan and Europe has reinforced that shift. And at home, term premiums apparently have risen from their lows, perhaps as the path for US monetary policy is becoming less certain. However, some believe that structural drags — such as high energy prices, prospectively slower growth in home prices and a rise in household saving, a global saving glut, or an ever-widening real trade gap — have depressed and will continue to depress US growth. Concurrently, they reason, real yields thus have remained low to offset the depressing influence on growth from those headwinds. How valid are those concerns? As I see it, the structural drag story may have had merit in the past, but now is fading as global growth and domestic personal income improve. Over the 2002-05 period, rising energy prices and tepid growth abroad were drags on the pace of US economic activity. Crude oil and natural gas quotes have tripled and retail petroleum product prices have jumped 60% over the past four years, draining roughly $55 billion annually (0.6% of disposable income) from US consumers’ purchasing power over the same period. Small wonder that consumers dipped into savings to defend their lifestyles. And slower growth abroad, coupled with rising import penetration and thus the daunting arithmetic of our yawning trade gap, meant that sagging net exports trimmed US growth by roughly 0.5% annually in the four years ended in 2005. It’s worth noting that these developments could have been consistent with a “saving glut” — or investment ex ante persistently falling short of saving. The rise in energy prices transferred income from US and other energy consumers to energy producers overseas, not all of which was spent. And the combination of strong growth in US domestic demand and weak growth abroad implied that our major trading partners were content to finance our ever-burgeoning current account deficit — a huge source of saving now at 7% of GDP — on attractive terms. That was then. Looking ahead, if we are right that energy prices will stay roughly stable, consumers will stop suffering the loss of discretionary spending power witnessed over the past few years. Moreover, I think robust growth in real consumer wage income will sustain growth in consumer spending and allow a modest pickup in personal saving. In addition, improving global growth, despite daunting deficit arithmetic, implies that net exports at worst will be a smaller drag on US growth this year than in the past, and might even contribute modestly to growth in the next two years. Those positives should swamp the effects of the coming slippage in housing and housing wealth this year (see “Housing, Mortgages and Consumption: Are Australia and the UK Templates for the US?” Global Economic Forum, March 3, 2006). Put differently, stronger global growth is now likely to absorb a significant portion of the excess global saving that formerly came to us. Stable energy quotes would mean that soaring growth in petrodollars likely will slow, reducing that source of saving. Domestic saving swings are important as well: With US earnings growth slowing and capital spending continuing to advance briskly, corporate external financing needs likely will start rising this year. Thus the saving glut, if there really was one (and recent IMF data cast doubt on that hypothesis), likely is now in the process of moving into better balance. US nominal 10-year yields have backed up 25 basis points over the past month, with virtually all of it in real terms, so the yield curve has become less inverted. Have changes in the outlook, including any structural drags, been the dominant factor behind that move, or have changes in term premiums been the driving force? For bond market investors and for the Fed, the distinction is critical. As Fed Chairman Bernanke noted this week, if it is the former, real rates should be higher to assure price stability, and monetary policy should be tighter. Past structural drags required a lower level of real yields to be consistent with solid growth, and as these headwinds fade, policy must provide an offset. Conversely, if higher term premiums are at work, other things equal, a rise in market yields is making financial conditions less accommodative, so policy does not have to tighten as much. Despite any rise in term premiums so far, however, I think there is probably still too much economic pessimism priced in to the term structure of yields. For example, the re-inversion of the yield curve this week may signal that market participants are still expecting that the economy will soften as the Fed overshoots, and that officials will have to reverse course and ease no later than sometime this year or early next year. I disagree. In my view, the combination of solid growth, an upcreep in core inflation, and higher term premiums implies further yield increases and a re-steepening of the curve. It’s easy to catalogue the downside risks to US growth. For example, the structural drag story could resurface if energy prices surged, overseas growth weakened, and/or housing prices decelerated abruptly. But few investors are thinking about the upside risks to growth, and even fewer are concerned about upside risks to inflation. That complacency suggests that bonds are more vulnerable to inflation surprises than they are to unexpectedly stronger growth.
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Still Anticipating a Cyclical Downturn in the Dollar
Mar 24, 2006
Stephen Jen (Hong Kong)
Reiterating my view on the G10 currencies In this note, I reiterate my base case for the currency markets this year, which is that the dollar index is likely to experience modest cyclical weakening this year, particularly after the fed funds rate (FFR) peaks. The prospective USD depreciation is likely to be modest against the currencies such as the EUR and GBP, but more significant against the Asian currencies. In addition, in contrast to the previous four years, the dollar bilateral rates vis-à-vis different currencies are likely to diverge, with it depreciating against the majors, but appreciating against some other currencies, such as the commodity currencies. My central case view on the dollar this year First, the dollar won’t exhibit powerful trends, mainly because the USD index is very fairly valued. Some time this year the structural dollar bears will almost certainly try to push the dollar lower and, if our valuation work is right, any sharp sell-off in the dollar against the likes of EUR or GBP will be followed by a snap back in the dollar. Second, the key story for the dollar this year will be cyclical, and centered on the US housing market rather than structural. I am of the view that there are enough structural dollar/US bears in the currency markets that if the US does start to show signs of a genuine slowdown in the housing sector, the dollar will likely be sold, even if capex surges to offset the weakness in consumption. Third, I argued that this will likely be the ‘Year of the CNY’ and, as a result, Asian currencies will likely significantly outperform the dollar this year. Fourth, I believe that the dollar’s movements this year will likely be asynchronous against various currencies. Key developments so far this year · Development 1. A slightly more hawkish Fed. The peak in the FFR is the key determinant of the timing of the prospective turn in the dollar. I fully endorse our US economists’ new FFR forecast of 5.25%, and believe that the market turned too dovish on the Fed last week. If we are right on the Fed, the dollar index is likely to stay supported for the time being, and any downturn in the dollar is likely to come in the summer when the FFR peaks, rather than now. · Development 2. A meaningfully more hawkish BoJ. My view on the BoJ has evolved over time. I am now much more worried about a hawkish BoJ than I was at the start of the year. I believe that the BoJ is similar to the ECB, in that it is at least as worried about prospective asset price inflation as it is about actual goods price inflation. Since the neutral rate in Japan is probably 2.50%, it is conceivable that the BoJ tightens by 100bp and the monetary conditions would still be described as ‘accommodative’. I suspect that the BoJ wants to terminate ZIRP as early as politically feasible. To me, this means some time this summer. But the real risk I see is that it will tighten further in 2H. A more hawkish BoJ could trigger a sell-off in USD/JPY later this year. · Development 3. Global long bond yields have risen. Rising long bond yields, in addition to monetary normalization, have been one of the key drivers of the global liquidity cycle. As the global liquidity cycle turns, some of the ‘risky’ assets (e.g., commodity currencies and LatAm and eastern European currencies) may come under downward pressure. Since some of these positions are funded out of JPY, a sell-off in these assets could lead to a vicious circle with USD/JPY, but not as intense as in 1998. · Development 4. Monetary normalization by creditor countries. Central banks of the savings deficit countries (UK, Australia, New Zealand and the US) began to tighten a couple of years ago, while the central banks of the savings surplus countries (Japan, Euroland, Switzerland and some Asian countries) have only recently begun to tighten. First, this reflects a ‘balancing up’ scenario. Second, as a tautology, the countries running C/A deficits had faster growth. Third, however, a rise in the interest rates in the creditor countries, relative to the debtor countries, could be somewhat negative for the currencies of the deficit countries. Bottom line I maintain my view that the dollar may experience a cyclical downturn after the FFR peaks, particularly against the Asian currencies. Central bank policies will continue to be important drivers of the spot rates. Among the G3, I believe that the biggest surprise could come from the BoJ.
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UK Budget
Mar 24, 2006
David Miles (London) and Melanie Baker (London)
As expected, there were no single major tax, or spending, changes announced in this week’s UK budget. The Treasury’s borrowing projections were left largely unchanged from December’s Pre-Budget Report (PBR) levels. The Chancellor announced a change in the Debt Management Office’s (DMO) remit, which gives it more flexibility and also implies more issuance of longer-dated and index-linked debt. There were no significant changes in the government’s forecasts of aggregate tax revenues, nor in the main tax rates, beyond those announced in the December PBR. But revenue projections are higher than forecast a year ago, in significant part because of major increases in tax on North Sea oil companies (announced in December). There have also been increases in projected revenues from asset sales, which are now predicted to generate (on a cumulative basis) an extra £7 billion of cash up to 2010. The Chancellor expects to be able to keep net debt at under 40% of GDP — but only just — and the extra revenue from higher asset sales plays a significant part here. With no extra revenue from asset sales (relative to previous plans), net debt would be around 39% of GDP within a few years. As it is, the Chancellor forecasts that he hits his fiscal targets by a small margin. But there is a significant chance that on unchanged policies one (and conceivably both) of the fiscal rules could be broken. Arguably, the sustainable investment rule is the more challenging. Extra asset sales are a factor allowing the Chancellor to plan to increase spending in education and on training and skills without planning to borrow more than announced in the PBR last December. Any undershoot on tax revenues — which is quite likely — or on proceeds from planned asset sales will be problematic for public finances. The task of sticking to the ‘sustainable investment rule’ (net debt should not rise above 40% of GDP) is very challenging. But the scope to accelerate asset sales is also significant. The public sector has a stock of assets worth around £800 billion — comparable to all the assets of UK pension schemes. On debt issuance, the Treasury announced "temporary changes intended to allow greater responsiveness in gilt issuance by the DMO during 2006-7". There is £63 billion of gross gilt issuance planned, including £10 billion ‘unallocated’ (that is, it has not been decided whether those issues should be short, medium or long dated debt). The ‘unallocated’ requirement to sell gilts is "intended to increase the ability of the government to respond to substantial changes in market conditions and in the pattern of demand for gilts throughout the year". Although this change in strategy for debt issuance falls well short of a ‘regime change’, if most of the unallocated gilts to be sold are longer term issues then the proportion of long dated (both conventional and index linked) bonds will be a bit above two-thirds. Close to 30% of total issuance is likely to be in index linked debt (up from around 20% in 2005/6). These are significant increases relative to 2005-06. The Treasury still sees itself on target to meet the Golden Rule (that the average current budget — which excludes net investment — must at least balance over the cycle). For the deficit on the current budget, the estimate for the 2006-7 fiscal year was increased to £7 billon from £4 billion previously. However, the Treasury announced it still expected to meet the ‘golden rule’ over the cycle (with an average current surplus over the cycle of only 0.1% GDP — unchanged from the Pre-Budget). We remain sceptical that the Treasury will be able to achieve this without needing to make policy changes.
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Home, Sweet Home
Mar 24, 2006
Elga Bartsch (London)
A striking feature of the German economy is the disappointing development in the housing market over the last ten years. The recession in the construction industry accounts for some 0.4 percentage points of Germany’s underperformance in terms of GDP growth vis-à-vis the euro-area. Beyond the near-term cyclical recovery in construction activity and real estate markets, we expect home-ownership rates to start rising over the longer term. The current debate about making owner-occupied housing eligible for individual retirement accounts is crucial. In addition, the favourable treatment of corporate pension schemes is likely to be phased out in 2008. In our view, this offers a unique opportunity to raise home-ownership rates, which, at 42%, are low by European standards. The demographic drift and declining income uncertainty should further boost the propensity to buy. The outlook for the residential real estate market is gradually improving, as corporate restructuring of the last few years will eventually also benefit the real estate market, we think. Together with continued very low interest rates by historical standards, a rebound in construction activity and in real estate prices is likely to boost mortgage demand. What we are seeing in Germany at present is a smart cyclical recovery that is spilling over from booming export demand to domestic demand. With an above-trend GDP growth rate of 1.8% this year, on our forecasts, the German economy looks about to stage an impressive comeback. The experience of the restructuring episodes in the US and the UK in the 1980s show that these efforts eventually bear fruit in the form of more dynamic job and income growth. The observed pick-up in building permits in the second half of last year is only partially related to the scrapping of the first-home-buyer allowance in January. The rebound is much more marked for non-residential construction and infrastructure projects. Against a backdrop of a smart cyclical upswing in corporate investment spending and a below average starting point, we expect the recovery in commercial construction to continue. Similarly, an ongoing improvement in public finances and a push towards more public-private partnerships should sustain public sector infrastructure works even after the World Cup this year. Anecdotal evidence suggests that, contrary to expectations, residential real estate prices and housing demand have held steady in early 2006. Hence, we would ascribe the recent weakness in construction activity largely to unusually bad winter weather. Despite a multi-year recession in the sector, which caused the German construction industry to contract by more than a quarter, the spending on residential housing per capita still remains elevated compared to the rest of the euro area. This likely in part reflects the high, but also expensive standards in German residential housing, which include strict environmental and safety standards as well as a strictly regulated crafts trade. While the year-end rush in obtaining a building permit ahead of the abolition of the first-home buyer allowance could boost construction this year, the VAT hike planned for next year poses the risk of a renewed retrenchment. We would therefore stress the pick-up in commercial construction and infrastructure as likely the more resilient part of the construction recovery. In addition, policy-makers are currently debating whether owner-occupied housing should be made eligible for individual retirement accounts under the so-called Riester-Rente next year. Extending the list of eligible assets under the government-subsidised funded pension scheme could be an important catalyst in boosting homeownership in Germany, we think. The government’s recent Rentenbericht underlines that the statutory Pay-As-You-Go pension system will have to be scaled back noticeably over time (from a current replacement rate of 53% of gross wages to 46% in 2020) despite a freeze in nominal pensions until 2009 and a gradual increase in the statutory pension age from 65 to 67 years by 2029. Along with potential changes to the Riester-Rente next year, the phasing-out of the favourable treatment of the Entgeltumwandlung in the context of corporate pension plans after 2008 would remove the current asymmetry between corporate pension schemes and individual ones. As real estate is essentially a long-duration, inflation protected asset, which can be used to live in, a more prominent role for owner-occupied property could be an important catalyst for a move toward more homeownership. The change in the population pyramid in the coming years should help to raise homeownership further, we think. Using available age-specific homeownership rates and future demographic projections, we estimate that the share of homeowners could rise between 0.25 and 0.5 percentage points per year in the coming ten years. Changes in behaviour, however, imply that the demographic drift could be smaller. A number of near-term factors bode well for the propensity to buy a property. First, affordability has improved noticeably since mid 1990 with house-price-to-income and house-price-to-rent ratios dropping sharply. Second, interest rates are likely to remain low by historical standards. Third, a turnaround in the labour market, notably for jobs subject to social security contributions, seems to be in the making. Academic studies show that households’ aversion against income uncertainty rather than credit constraints are a drag on the decision to buy. A further rise in female labour-market participation should help to diversify income risk further. Finally, the new insolvency legislation introduced in 1999, at least at the margin, reduces the adverse effect of debt default. At the same time, a number of factors, which have propelled property markets in other parts of Europe towards the stratosphere, are unlikely to be present in Germany. German households are already heavily indebted, with household debt amounting to 105% of disposable income, a level only surpassed in the US, the UK and Japan. In addition, there is probably still a considerable, albeit shrinking, supply overhang in the German property market.
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View on Excess Liquidity
Mar 24, 2006
Takehiro Sato (Tokyo)
Opinion is still divided on the impact of the end to quantitative easing (‘QE’). The optimists say that, even with the BoJ’s increased supply of liquidity, the excess reserves did not seep much into the economy and asset markets. Hence, a tightening of the supply of funds should not have much effect. The pessimists, however, see the surfeit of funds supplied by the BoJ as the source of the global excess liquidity, which they now expect to dry up if the BoJ cuts off some of the supply. Pessimists’ argument based on unwinding of carry trades The pessimists are most concerned about the unwinding of yen carry trades by hedge funds because of a possible drying up of ultra-low-cost yen financing following the end to QE and higher funding costs if the BoJ starts to raise rates. They expect a sharp pullback in emerging markets and strong yen-buying pressure as a result. However, we have doubts about this view. The boom in yen carry trades was around 1998, when Japan faced a financial crisis. Japanese banks had weak credit and difficulties raising foreign currency-denominated financing; to do so, they had to pay a high premium and use currency swaps. Their counterparts, foreign banks, built up substantial amounts of yen funds that came from Japanese banks. It was widely believed that these funds were the source of the carry trades. However, now that Japanese banks have improved credit ratings, they do not need to use swaps to raise foreign currency-denominated financing. This also means that foreign banks’ yen funds are not building up. We thus strongly doubt whether substantial yen carry trade positions have built up. Another important element is the strong conviction that the yen will weaken, on the assumption that hedge funds have sizable yen carry trade positions. After all, a 5% rise in the yen’s value, even with a 4.5ppt spread in policy rates in the US and Japan, would wipe out any carry trade returns. However, we are skeptical that they would close out their positions just because the policy rate differential looks likely to narrow to 4.25ppt. They are counting not only on rate differentials but also exchange rate gains, in our view. We wonder whether they would even take such positions in the first place, despite the absence of strong expectations among market participants that the yen will weaken the way it did in 1998. During our recent visit with more than a dozen European investors, including a number of hedge funds, they all said they had not engaged in yen carry trades. Assuming, for argument’s sake, that they do have such positions, we would expect market volatility to have substantially increased as they immediately closed out their positions, being sensitive as they are to information and sensing the BoJ was close to ending QE. It turns out that the currency market is fairly calm even now, after the official BoJ decision. Major stock markets have held up well, after the digestion of the bad news. We think these trends demonstrate that the pessimists’ concerns are almost groundless. What would change with the end of ZIRP? If the BoJ does away with ZIRP, what would happen? On the question of timing, we believe that the chances of a rate hike being brought forward to the summer are increasing, judging by the groundwork being laid by the prime minister’s camp for a call on the end of deflation before Koizumi leaves office in September. In that event, the markets would very likely show a renewed awareness of liquidity risk since the BoJ is no longer committed to supplying unlimited liquidity in order to keep rates at zero. Would such liquidity concerns be an ongoing drag for the markets? We favor the optimistic view here. Namely, even if Japan’s policy rate moves up a shade it is hard to imagine this having a significant impact on the risk preference of investors. The short-term money markets have already discounted for two or three interest rate hikes within this year, and in turn for four or five within the next 12 months. A rate hike would simply confirm what is already expected, in our view. In this context, an increase would likely moderately raise the carrying costs of holding equities, but is hardly likely to spook investors. We see little likelihood in the first place that investors’ commitment to Japanese equities would waver as a direct result of ditching ZIRP. Although valuations in the Japan’s stock market as the country pulls out of deflation are expensive, the momentum of change continues to make investment opportunities look inviting, in our view. For the bond markets, the prospect of further strength for prices in April and concern about an earlier rate hike make for conditions that continue to militate against a fall in yields, in our view. However, conditions would be less conducive to predictions of interest rate hikes from May, when the price data is likely to be spottier. This makes CPI data for April coming out on May 26 of critical importance for reading the course of the markets in F2006. With restructuring drives over recent years having led to improvements in productivity, downside price risk ahead cannot be dismissed, in our view. This applies particularly to July nationwide CPI data coming on August 25, when revised compilation standards carry a risk that the index will turn negative YoY. This circumstance could dramatically alter the market’s perceptions of where interest rates are headed. In this sense, our impression is that regardless of the timing, the markets may be pricing in a larger hike than is likely. In this light, it is comparatively easy to guess where forex markets might go. Our currency strategy team is betting on a rise in the yen against the dollar, amid an outlook for structural dollar weakness as the BoJ moves to tighten. But I personally do not endorse that view. The outcome of a retreat in the market’s current implied expectations for excessive rate hikes should be another leg of yen depreciation. And, as the Fed’s cycle of tightening comes to an end, this trend should be amplified as dollar assets become more appealing to investors.
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The Output Gap - Less Truth than Tongue
Mar 24, 2006
Robert Alan Feldman (Tokyo)
Recent press reports have blared the purported closing of the output gap — the gap between actual and potential GDP. Unfortunately, the output gap has thus been transformed into a political football. The politics imply that the BoJ might be able to hike rates very early, perhaps as early as this summer. Regardless of politics, one thing is clear: Placing faith in any calculation of the output gap would make senior officials look amateurish — and would damage confidence in policy making. The reason is clear from an examination of the four weaknesses of output gap calculations. Weakness Number 1: Poor Data The first problem with output gap calculations is that they are based on GDP, capital stock, and labor market data, all of which are subject to distortions and revisions. Capital stock data — which are required in calculation of production functions behind certain types of output gap estimates — are notoriously hard to estimate. Labor hours are hard to estimate, and intensity of work is impossible. Weakness Number 2: Arbitrary Methods of Estimate Even if the data were perfect, extracting potential output from the data is subject to many uncertainties. Just as different cultures draw different pictures from the same stars, different formulae generate different estimates of the output gap from the very same data. Moreover, there are two totally separate types of estimation techniques. The first technique uses a statistical filter — i.e. some method of extracting signal from the noise of the data. Filters all use past data for GDP alone to extract an underlying value, and then call that value potential GDP. For example, a 20-year natural log linear trend line calculation, through the end of 2005 implies that the output gap was slightly negative (-0.7%) in 4Q05. Unfortunately, the results are highly sensitive to the end points of the calculation and the length of the sample period. For example, a ten-year log linear trend calculates that actual GDP would exceed potential GDP by about +3.4% in 4Q05. A five-year trend yields an output gap of about +1.5%. Thus, even the simplest of filters can generate very different results, depending on sample length. Complex filters are far less transparent, and thus more likely to deceive. The second estimation technique uses a formal production function, i.e. an equation that relates the output of the economy to the inputs (e.g. land, labor, capital). Even if the data on inputs were perfect, there is a problem in specifying the equation for the link. The most common method is the so-called Cobb-Douglas formula, which gives output as a product of capital and labor inputs, each raised to a power. Alternative forms for production functions can generate wholly different output gap estimates. Even worse, there is no way of knowing which formula is right, just as there is no ‘right’ way of connecting stars into constellations. Weakness Number 3: Poor Estimation Accuracy Third, any estimate of potential GDP at a point in time is accompanied by a statistical error. Even the best estimate from an equation may not be very good. For example, in the natural log trend method described above, the standard error of estimate for the 5-year trend version is 1.08%-pts for the period ending in 4Q05. Thus, the 95% confidence band is -0.63% to 3.69%. For the 20-year trend version, the standard error is 4.2%-pts, leading to a 95% confidence band of -8.1% to +7.7%. It seems imprudent to base major policy decisions on estimates that are so uncertain. Weakness Number 4: Poor Connection to Inflation Fourth, the measured output gap often does not correlate with measured inflation. Without a reliable correlation, there is little meaning in declaring an end to deflation on the basis of an output gap. In Japan, the relationship between measured output gaps and inflation is very weak. Between the trough of core inflation at -0.87%YY in 3Q02 and its increase to +0.07%YY in 4Q05, the measured output gap (based on the 20-year log linear trend) has improved from -8.1% to -0.7%. Each 1%-pt shrinkage of the output gap was accompanied by only a 0.15% rise of core inflation. At this pace, actual GDP would have to exceed potential GDP by 6.2%-pts, in order for core inflation to hit the 1% YY, the center of the BoJ’s reference range. Conclusion Calculating output gaps is an important part of economic research. The results of such estimates are an important support for policy making. However, the evidence demonstrates that output gap calculations must be subjected to intense scrutiny. Their weaknesses are so many and so serious that no single estimate of the output gap should play a central role in policy decisions. Output gaps have more noise than signal, and less truth than tongue. To give them a large role in policy would merely invite error.
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