The Nat-EUR-al Rate of Interest (Part I)
May 03, 2006
Joachim Fels (London) and Manoj Pradhan (London)
“The neutral rate itself is a very complex, Wicksellian concept. It is one of these concepts on which, of course, you could see a lot of different analysis and a lot of different opinions. I would only say that we are in a process of normalisation, we are in the process of countering inflation risks that we have seen as being on the upside for some time.”
Jean-Claude Trichet at the press conference on April 6, 2006. Trichet’s tricky tool As the quote above (together with various speeches and articles in the Eurosystem’s publications) illustrates, ECB policy makers are well familiar with the concept of a neutral, or natural, rate of interest, usually defined as the interest rate that would keep inflation stable over the medium term. If estimated properly — as an unobservable variable it has to be estimated — the natural rate of interest can serve as a reference point or benchmark for assessing whether monetary policy is accommodative, neutral or restrictive. It is thus a potentially powerful tool for monetary policy makers and financial market participants alike. The ECB is usually quick to point out that the concept of a neutral rate does not play a prominent role in its monetary policy strategy, which focuses instead on a broad-based assessment of risk to price stability emanating from economic and monetary factors. However, policy makers’ recent statements, such as the one from President Trichet quoted above, that euro area interest rates need to be ‘normalised’ implicitly require an idea about the ‘normal’ or ‘natural’ level of interest rates. In fact, internal estimates of the natural rate are part of the information set that the ECB council uses (along with many other indicators) in its deliberations on monetary policy. In this note, we present for the first time our proprietary estimate of a time-varying, Wicksellian natural rate of interest for the euro area and discuss its implications for monetary policy and bond markets. This note should be read in conjunction with our earlier note, In Search of the Natural Rate of Interest (February 10, 2006), where we first presented our estimate of the natural rate for the US economy based on the same methodology. Wicksell’s wiggly widget In a nutshell, Swedish economist Knut Wicksell (1898), who devised the concept, thought of the natural rate as “the level of interest on loans which is neutral in respect to […] prices, and tends neither to raise nor to lower them”. If the central bank sets an interest rate below the natural rate, bank lending would pick up 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, if the central bank sets interest rates above the natural rate, bank lending, the economy and inflation would slow. Importantly, Wicksell’s natural rate is not a constant. For example, a slowdown in productivity growth or in population growth or a rise in households’ propensity to save would lower the natural rate of interest. This makes it immediately obvious that the commonly used approach of calculating the natural or equilibrium rate by taking long-term averages of actual interest rates, as is often done when calibrating Taylor rules, is inadequate. As our earlier results for the US showed, the natural rate has undergone considerable trend changes and fluctuations over the past 40 years. A priori, we would expect the natural rate in Europe to have been even more variable than in the US, given the many changes in European macroeconomic policy regimes and the changing underlying dynamics of the European economy over the past few decades. We describe our model and estimation method in more detail in the Appendix of our full briefing note and in the earlier note on the US. Here, we only focus on the results and their interpretation. Big swings in the natural rate over time As Exhibit 1 in the full briefing note illustrates, the real natural rate of interest in fact exhibited significant fluctuations over the past 30 years, oscillating between 1.25% and 3.25%. The low point of this range was reached during the recession of 1982, when the European economy had been weakened by the two oil shocks of 1973 and 1979, a trend decline in productivity growth starting in 1973, runaway inflation and excessive government regulation. During the 1980s, the natural rate rose significantly to more than 3% in 1989 as the economic environment improved, but then declined during the first half of the 1990s when the European economy slumped. Following a pick-up in the second half of the 1990s — a time of stronger growth and significant deregulation of the European economy — the natural rate of interest fell from a local peak of 2.4% in 1999 to a low of 1.3% in late 2004. Since then it has recovered only marginally. Adding the current annual increase of HICP inflation (2.2%) yields a current estimate of 3.5% for the natural rate of interest in nominal terms. As the single currency was only introduced in 1999, and the pre-1999 euro area data for GDP, inflation and interest rates are merely a synthetic aggregate of data for the participating countries, which had different monetary policy regimes, these estimation results for the 1970s, 1980s and most of the 1990s should be taken with more than the usual pinch of salt. In what follows, we therefore concentrate on the evolution of the natural rate in the first seven years of the euro’s existence. A one point decline since 1999. Why? As noted above, our estimates show the real natural rate of interest declining by around one percentage point to a current level of 1.3% or so since the start of EMU in 1999. Such a steep drop raises the question of whether this is a plausible estimate and what factors might account for such a shift. We have two complementary explanations for why the natural interest rate may have fallen over the last seven years. The first is that the factors that Wicksell mentioned as potential movers of the natural rate over time have all worked towards lowering the natural rate since the start of EMU. Both productivity growth and population growth have eased, which should depress the real equilibrium interest rate. Also, private households’ propensity to save has probably increased, due to a growing realisation that public pension systems will not be able to deliver on earlier promises. A higher propensity to save would also tend to depress the real equilibrium interest rate. However, we have difficulty believing that the glacial changes observed in productivity, population and savings trends would be sufficient to explain the fairly large estimated decline in the natural rate of interest since 1999. Something else is likely to have been at work in addition to these factors. We find it plausible to ascribe at least some of the decline in the natural rate to the fact that the ECB quickly acquired a high degree of credibility in terms of its commitment to keep inflation low. Recall that in the years prior to 1999 there was no unified monetary policy in Europe. While central banks increasingly shared a common low-inflation philosophy already before EMU, and monetary policies were linked via a system of fixed exchanged rates with the Deutsche mark (de facto though not de jure) as the anchor currency, there was still a non-negligible risk of exchange rate realignments and considerable uncertainty as to whether the nascent ECB would be able to keep its promise of price stability. As a consequence, at least in the run-up to and in the early phase of EMU, a higher natural interest rate was required to keep inflation in check. Yet, as the ECB quickly gained credibility, the natural rate declined. Put differently, its rising credibility allowed the ECB to progressively keep interest rates lower than otherwise, without endangering the objective of price stability. We think that this could well be the main reason why the natural rate of interest in the euro area has declined by a full percentage point since the start of EMU. ECB policy still very expansionary at 2.5% refi rate Turning to the present situation, the most important conclusion that derives from our nat-EUR-al rate estimate is that the current stance of monetary policy in the euro area remains very expansionary, even though the ECB had raised the refi rate by 50bp to 2.5% since December. With headline HICP inflation at 2.2%Y in March, the current real refi rate is only 0.3% and thus a full percentage lower than our present estimate of the real natural rate of 1.3%. The difference between the actual and the natural rate is called the real interest rate gap and is depicted in Exhibit 3 of our full briefing note. A negative real rate gap signals an expansionary monetary policy stance and would, according to our model, tend to push output growth above trend and inflation higher over the medium term. The size of the real rate gap (some 100bp presently) gives a rough indication of the size of rate hikes needed to return monetary policy to a neutral stance, which would be consistent with the economy growing at its trend pace and with stable inflation. Thus, if the ECB is serious about normalising interest rates, our nat-EUR-al rate estimate suggests that it still has quite some way to go. Putting Wicksell back into the natural rate In Wicksell’s theory, deviations of the actual interest rate from the natural rate set in motion a process of credit creation or contraction, which in turn drives the business cycle and prices. If actual interest rates are below (above) the natural rate, credit growth should thus accelerate (decelerate). This relationship between the real interest rate gap and credit growth can, in fact, be observed for the euro area. As Exhibit 4 in the full briefing note illustrates, euro area credit growth (like the ECB, we use bank loans to the private sector as the preferred measure for credit) accelerated in response to the negative real interest rate gap during the first two years of EMU. When the ECB pushed actual rates above the natural rate in the tightening cycle of 2000, credit growth started to decelerate, bottoming out in 2003. Since then, as a lagged response to the emergence of a significant negative real interest rate gap reflecting the ECB’s rate cuts during the 2001-03 period, credit growth has accelerated sharply into double-digit territory. Exhibit 5 in the full briefing note shows the negative correlation between the real interest rate gap and both credit growth and inflation for up to eight quarters ahead. As predicted by Wicksell’s theory, a positive (negative) real rate gap produces a deceleration (acceleration) of both credit growth and of inflation. Thus, watching credit developments closely, as the ECB does, is an alternative way of judging whether the actual policy rate is above or below the (unobservable) natural rate. Tune in tomorrow for Part II of this piece, which compares our estimate for the euro area natural rate with our earlier estimate for the US natural rate and discusses the implications for the transatlantic bond yield spread.
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Productivity-Driven Monetary Policy
May 03, 2006
Serhan Cevik (from Cairo)
Though the surge in oil prices is a challenge, more powerful currents keep disinflation on track. The price of a barrel of crude oil recently hit the peak of $75, sending shockwaves across the global economy and putting upward pressure on production costs, especially in oil-dependent economies. Given its increasing reliance on energy imports, Turkey is particularly vulnerable to the rise in oil and natural gas quotes. In addition to a growing import bill, higher energy prices have already contributed as mush as 150bp to headline inflation and consequently slowed the pace of disinflation. This is why we recently revised our inflation forecasts from 4.8% to 5.4% at the end of this year and from 3.6% to 4.0% in 2007. However, these changes in the inflation outlook reflect first-round effects of higher-than-expected oil prices, not a reversal in Turkey’s secular disinflation process. Despite the possibility of more pronounced effects in the coming months, we still believe that there are far more powerful structural changes that will balance out inflationary pressures arising from the energy shock. Core measures of inflation remain in line with the central bank’s target path. If you track inflation in the past 18 months, you would see nothing much changed in terms of the headline figure. However, that would be a misleading — and backward-looking — way of analysing Turkey’s inflation dynamics. The ‘stickiness’ in inflation is mainly a result of the rise in energy quotes and ‘unusual’ price increases in the alcohol and tobacco component of the consumer price index. As a matter of fact, the ‘core’ measure of inflation, excluding these two factors, fell from an annual average of 8.6% in 2004 to 7.3% last year and 6.5% in 1Q06. Moreover, adverse weather conditions earlier this year resulted in a sharp rise in unprocessed food prices. Thus, the CPI excluding food and energy shows an annualised inflation rate over three months of -1.5% in March (and an average of 2.9% in the first quarter), down from 7.7% last year. In other words, apart from the usual suspects (including the inertia in non-tradable prices), core measures of Turkish inflation remain on track towards the ‘price stability’ range. Prudent policies and structural changes limit the indirect effects of higher energy prices. Even though the direct effect of higher oil prices is enough to warrant an upward revision to our inflation projections, the future direction of inflation depends on second-round effects in non-energy sectors. We are confident that the continuation of prudent macroeconomic policies (including incomes policies in line with the central bank’s multi-year target path) would contain second-round inflationary effects of higher energy prices. In particular, the end of fiscal dominance — the public-sector borrowing requirement declined from the peak of 16.4% of GDP in 2001 to 0.8% last year — should continue anchoring inflation expectations and therefore wage growth and pricing behaviour in the corporate sector to the multi-year targets. Increased competitive pressures rein the pass-through to consumer prices. Inflationary inertia and relative price adjustments in sectors close to competition limit the pace of disinflation in non-tradable prices, but Turkey’s deepening integration with the global economy and normalisation of its macroeconomic landscape have heightened the competitive environment in sectors open to international trade and forced companies to keep a tight rein on unit labour costs. There is indeed a significant inverse relationship between openness and the behaviour of mark-ups. Those sectors with a higher degree of exposure to international competition have higher productivity growth and lower price-cost margins (see The Wal-Mart Effect without Wal-Mart, January 30, 2006). Turkey’s macroeconomic stabilisation and global forces shifting the supply curve function like an instrument of structural change and effectively curb the rate of price increases. For example, productivity growth, accelerating to an annual rate of 8.5% in the post-crisis period, resulted in an unprecedented 40% drop in unit labour costs. In our view, this is a sustainable phenomenon, thanks to the corporate sector’s growing appetite for investment spending that will keep productivity growth at an above-trend pace and push the economy’s production frontier to a higher plateau. Productivity growth, shifting the supply frontier, paves the way for further monetary easing. The rise in total factor productivity growth — from an annual average of 0.5% in the 1990s to around 5% in the post-crisis period — has minimised the volatility of the business cycle and raised the level of potential output. This is why, despite a 33.5% increase in real GDP in the last four years, the Turkish economy is still operating with an output gap that keeps inflationary pressures at bay. Even though higher energy prices slow the pace of disinflation, excess capacity — not just in Turkey but also in the global economy — prevents an abrupt built-up of demand-driven inflationary pressures (see our chief economist Stephen Roach’s report on the global output gap, The Global Price Rule, April 10, 2006). All in all, the balance between aggregate demand and potential supply points to a non-inflationary growth trajectory and therefore allows the Central Bank of Turkey to lower short-term interest rates by as much as 125bp in the remainder of this year.
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Growth Remains Strong in 2Q06; 3Q06 May See Deceleration
May 03, 2006
Andy Xie (Hong Kong)
Global economic growth accelerated to 5% in 1Q06 — the strongest rate since 2Q04 — compared with 4.5% in 4Q05. Momentum remains good in 2Q06, such that the quarter could see growth of above 5%, close to the cycle high of 5.3% in 2Q04. The growth acceleration is due largely to growth spreading from the US-China axis to Europe and Japan. This growth momentum could shift down in 3Q06, due mainly to the effects of tightening on the China-US axis. China’s credit tightening could hold down investment in 3Q06. Rising bond yields could dampen US consumption. I believe that inflation may accelerate despite the slowdown. The scope for substitution between service and manufacturing in OECD countries has diminished. The global output gap may be closing despite pockets of overcapacity in China. The second wind The current cycle began in 3Q02. The GDP growth of Asia ex-Japan accelerated from 5.7% in 2Q02 to 8.4% in 2Q04. Instead of decelerating post the peak, as in previous cycles, this cycle has seen a second wind that began in 2Q05. The growth rate of Asia ex-Japan bounced back from 7.1% in 1Q05 to 8% in 1Q06. As momentum remains good in 2Q06, it would appear that growth in the current quarter could reach close to the level seen in 2Q04. The second wind in this cycle is due largely to two factors. The US-China axis was the key driver during the first phase of acceleration. The buoyant US housing market, resulting from low bond yields, kept US consumption strong after the tech burst. China’s property investment accelerated, too, on low US interest rates. China’s investment boom triggered a commodity boom that spread growth to emerging economies. Japan and Europe benefited from exporting more during the first phase, but did not contribute as much to global growth. The situation has changed in the past five quarters. Europe and Japan are contributing more. The multiplier effect from the first wave of growth is causing the second wave. The nature of the second wave effect can be observed in the trend of Asia’s trade account balance. The trade surplus of Asia ex-Japan declined to US$24.4 billion in 1H04 from US$46.5 billion in 1H02, indicating a meaningful contribution from Asian domestic demand in the first wave of growth. In contrast, the region’s trade balance increased from US$21.3 billion in 1Q05 to US$31.3 billion in 1Q06, despite a 40.6% increase in the Dubai crude price. Without the extra import costs, the region’s trade balance would have surged 114.1% instead of 46.9%. The improving trade account contributed to about two percentage points of the region’s growth in 1Q06 — i.e., the Asian growth story was a trade story. Financial globalisation has contributed to the strength of the multiplier effect in the global economy (see The Stir-fried World, April 21, 2006). This force has allowed national economies to ignore their balance of payments for the time being and not to tighten against inflation as much as before, as global capital flows to tightening economies, keeping interest rates low. Financial globalisation has caused inflation to react to the global output gap rather than national output gaps, increasing the multiplier effect from the spread of growth and prolonging the cycle. Growth momentum remains strong in 2Q06 Korea’s exports grew by 12.6% YoY in April, compared with 10.7% in 1Q06. European forward indicators continue to point upwards (see Slowdown? What Slowdown? Eric Chaney, April 28, 2006). Japan’s composite leading indicator was 2.2% higher in January-February 2006 than in 4Q05, and the leading diffusion index was 45% higher. US personal income rose by 0.6% in March 2006 after rising by 0.2% in February and 0.9% in January. China’s tightening measures are not biting yet. The effect of the massive loan growth in 1Q06 is likely to show up mainly in 2Q06. The tightening measures should impact demand in 3Q06. In summary, the global economy remains quite strong in 2Q06. Momentum appears strong in Europe and Japan and remains solid on the China-US axis. Rising commodity prices in 1Q06 should have provided emerging economies with extra growth momentum. Hence, it seems possible that the global economy could grow at above 5%, close to the 5.3% peak in 2Q04 during the first wave of growth. 3Q06 could see a significant slowdown Fed Chairman Bernanke is so worried about the US economy slowing down that he announced on television that the Fed would stop raising interest rates at the meeting after next regardless of the data flow in the meantime. I believe that there will be a global slowdown in the third quarter, originating from the US, China and emerging economies — i.e., the growth stars in the first wave will be the first to shine less brightly. I see three reasons for a 3Q06 slowdown. First, China’s tightening should bite in 3Q06. China’s loan growth doubled YoY to Rmb 400 billion per month in 1Q06. This loan acceleration caused the economy to accelerate in March 2006, and the momentum remains strong in 2Q06. The tightening is likely to slow loan growth to Rmb 200 billion per month again. The impact on the economy should be visible in 3Q06. Second, I expect a meaningful slowdown in the US due to rising bond yields and gasoline prices. Chairman Bernanke has stated that a slowing housing market, rising gasoline prices and higher interest rates should slow down the US economy soon. The strong labour market and robust income growth offset these negative factors for now. A more worrying sign for US consumption is the steepening yield curve. This is a global phenomenon, indicating that global liquidity is tightening owing to the cumulative effect of strong growth and interest rate hikes. The higher bond yields should further slow the US housing market. As the US consumer is mostly leveraged at the long end, rising US bond yields could have a meaningful effect on US consumption. Third, the steepening yield curve could cool commodity speculation and trigger a slowdown among emerging economies. Surging commodity prices are the result of strong demand and financial speculation. The latter is more important, in my view. Financial demand is growing faster than China’s demand for oil, copper and many other commodities. Rising inventories and higher prices have become the norm in the commodities universe. High commodity prices have been good for global growth, as they have given spending power to erstwhile financially depressed emerging economies, while the negative effects on OECD consumers have been mitigated by the availability of cheap credit. A flat yield curve is a necessary precondition for commodity speculation, as it keeps down the holding cost. When the yield curve steepens, it increases the cost of speculation. I estimate that the global yield curve could steepen by 100bp through the remainder of this year. This could reverse commodity speculation, which would slow down emerging economies at the margin. I think that the 3Q06 slowdown is likely to be mild, with the global economy growing by perhaps 4.5%. It may be enough to cause another growth scare, which could decrease speculation. As the Fed is in ‘pause’ mode already, levels of risk appetite are likely to decrease gradually. Inflation will likely accelerate I believe that inflation is likely to surprise on the upside in coming months. When central banks realise that inflation could get out of hand, they may have to tighten despite decelerating growth. This is how this cycle is likely to end, in my view. Inflation has been creeping up slowly everywhere. Central banks have been using the relative stability of core CPI to justify a gradual tightening stance. The slow spread of headline CPI into core CPI is due to globalisation checking wage growth in the OECD consuming economies. Nevertheless, globalisation has slowed, not stopped inflation spreading into core CPI from headline CPI. I see two factors that may cause inflation to accelerate globally. First, the substitution scope between tradable and non-tradable economic activities has diminished. The OECD consuming economies have been able to deal with inflationary pressure in the service sector by shifting labour from manufacturing to services and shifting manufacturing to China. The current wave of manufacturing migration is being driven by the relocation of electronics manufacturing to China. This process is coming to an end. Other industries, such as equipment production, may migrate to China in future. However, the OECD countries are trying to hold onto these industries for as long as possible. Manufacturing is likely to compete for labour against services in the OECD economies now. The low unemployment rates in the US and Japan could accelerate wage growth and inflationary pressure. Second, the global output gap looks to be closing, after nearly four years of above-trend growth. There are still pockets of excess capacity (commodity industries in China are the notable examples). However, their deflationary effect is limited by rising prices of raw materials and already thin margins for such industries. In short, China’s overcapacity is not exerting deflationary pressure on the global economy as before. I view the inflationary trend in Australia as a harbinger for the US and other OECD economies. Australia’s housing market has been soft for two years. Its economy has been weak for the same period. However, inflation has remained high and picked up in 1Q06, triggering another rate hike by the RBA after pausing for 14 months. The lesson from Australia is that, after boiling growth for several years, inflationary pressure has remained intense during a gradual slowdown. The major central banks have got used to the notion that inflation does not pick up fast and they have the luxury of time in tightening. Whenever there is doubt, central banks nowadays err on the side of easing, the opposite approach to that adopted in the 1980s. The slow response of inflation to demand in this cycle is due to globalisation — more or less a one-time benefit. As the disinflationary force from globalisation is absorbed, inflation is likely to become sensitive to demand once again. This is why I believe that the big central banks will pay a high price for their gradualism. Inflation will stabilise at a higher level due to this policy. The casualty will be bond yields. The world is just entering a bear market for bonds, in my view. The bear market will take time to unfold but will be very long-lasting. For bond investors, it may be a case of ‘death by a thousand cuts’.
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Twin BoP Surplus on Strong Exports and Rmb Optimism
May 03, 2006
Denise Yam (Hong Kong)
2005 balance of payments released. The State Administration of Foreign Exchange has released China’s 2005 balance of payments (BoP) data. In line with the gigantic jump in forex reserves, the overall BoP surplus came in at US$207 billion in 2005, similar to that in 2004. The current account surplus surged beyond expectations to US$160.8 billion, or 7.2% of GDP, from US$68.7 billion in 2004, while the financial account surplus was smaller than expected at US$58.9 billion, down from US$110.7 billion in 2004. Goods surplus expands on excess manufacturing capacity. The BoP goods surplus (FOB exports - FOB imports) jumped to US$134.2 billion from US$59 billion in 2004, as resilient global demand gave continued support to exports, while import growth lagged amid excessive local production capacity. Excess supply in the domestic market made manufacturers more aggressive in pushing shipments abroad, which we believe will sustain a respectable trade surplus over the next few years. Steady growth in services trade. Invisible trade posted a similar deficit (US$9.4 billion) as in the previous year (US$9.7 billion), with steady growth seen in both service exports (+19.2% to US$74.4 billion) and imports (+16.2% to US$83.8 billion), though slowing from the pace seen in 2004 (+33.6% and +30.4%, respectively). Though becoming a larger net exporter of tourism-related services (US$7.5 billion, +14% YoY), China remained a net and larger importer of transport services (US$13 billion, +4% YoY), insurance (US$6.7 billion, +16%) and patents and royalties (US$5.2 billion, +21%). Upside current account surprise came from factor incomes. The upside surprise in the current account came through the swing in net factor incomes from deficit since 1993 to a surplus of US$10.6 billion in 2005, evidence of how China has become an increasingly ‘outgoing’ economy, as an active investor in foreign businesses and financial assets. In particular, China reported US$35.6 billion ‘profit from investment’ in overseas assets in 2005, up from US$18.5 billion in 2004, swinging the investment income account into surplus. Smaller financial account surplus indicates cooler RMB speculation sentiment… The long-awaited revaluation in the RMB took place in July 2005, calming speculative capital inflows thereafter. Needless to say, there continue to be significant flows into RMB assets in anticipation of further currency appreciation, but the latest figures suggest that aggregate flows have cooled. The overall financial account surplus trended down to US$22.7 billion in 2H05, from US$36.1 billion in 1H05 and US$110.7 billion in 2004. …as reflected in ‘other investment’ deficit in 2H05… Inflows associated with renminbi optimism during 2004 were most evident in the ‘other investment’ account, which saw a US$37.9 billion surplus in the year. In 2H05, however, China saw the first net outflow in ‘currency and deposits’ since 2H03 of US$6.5 billion, and a large outflow in terms of loans made to overseas borrowers (US$17.4 billion). …and portfolio outflows as well as errors and omissions. In terms of securities investments, Chinese investors stepped up purchases of foreign portfolio assets (US$17.7 billion) in 2H05 (total US$26.2 billion for 2005), versus net repatriation of US$6.5 billion in 2004. The ‘errors and omissions’ item in the balance of payments accounts noted a negative entry unseen since 2001, of US$16.8 billion. BoP surplus seems likely to be sustained for a few more years. China’s balance of payments surplus has always been quoted by the US and China’s other trading partners as evidence that the RMB is undervalued. The 3.3% appreciation since July 2005 is often criticised as insufficient. The gradual appreciation in the renminbi and the expectations for further gains are sustaining capital inflows, complicating the management of monetary conditions. Foreign reserves increased by another US$56.2 billion in 1Q06, even exceeding the US$49.2 billion gain in 1Q05, suggesting a persistent BoP surplus. In our view, the significant investment in manufacturing capacity in the past few years over and above that which can be absorbed by domestic demand will likely sustain China’s large trade surplus in the medium term. To ease the BoP surplus, we believe that China will further relax restrictions on outward investments. The recent move to allow investments in foreign securities by local financial institutions was a step in that direction. Similar moves will come in a gradual manner, we believe. In other words, China’s BoP surplus is likely to be sustained for at least a few more years.
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What the RBA Hike Means
May 03, 2006
Gerard Minack (Sydney)
Today the RBA lifted its cash rate target to 5.75%, a move expected by markets, the buy-side consensus, but not by the sell-side (economic) consensus. Short-end futures have now moved to price in a slightly-higher-than-50% chance of another 25bp tightening before year-end. A few thoughts: The tightening makes me more confident on the downside in 2007. Of course, a single 25bp tightening is not a decisive, view-changing move, but with leverage at all-time highs, a 25bp change will have a bigger impact than it used to. Moreover, this impact of this tightening could extend beyond the direct financial drag of higher debt-service payments. That's because there remains a resilient view that house prices will go up — as seen by the ongoing very high levels of new money flowing into investment properties — and the ongoing use of home-equity extraction. Put another way, the RBA could get quite a big bang with today’s 25bp buck. Today’s move makes me more willing to bet against a consumer revival this year. This is partly because I think that the RBA is misreading the consumer (see next point), but also because the escalation of interest payments means that the household sector is getting more, not less, stretched. Net interest payments are now rising dollar-for-dollar with income tax payments or, put another way, the escalation in interest payments can quickly swallow up any tax cuts. I continue to disagree with the RBA’s reading of the economy. Two points of disagreement are noteworthy. First, I think that a lot of the recent strength in consumer spending has largely been driven by temporary factors — notably the reversal of petrol price increases from late 2005 and a warm summer — rather than “the dampening effects of household balance-sheet adjustment on consumer spending starting to wane”, as the RBA suggests. The recent strength in sales (almost 7% at an annual rate over the past three months) can been seen as payback for the very weak spending in the prior three months (growth of only 1%). Second, I think that business investment will make a diminishing contribution to growth over the next 18 months. Don’t confuse levels with changes — yes, everything indicates that business investment will keep going up, but there are lots of signs that it won’t rise as fast as it has over the past few years. Exhibit 4 in the full report shows business investment growth with the deceleration implied by taking the latest forecasts from the ABS survey and (critically) assuming the usual gap between the forecast and what eventuates. It may be that, as with last year, firms will again dramatically underestimate their ultimate investment spending — but that’s the assumption you’ve got to back if you want to claim that investment spending will keep making the same contribution to growth in the next year as it has in the past year. Today’s statement did suggest a couple of interesting things about the RBA. First, its comment that core inflation was already at 2.75% confirms that the key CPI measure it watches is its own — the trimmed mean/median. (All the other core measures were much better behaved than this.) Second, the comment on lending continues a pattern where the RBA frets about skinny credit pricing. This concern is spot on, in my view. If the banks haven’t already written loans that will blow up in their faces, they’re doing it as we speak. I believe that they will, at some stage, be a big sell. Bottom line · Today’s move has increased my confidence in the big bear view on Australia. · Today proved me wrong on the next-move-is-down call for the RBA, but now I think that, well, the next move will be down. And there remains a chance (although probably now less than 50%) that, if my reading on the domestic economy is right, the cut comes this year. · Equity-wise, today’s news supports the strong tilt in Mark Skocic’s portfolio towards stocks with offshore earnings.
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