Dollar Spin
May 08, 2006
Stephen Roach (New York)
Dollar depreciation is back on track again, and my guess is there is a good deal more to come. The good news is that the decline now appears likely to be measured and orderly -- a welcome departure from the dollar-crisis scenario I had previously feared. The bad news is that a weaker dollar will accomplish surprisingly little in fixing all that ails an unbalanced world.
The US dollar appears to be entering the second major phase of its multi-year structural decline. The first, which lasted from early 2002 through late 2004, saw the broad trade-weighted dollar index decline 16% in real terms. The bulk of this decline was concentrated against the euro, which rose nearly 60% versus the dollar, from 0.86 on 31 January 2002 to 1.36 on 31 December 2004. By contrast, the dollar adjusted considerably less against Asian currencies; the yen/dollar cross rate appreciated by 32% from early 2002 through early 2005, whereas the Chinese currency peg remained unchanged over that period. The mistake we all made -- and I am certainly as guilty as anyone -- was in believing the dollar’s downtrend would continue in a straight line. With the consensus tightly clustered around that presumption in late 2004, the currency markets did what they always seem to do best -- go the other way. The dollar rose instead of fell for most of 2005 -- appreciating 5% in real terms on a broad-trade-weighted basis, or unwinding about one-third of the decline that had occurred over the preceding 34 months. The case for global rebalancing, which had done an excellent job in explaining the first leg of the currency realignment, was suddenly in tatters. New paradigmers came out in force, arguing that the world had reorganized itself around a “Bretton Woods II” framework -- in effect, an expanded dollar bloc that required a cheap currency for the producers/savers (Asia) and a strong currency for the recipient of surplus saving (the United States). In retrospect, the dollar’s detour of 2005 may have had nothing to do with the esoteric battle of the paradigms. It may have been as simple as an outgrowth of asynchronous moves by the world’s major central banks. Fixated on normalizing an overly-accommodative policy stance, the Federal Reserve tightened in each of its eight policy meetings of 2005; by contrast, the Bank of Japan did nothing, and it wasn’t until December of 2005 that the European Central Bank finally awoke from its slumber. With Fed normalization sticking out like a sore thumb in a world where other central banks were sitting on their collective hands, the interest rate differential -- a proxy for asset-based returns -- tilted away from dollar weakness toward strength. The saga of the interest rate differential is now, of course, going the other way. Notwithstanding unfortunate cocktail party chatter, Fed Chairman Ben Bernanke sent a clear signal in his recent testimony in front of the Joint Economic Committee that the US central bank is nearing the end of its long march toward normalization. At the same time, the BOJ has turned increasingly aggressive in upgrading its assessment of the outlook for the Japanese economy; this has prompted our Japan team to place a 90% probability on a rate hike in either June or July, which would bring an end to over seven years of ZIRP (zero interest rate policy). And Jean-Claude Trichet has just upped the ante on the ECB’s assessment of policy risks -- making a June rate hike a foregone conclusion and prompting debate over whether 25 basis points will be enough. Just like that, interest rate differentials are now tilting away from the dollar. Moreover, the G-7 communiqué of 21 April -- a major flashpoint on my own road to conversion -- provides financial markets with a framework to extrapolate these trends into the future. By voicing explicit concerns over global imbalances in the form of a rare annex to the main statement and by underscoring the need for “greater exchange rate flexibility” as the means toward this end, global authorities have drawn a new and important line in the sand. The IMF’s companion announcement of a new multilateral process of surveillance and consultation adds teeth to the rebalancing commitment. That has added more fuel to the second downleg of the dollar’s decline. The surprise to date is that it has not been more concentrated against Asia. The G-7 singled out China and other emerging markets -- code words for developing Asia -- as being the most likely candidates for adjustment. But China has not taken the bait -- at least not yet -- and the euro and yen have both appreciated by roughly the same 3 percentage points against the dollar since 21 April. The problem for me is that this all sounds too neat. Theory tells us that relative price changes are the cure for global imbalances -- specifically, that a weaker dollar will be the means by which America finally tames its gaping trade deficit. Not only should a cheaper greenback make US exports more competitive, but it should also make imports more expensive -- forcing a shift in the sourcing of domestic demand away from goods made overseas toward those produced at home. Sure, there are lags and other complications, but the standard conclusion from academia is that the broad trade-weighted dollar index needs to decline by a minimum of 20-30% in real terms in order to fix America’s current account problem. While the academics concede the fix may not completely eliminate the US current account deficit, they argue that it will at least take it down to a more sustainable range of 2% as a share of GDP. I don’t buy this logic for several reasons: First, as Stephen Li Jen has pointed out, the arithmetic of a large dollar decline has very ominous -- and politically unpalatable -- implications for other currencies (see his 12 April dispatch, “The Math of the Coming Decline in the Dollar”). By his calculation, a drop in the real effective exchange rate of 20% -- the minimum the academic consensus is looking for -- would require dollar cross rates of 1.50 versus the euro, 94 against the yen, and 6.4 against the Chinese renminbi. Similarly, a 30 % dollar depreciation would imply 1.70 against the euro, 83 versus the yen, and 5.6 against the RMB. In my view, these thresholds would evoke howls of protest and massive intervention. As such, they can hardly be considered as a realistic option for resolving the US current account deficit -- the central source of disequilibrium for an unbalanced world. Second, currency depreciation is no substitute for the tough medicine America needs in order to fix its trade deficit. In my view, it’s all about resolving a massive excess consumption problem. In the first quarter of 2006, tradable goods imports into the US were fully 83% larger than America’s exports of such goods (in real terms). This huge mismatch is largely an outgrowth of record import penetration in conjunction with an unprecedented consumption binge. By our calculation, goods imports hit a record 34% of domestic demand for goods in 1Q06 at the same time that increasingly wealth-dependent US consumption has been holding at an unheard-of 71% of US GDP since early 2002. Given the hollowing out of US manufacturing, it is hard to envision a currency correction that would enable America to export its way back to a trade balance and/or miraculously replace foreign sourcing by a rebirth of domestic production. The only realistic cure for this mismatch, in my opinion, is a post-housing bubble shakeout of the excesses of wealth-dependent consumption -- aided and abetted by a meaningful back-up in real long-term US interest rates. Those adjustments may just be getting under way. Third, globalization has fundamentally altered the transmission mechanism between currencies, trade adjustments, and broader macro impacts. This shows up loud and clear in research undertaken by the BIS over the past year as well as in more recent findings by Fed economists (see, for example, Chapter 2 of the 75th annual report of the Bank for International Settlements, June 2005, and Jane Ihrig et al., “Exchange-Rate Pass-through in the G7 Countries,” Federal Reserve International Finance Discussion Paper 851, January 2006). In an increasingly open global economy, with world trade now closing in on 30% of world GDP, the battle for market share has apparently become so intense that currency movements are now reflected more in the form of fluctuations in profit margins than by major shifts in global trading patterns. Clearly, massive currency realignments might change that result, but, as argued above, the odds of such extreme swings are quite low. Unless the forces of globalization are arrested -- something Washington-led protectionists certainly wouldn’t mind -- US trade deficits may well be here to stay. Nor do I buy the idea that the inflationary impacts of a weaker dollar may prompt a policy response from the Fed that would push up real interest rates, hit the housing market, unwind the wealth-dependent excesses of US consumption, and fix the trade deficit. Reduced inflationary impacts are an important corollary of globalization’s impact on the macro transmission of currency fluctuations (see my 10 April dispatch, “The Global Price Rule”). I do not share Dick Berner’s view that a modest cyclical tightening in US labor and product markets outweighs the powerful structural headwinds of globalization -- transforming what has so far been an orderly decline of the dollar into a more serious threat to US inflation (see Dick’s 5 May dispatch, “The Dollar and Inflation”). Take a look at what happened -- or actually, what didn’t happen -- to US inflation when the dollar sagged to record lows in the spring of 1995. The US dollar is headed lower. In a rebalancing framework, this move should be seen as a necessary, but by no means sufficient condition for fixing America’s trade deficit. The recent actions of the G-7 and the IMF, in conjunction with signals from the world’s major central banks, are consistent with a resumption of the dollar’s structural depreciation that began in early 2002. Over time, I believe this downtrend in the dollar will be reinforced by an important evolution in the reserve management practices of developing economies -- moving a significant portion of what Larry Summers estimates to be some $2 trillion of “excess” reserves out of a massive overweight in low-yielding, dollar-denominated assets into higher-yielding investments that are more compatible with urgent development needs (see my 5 May dispatch, “Imbalances Matter More than Ever”). This could well be one of the most important developments -- as well as one of the biggest risks -- currency markets will need to face in the years ahead. The major thing that has changed for me is that I no longer see a dollar crisis as a high-probability outcome for an unbalanced world. Courtesy of encouraging actions by the stewards of globalization, the fat tail has just gotten thinner. That hardly puts me in the strong dollar camp. It means, instead, that I now embrace a managed dollar-decline scenario that could take the broad dollar index down on a “measured” basis by about 10-15% over the next couple of years. What that also means, of course, is that in the end there must be far more to global rebalancing than currency realignment. The heavy lifting on the policy front has only just begun.
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Pause or Not, the Fed Has More to Do
May 08, 2006
Richard Berner (New York)
Forecast at a Glance | | 2005E | 2006E | 2007E | | Real GDP | 3.5% | 3.4% | 3.1% | | Inflation (CPI) | 3.4 | 3.5 | 2.4 | | Unit Labor Costs | 2.6 | 2.6 | 3.6 | | After-Tax “Economic” Profits | 9.4 | 14.5 | 2.2 | | After-Tax “Book” Profits | 34.5 | 12.6 | 2.7 | Source: Morgan Stanley Research E = Morgan Stanley Research Estimates US inflation risks have risen slightly over the past month, warranting another adjustment to our Fed call: The pace of monetary firming will slow after the May FOMC meeting, but we now think that the Fed will likely raise rates another 50 bp by year-end, taking the funds rate to 5½%, or 25 bp higher than we thought a month ago. Concurrently, the yield curve may invert slightly as ten-year yields peak just below the funds rate. Of course, inflation risks haven’t lately been the main drivers of price action in fixed-income markets. Unexpectedly strong US and global economic growth has been the key factor lifting interest rates so far this year, and a strong economy is the primary reason central banks around the world have been renormalizing policy interest rates or are beginning to do so. In the US, the process of normalization is essentially complete, so following strong signals from Fed Chairman Bernanke that it’s time to take stock of what the Fed has accomplished, officials are likely to pause following this week’s FOMC meeting. Indeed, while Fed officials have expressed satisfaction at the economy’s past resilience in the face of shocks, downside risks to US growth are now a factor in Fed thinking: Several officials have expressed concern about “overshooting” — the risk that policymakers overdo the tightening process. Likewise, many market participants are hoping for an end of the tightening cycle in the wake of a weaker-than-expected April increase in nonfarm payrolls and ample signs that housing is fading and higher energy prices may take a toll on growth. In contrast, while the strength of the expansion matters, we think the inflation prognosis will be the key factor influencing monetary policy for the balance of 2006. We now see core inflation measured by the Fed’s preferred metric — the personal consumption price index — rising by 2½% by year-end (in our forecast tables we show the “market-based” version of that measure, which removes the influence of prices for which there are no market measures such as financial services rendered without charge); measured by the CPI, we forecast that core inflation will rise to 2.7% by year-end. Both are 0.1% higher than last month. Four factors are hiking inflation risks despite prospectively somewhat slower growth: First, inflation expectations have drifted higher, reflecting past hearty growth and perhaps rising energy quotes. Fed officials and we track several metrics, but two stand out, because they reflect longer-term expectations which have remained well-anchored over the past several years. The measure of 5-10 year inflation expectations in the University of Michigan’s consumer surveys edged up to 3.1% in April, or slightly higher than its 2005 average of 2.9%. And five-year expectations of inflation five years forward measured in the TIPS market have ratcheted up by 20 bp in the past month to 2.65%. Clearly, neither is alarming but the direction points to changes in behavior that could fuel higher inflation. Second, slack in product markets has dwindled as companies have maintained highly-disciplined capital spending programs that limited the growth of capacity, restored returns on capital, and revived pricing power. As a result, industrial operating rates have risen by about 850 basis points in the past five years and now stand about a percentage point above their long-term norms. Non-manufacturing business operating rates, according to the Institute of Supply Management, have risen by some 400 basis points from their trough. The so-called “output gap” — the difference between actual and potential GDP — has narrowed to a percentage point or less. Dwindling slack enables companies to boost prices without losing market share and should contribute to their collective ability to pass costs through to customers. Lately, for example, airlines — previously plagued with excess capacity — have boosted load factors over 81% and have been raising fares significantly. Measured in the CPI, fares are 6.7% higher than a year ago. Third, we think a weaker dollar is magnifying companies’ pricing power and is now slightly tilting the balance of risks for US inflation higher. To be sure, the boost to inflation from a weaker dollar has dwindled over the past two decades, reflecting weakening links between exchange rate changes and import prices and also between import prices and consumer prices. But the empirical fact that such exchange-rate “pass-through” has apparently weakened over the past several years may reflect other forces holding inflation down. We suspect that the link varies with the cyclical state of the economy and inflation expectations. With those factors now tilting towards higher inflation, the dollar’s effect on inflation now could be larger than over 2002-04 (see “The Dollar and Inflation,” Global Economic Forum, May 5, 2006). Finally, slowly accelerating costs are adding to price pressure. Energy and materials costs have been rising for four years as strong Asian demand and restraints on the growth of supply have lifted prices steadily. Now, however, labor market slack has also narrowed, reflecting stronger demand and limited increases in labor force participation, and that demand-supply dynamic suggests further tightening is possible (see “Will Labor Markets Tighten Further?” Global Economic Forum, April 3, 2006). With the unemployment rate down by 1.6 percentage points and job opening rates up by 90 basis points from their respective high and low points, compensation and wage growth are beginning to pick up. Ironically, the decline in the growth of benefit costs, which have lately decelerated to 2.9% in private industry, may now enable employers to grant faster pay gains. While it is a flawed measure of pay, we calculate that average hourly earnings adjusted for changes in the industry mix of jobs rose by 3.6% in the year ended in April (the officially published composite rose by 3.8%). Not surprisingly, skilled worker pay is rising most quickly; for example, hourly pay rose by 5.8% in professional and business services and 5.3% in information industries. Coupled with slower growth in productivity as employment catches up to the economy, we estimate such pay gains will close the last link in the inflation chain by boosting unit labor costs to more than 3% this year and next. But will a number of strong challenges prevent employment gains from catching up with the economy and rob economic growth of its vigor? As we see it, growth will slow in the second quarter to just over 3% at an annual rate from an unsustainable 5%-plus (estimated) rate in the winter quarter. And the challenges to growth are certainly in evidence: The spike in energy quotes induced by US refinery downtime, changes in environmental regulations, and concerns over geopolitical risks and another nasty hurricane season this fall has already taken some $65 billion from consumers’ pockets at an annual rate (see “How Vulnerable Is the Economy to Another Energy Shock?” Investment Perspectives, April 24, 2006). Housing is weakening, and the decline has further to go: Courtesy of rising incomes, affordability may have bottomed for now, but sliding demand, high inventories, and higher interest rates will hobble housing activity and dampen the growth of home prices. And the backup in interest rates over the past three months likely will take some additional steam out of credit-sensitive components of demand. Given those factors, it’s possible that April’s deceleration in job growth — to 138,000 from a 185,000 monthly average in the first three months of 2006 — represents the first concrete evidence of a downshift in the pace of economic activity. In our view, however, the deceleration in the economy is temporary, for three reasons. First, stronger income gains and improving global growth are underpinning demand in an already-resilient economy. We estimate that real disposable income will rise at a 5.2% annual clip in the last three quarters of 2006, as employment and wage gains remain strong and energy quotes stabilize or drift somewhat lower from the peak we guess will occur around Memorial Day. Evidence of stronger global growth seems to accumulate daily; for US exporters it is manifest in steady improvements in purchasing managers’ export orders for both manufacturing and non-manufacturing industries. Second, financial conditions are highly supportive of growth despite the backup in interest rates. Credit spreads have tightened, and lenders have yet to trim credit availability. Equity markets are performing well. The dollar seems to be on track for a significant, orderly decline. Importantly, the rise in rates itself is largely the result of strong growth, rather than of credit restraint. And we believe that financial innovations have made the economy progressively less sensitive to changes in interest rates than in the past (for details, see “The Yield Curve’s Uncertain Message,” Investment Perspectives, May 4, 2006). Finally, we continue to think that there is a reservoir of hearty pent-up demand for business capital spending, and that rising operating rates now mean such spending is moving into the expansion phase (for details see “Bullish on Capex,” Investment Perspectives, January 26, 2006). The upshot is that we think GDP growth will improve in the second half of 2006 at close to a 3½% annual rate. For market participants, both near-term and medium-term perspectives on these developments are important. The near-term prognosis is benign. Fed officials can reasonably pause from the tightening process following their meeting this week: They will have raised the funds rate by 400 bp from its trough, the near-term risks for growth seem tilted to a slightly below-trend pace, and the upside risks to inflation are neither sharp nor immediate. The dollar is declining in an orderly way, fostering hopes for reducing the tensions surrounding global imbalances. The immediate challenge for officials lies more in communicating policy intent — leaving the door open for future moves — than in taking action today. But for both policymakers and market participants, the medium-term challenge will be to decide whether inflation risks are tame or not. Risks abound in both directions. Supply-induced energy price shocks and protectionism remain at the top of our worry list. The dollar’s decline could turn less benign, especially as it is now running at a faster pace than it did in 2002-04, and renewed escalation of trade tensions in the run-up to US elections could threaten US and global risky asset markets. Conversely, the market melt-up in risky assets seems increasingly oblivious to such risks, and the resulting easing in financial conditions is highly supportive of growth.
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Review and Preview
May 08, 2006
Ted Wieseman (New York) and David Greenlaw (New York)
Treasuries saw decent losses at the shorter end over the past week and a flattening in the curve from the highs of the year hit mid-week after larger losses through Thursday were partly reversed by a modest rally following a somewhat mixed employment report. Taken as a whole, the employment report was actually robust, as average hourly earnings, aggregate hours worked, and aggregate earnings surged. But a modestly lower than expected headline payroll outcome apparently proved calming to a market that had been getting increasingly rattled by a run of strong data seen in the two weeks leading up to Friday’s report. After the prior week’s upside in consumer confidence, home sales, durable goods orders, and GDP, the hot run of data prior to the more mixed employment report continued in the latest week with strength in both the manufacturing and nonmanufacturing ISM surveys, construction spending, factory orders, and consumer spending as reflected in a modest gain in auto sales and very strong chain store sales results. Given the recent spike in energy prices and absence of some special factors that helped prop up first quarter growth (in particular, unusually warm weather and a post-hurricanes snapback from a depressed Q4), a notable moderation in Q2 GDP growth seems likely, but it is certainly not showing up in the data just yet. And for a Fed that likely wants to pause to assess the impact of its past rate hikes but will be in a “data-surprise dependent” mode after Wednesday’s almost certain hike in the funds target to 5%, this continues to keep alive the risks of further rate hikes down the road. Benchmark Treasury yields rose 3 to 7 bp over the past week after a 3 to 4 bp rally following Friday’s employment report partly reversed some more substantial losses through Thursday. After steepening to their highs for the year at Wednesday’s close, 2’s-10’s and 2’s-30’s reversed course to end 2 bp and 4 bp flatter on the week, respectively, with the 2-year yield rising 7 bp to 4.94%, the 10-year 4 bp to 5.11%, and the 30-year 3 bp to 5.20%. The 3-year and 5-year yields both rose 7 bp to 4.95% and 4.99%. At the two prior rate hikes this year, the 2-year, 3-year, and 5-year yields also ended the Friday before the FOMC meeting below the upcoming new funds target and then almost immediately went above it when the change was made, so we’ll see if a similar pattern holds this time. Obviously with the Fed likely to provide some hint of a possible pause in June on Wednesday, the circumstances are more favorable for rates holding below the new funds target this time around, but we wouldn’t bet on it. The strong data released the past week led the futures market to raise the odds that the “data-surprise dependent” Fed would be surprised by the end of June to continue raising rates – and if not in June then most likely by September. The July fed funds contract was off 3 bp to 5.095% and the September contract 6.5 bp to 5.19%. After the sizable move towards disinverting the prior week, the eurodollar curve beyond the presumed 5.25% funds target peak moved a bit in the other direction, with the max one-year invested Dec 06 to Dec 07 spread falling 2 bp to -7 bp, with the former off 9.5 bp to 5.34% and the latter 7.5 bp to 5.27%. Economic data released the past week were strong. Perhaps because it followed a more unambiguously positive run of numbers, the somewhat mixed employment report provoked a modest relief rally from the jittery market, but the report was hardly weak. April nonfarm payrolls rose 138,000, moderating from 200,000 gains in the prior two months and leaving the unemployment rate at 4.7%. The main downside was in retail trade, which fell 36,000 after rising 23,000 in March, possibly reflecting some seasonal adjustment problems. Other details of the report were quite robust. Average hourly earnings jumped 0.5%, bringing the year/year rate to +3.8%, a five-year high. The average workweek rose a tenth to 33.9 hours, the high since late 2002, which combined with the gain in payrolls led to a 0.5% gain in aggregate hours worked, a nine-month high. The upside in hours and average earnings led to a 1.0% surge in aggregate weekly payrolls, pointing to a sharp gain in April personal income. Even before April’s sharper acceleration, the upswing in income growth that has been under way since the second half of last year led to an upside surprise in unit labor costs in the first quarter productivity report. Nonfarm business labor productivity rose at a 3.2% annual rate in Q1, as output surged 5.8% and hours worked rose 2.5%. On a year/year basis, productivity was up 2.4%, little changed from Q4 and probably close to the long-term sustainable trend. With compensation per hour jumping 5.7%, the largest rise since 2004Q4, unit labor costs rose at a 2.5% annual rate in the first quarter. On a year/year basis, unit labor costs ticked up marginally to +1.4%, though they have risen at a more rapid 2.2% annual pace in the past three quarters as income growth has accelerated. Clearly, with hours and earnings both surging in April, Q2 is starting off on track for a notable slowdown in productivity and further acceleration in unit labor costs. In addition to the employment report, other early April economic data were also strong. Both ISM surveys improved notably despite sharp increases in prices paid. The composite manufacturing ISM diffusion index rose 2.1 points in April to 57.3, the highest reading since October and significantly stronger than the widespread moderation seen in various regional manufacturing reports. The gain was particularly impressive as it came despite a 5.0-point jump in the prices paid index to 71.5. The main contributors to the rise in the composite index were the production (60.4 v. 57.5) and employment (55.8 v. 52.5) gauges, while the orders index (57.6 v. 58.4) moderated slightly. Meanwhile, the headline nonmanufacturing ISM business activity index rose 2.5 points in April to 63.0, the high since August. The employment (56.5 v. 54.6) and orders (64.6 v. 59.5) posted strong results. As in the manufacturing survey, renewed surges in input prices didn’t seem to have a notable negative impact, as the prices paid index jumped 10 points to 70.5, a five-month high. After surging 5.5% in Q1, consumer spending also appears to have started Q2 on a robust pace. Motor vehicle sales ticked up to a 16.7 million unit annual sales pace in April from 16.5 million in March, though the mix was on the weaker side, as imports significantly outperformed domestically produced vehicles, and cars picked up share versus trucks (perhaps reflecting a quick response to surging gasoline prices). Meanwhile, sales results in April from the various national chains were quite robust overall. This was partly a result of the Easter calendar shift making for a tough comp in March and easy comp in April, but even taking this into account, April results were better than expected. A weighted aggregate of comp store sales we calculate from the thirty or so biggest companies was +6.9% year/year in April, the largest rise in the more than three years we have computed these figures. Excluding drug stores, the gain was +6.6%, the largest rise since March 2004 and above industry expectations for a 6% to 6.5% gain. Combining the auto and chain store sales results and an expected price related boost at gas stations, we forecast a 1.0% surge in overall retail sales in April and a 0.9% gain ex autos. We expect the recent spike in energy prices to lead to some significant slowing in the next few months, but clearly this would start Q2 consumption off on a very solid footing. Even as Q2 has apparently gotten off to a surprisingly strong start, some of the remaining March data released the past week suggested that the initially reported +4.8% advance Q1 GDP estimate was too low. Combining the results of a much larger than expected 0.9% rise in March construction spending with an upward revision to March capital goods shipments and a larger than expected inventory gain in the factory orders report, we now see Q1 growth on track for about a half point upward revision to +5.2%. Most of the key remaining data that would impact that estimate will be released in the coming week – wholesale inventories, retail sales and inventories, and international trade. With the Fed universally expected to hike the funds target another 25 bp to 5% on Wednesday, main focus in the coming week will be on the language in the accompanying statement. We suspect that the statement will contain some small changes aimed at providing a somewhat greater degree of policy flexibility going forward. For example, the indication that “some further policy firming may be needed” could be altered to “may or may not be needed.” Of course, the forward looking language could just be eliminated entirely, but Fed officials probably fear that this would be misinterpreted as coming close to ruling out a June rate hike. In our view, the outcome of the June FOMC meeting will be data-dependent and, at this point, it looks like a close call. Looking ahead to the next round of key indicators, we expect strong April retail sales and an uptick in the April core CPI inflation rate to +2.2%. But there will be yet another round of retail sales, inflation, and employment data before the June 28-29 FOMC meeting, and we suspect that after the apparently robust start to the quarter some signs of an energy-induced slowdown in Q2 growth will be evident by then. Supply will also be a market focus in the coming week, though with the 5-year having been moved back to its traditional month-end schedule this will be the smallest quarterly refunding in some time, with just a $21 billion 3-year Tuesday and $13 billion 10-year Thursday. Both these sizes were unchanged from February, which was a bit of a surprise against widespread expectations for modest increases. But by week-end, the rationale for both the unchanged auction sizes and the seemingly very optimistic Q2 and Q3 borrowing projections announced by Treasury on Monday became much clearer as the Daily Treasury Statements released through the week showed a late surge in tax season payments. From April 1 through May 4, cumulative individual nonwithheld tax receipts have now risen 22% (or $34 billion) from the same period last year. We are still working through revisions to our budget forecasts, but with the upside in April tax season inflows combined with the general robustness in individual withheld income and payroll and corporate taxes, it now seems clear that the FY2006 deficit will come in well below our prior $375 billion estimate and will likely decline as a share of GDP from last year’s roughly average 2.6% shortfall. Key data releases due out in the coming week include the Treasury budget statement Wednesday, retail sales Thursday, and the trade balance Friday: * We estimate that the federal government ran a budget surplus of $118 billion in April, up from $58 billion a year ago. The Treasury’s tally of April 15 tax payments started off a bit slow but accelerated dramatically in the final week of the month and continued into early May. In fact, it now appears that the tax season inflows will be up about $35 billion (or 20%) from a year ago – versus our own original estimate of a $10 billion jump. Although about half of this improvement will not show up until we get the May results, we still see the April surplus running $60 billion better than a year ago with about $30 billion of the swing attributable to calendar effects. * We look for a very sharp 1.0% jump in overall April retail sales and 0.9% gain ex autos based on the unit sales results from the automakers and the impressive reports from the chain stores. In fact, retail control – the key input to consumer spending – is expected to be +1.0%. Obviously, some of this upside reflects an anticipated sharp, price-related jump in gasoline sales. However, we are actually factoring in a somewhat smaller increase in the service station category than implied by our model because of the tendency of the retail sales data to not capture the full extent of these types of sharp price-related swings in the advance report. In fact, we expect to see an upward revision to the surprising low -0.1% reading reported for the gas station category in March. * We expect the trade deficit to widen about $2 billion in March to $67.5 billion, with exports up 0.5% and imports gaining 1.3%. On the export side, the upside is expected to be more than accounted for by capital goods excluding high tech and aircraft based on a sharp gain in associated factory shipments. On the import side, a modest pullback in energy products, volume driven for petroleum products and price related for natural gas, and a reversal of the one time spike in services caused by Olympic broadcast rights payments last month should be more than offset by a sharp rise in other goods imports, which appeared to be temporarily depressed last month by Asian holiday distortions. Note that our forecasted deficit is several billion dollars wider than BEA assumed in preparing the advance estimate of Q1 GDP growth.
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The Direction of Monetary Policy in the UK
May 08, 2006
David Miles (London) and Melanie Baker (London)
We expect the MPC to raise rates to 5% by Q1 2007 — a central estimate of the neutral nominal rate. Simple estimates of the neutral rate. The simplest way to assess what the rate might be is to take an average of actual (or realised) real rates (calculated using actual/realised inflation and actual nominal base rates) and add on the target for inflation. Using a long period allows one to use the idea that, on average, output will be close to capacity and that, on average, actual and expected inflation might be equal. (The real rate that matters for economic decision making is the expected real rate, calculated using expected inflation.) The average (unadjusted) short term real interest over the 50 year period since 1957 is exactly 2%. But clearly there are significant differences in average realised real interest rates over sub-periods. However, since 2000 the average realised short term real rate is 2.12%. And the recent period is one where inflation has not obviously differed significantly from expectations nor has output deviated very much (on average) from trend. If the period since 2000 is ‘representative’, this estimate may be closer to the ‘neutral rate’. Based on the figures in Exhibit 1 there is very little evidence that today’s short term real rate is a number under 2%. Averages over longer periods based on either excluding periods when inflation was probably well in excess of expectations, or based on truncation, are higher and stretch from 2.5% up to above 3%. Alternative method suggests 2% for neutral real rate. A somewhat more scientific strategy than simply taking averages is to use regression analysis. We simply allow three factors to influence the (realised) real interest rate: the size of the output gap (lagged), the actual rate of inflation (the yoy change in RPI, also lagged) and a time factor that means that real rates can vary by decade. This could loosely be viewed as some sort of policy rule which has the monetary authorities try to set a real rate that depends on actual recent inflation and on the size of the output gap. It is highly unlikely that any such relation will be unchanging, which is why we allow for a crude shift effect so that real rates can vary (all else equal) by decade. Using the three different measures of real rates we then estimate the model (using OLS). We use the results to find what a neutral real rate is today is by setting (RPI) inflation to 2.75% (consistent with CPI inflation at the target rate of 2.0%), setting the output gap to zero and using the estimated ‘decade effect’ for the period since 2000. The estimates generated are close to each other and all close to 2%. Conclusion and Bond Market Implications. Based on a range of different statistics using the recent, and not so recent, past, it would be reasonable to believe that short term real rates could stay in the range 2%-2.5%. Evidence points to the best estimate of the short term neutral rate being slightly towards the lower end of that range. A central estimate of 2.15%, takes us close to 5% for nominal neutral base rates. If we take 2.15% (close to the ex-post average realised rate since 2000) as our central estimate of the neutral short term real rate, we can ask what nominal rate is consistent with inflation staying near the target set for the Bank of England. Using 2.75% RPI inflation — consistent with CPI inflation at the 2.0% target — takes us to 5.0% for our central estimate of the short term real rate We believe that a plausible range for the neutral nominal rate is 4.5% to 5.5%. Our lowest estimate of the neutral real rate is 1.9% and we believe the lowest plausible average difference between CPI and RPI inflation is 0.5% — that generates the lowest end of our range for the neutral nominal rate of about 4.5%. But some of our measures of the neutral rate based simply on historic averages would be close to 6%. We discount some of these high estimates since they give no weight to the idea that equilibrium real rates may have recently fallen. We conclude that a plausible range for the neutral real rate is 1.9% to 2.6% and 4.5% to 5.5% for the neutral nominal rate. A more sustainable level of bond yields on gilts is likely to be slightly above 5%. If 5% is a central estimate of a neutral UK nominal base rate then it remains surprising that gilt yields right across the maturity spectrum are under 5%. It is not plausible that term premia are significantly negative for gilts of all maturities. It follows that a more sustainable level of gilt yields, at least up to 10 year maturities, is likely to be slightly above 5%. Given this assessment, and with GDP likely to return to trend, and with inflation close to target, a rate rise later this year — towards ‘neutral’ levels — seems likely. Our central expectation remains that the BoE will raise rates from 4.50% to 5.00% by mid-2007 (with the first rise pencilled in for later this year).
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