Upping the Ante on Stimulus
January 28, 2008
By Richard Berner | New York
Spurred by a weakening economy and rocky financial markets, Congress and the Administration now agree that new fiscal stimulus should be a key prop for growth. We expect lawmakers to enact a package amounting to $175 billion, or 1¼% of GDP, in calendar year 2008. Although House Congressional leaders and the Administration last week agreed on a smaller $150 billion plan, we expect that compromise with the Senate probably will add another $25 billion in spending. We expect Congress to pass and the President to sign legislation in the next month or so.
Implementing such a plan might boost second-half annualized GDP growth significantly — by 2½ percentage points at an annual rate starting late in the summer. Most of the plan’s impact on growth will be temporary, indeed, “paybacks” from the one-time boost to consumer spending could be a short-term drag on growth early in 2009. Nonetheless, the combination of aggressive monetary and fiscal policy makes us increasingly confident of our call for a mild and short recession (for discussion of the Fed outlook, see “What Will be the Trough in Rates?” January 24, 2008). If passed, the plan would significantly boost the Federal deficit and Treasury financing needs; we now expect the FY2008 Federal deficit to rise to $400 billion (see David Greenlaw’s “Budget and Financing Outlook — The Check is in the Mail,” January 24, 2008). And as market participants begin to anticipate a healthy economic recovery later this year, our interest rate strategy team and we expect a bearish steepening of the yield curve as long yields back up. The centerpiece of the House-Administration proposal is $103 billion in tax rebates (called “stipend” checks) that the IRS likely will mail out over the summer (that the IRS is processing tax refunds now will delay the first checks until about July 1 even if the legislation is enacted in March). On the business side, the proposal includes $47 billion in two business tax breaks — an additional 50% “bonus” depreciation allowance for investments in capital assets and full expensing of $250,000 in both new and used tangible property in the year of purchase up to an overall investment limit of $750,000. (Contrary to earlier reports, the agreement does not include a longer carryback period for net operating losses). We expect that the Senate will get its way in adding funds for extended unemployment insurance, food stamps, infrastructure spending, and possibly grants to states for Medicaid, rounding out the total. How much bang for the buck? Like those employed in the past, the proposed tax rebates will offer only a temporary boost for after-tax income and thus for consumer spending. Indeed, from a growth standpoint, the temporary spending lift will likely be followed by a subsequent “payback.” True, there is a lot of dough: $100 billion amounts to about 1% of both overall disposable income and personal consumption expenditures, and concentrated into a short period, that adds up to a big annualized boost to growth. But there are legitimate questions about how much bang policymakers will get for each rebate buck. Many believe that rebates aren’t potent because consumers may save these windfalls. So will the rebates matter? Experience may shed some light on this question. Rebates were offered three times in the past — the 10% rebate on 1974 taxes in the Tax Reduction Act of 1975, the $36 billion “advance refund” of the Economic Growth and Tax Reconciliation Relief Act of 2001, and the $14 billion of advances on child tax credits in the Jobs and Growth Tax Relief Reconciliation Act of 2003. Analysis of these episodes offers a wide range of estimates. Studies of the 1975 rebates suggest that consumers then spent between 12 and 24 cents of each rebate dollar. But in the EGTRRA experience, a new lower (10%) tax bracket was made retroactive to January 1, 2001, and the rebates were actually an advance credit for those changes; at that time, the impact ranged up to 66 cents on the dollar. This analysis also suggests that when consumers lack other resources — they are at the low end of the income scale or they have difficulty getting access to credit or both — they will spend rebates (for a summary, see “Options for Responding to Short-Term Economic Weakness,” Congressional Budget Office, January 15, 2008). The proposed rebates have features that likely put their bang-for-buck in the middle of those two ranges (in agreement with others’ estimates; see “How Much Stimulus from Income Tax Rebates,” Macroeconomic Advisers, January 25, 2008). The proposed rebates target lower-income households, including those who paid no tax, which should increase their potency above the 1975 version. Anyone who earned at least $3,000 in 2007 will receive at least a $300 rebate check. Those individuals who paid tax will get $600, married couples filing jointly $1200, and families an additional $300 rebate for each child, all subject to income caps of $75,000 per individual and $150,000 for couples. We assume that consumers will spend 40 cents of each rebate dollar spread across the third and fourth quarters of 2008, adding roughly three percentage points to consumer spending in those quarters. Our presumption that there will be some additional funds for extension of unemployment insurance benefits and for food stamps will further skew this plan’s impact to lower-income recipients, which in turn will give it temporary traction. However, four factors imply that the follow-on or “multiplier” effects from this stimulus on the overall economy will be small. First, unlike in 2001, there is no permanent tax reduction, so there may be a bulge in spending in 2H08 followed by payback in 1H09. In addition, imports and inventories will satisfy some of the pickup in demand, so it will not translate completely into output. Third, firms aware of the transitory nature of the stimulus probably won’t step up hiring much to satisfy new demand. Finally, proposed business investment tax incentives may bring forward some spending but will not permanently boost it. Indeed, the “use-it-or-lose-it” nature of the business incentives increases their short-term influence, but leads to payback when they expire. And firms that have no tax liability won’t benefit from either the bonus depreciation or expensing features of this provision. Boosting the coming refi boom The 100 bp plunge in mortgage rates over the past several weeks has begun to spur a surge in mortgage refinancing; for example, the Mortgage Bankers’ refinancing applications index has doubled in the past month. Despite tighter lending standards, we think that such refi activity will free up some discretionary income for consumers. The mother of all such refinancing waves occurred in 2003, when roughly a quarter of all mortgages outstanding were refinanced, resulting in estimated pre-tax savings of $31 billion in interest expense, or about 0.4% of disposable income. With mortgage debt about half again as big as it was five years ago, the savings (per basis point of interest rate decline) could be as large or even larger this time. The stimulus plan also includes a feature that will magnify the impact of a coming refi boom. A proposed temporary hike in the Conforming Loan Limit (CLL) to as much as $729,750 will enable many consumers to refinance mortgages larger than $417,000 (“jumbos”) on attractive terms. That should offer a lift to discretionary income. Owing to the complex nature of the proposal — the CLL may rise to 125% of the median home price in the area (presumably the Metropolitan Statistical Area or MSA) — it is difficult to calculate the benefit from the implementation of this proposal. According to Fannie Mae, jumbos account for about 20% of mortgage debt outstanding, with about half of that ($1 trillion) in the $417,000-600,000 range. Refinancing that debt at a saving of 50 bp resulting from the higher CLL would add only $5 billion annually to consumer discretionary income. But the CLL benefit combined with the potential refinancing of those and other loans could add a much larger boost to consumer wherewithal, possibly more than 2003’s $31billion. Of course, how much of that windfall is likely to be spent will be hotly debated (for a pessimistic view of the 2003 experience, see Margaret M. McConnell, Richard W. Peach, and Alex Al-Haschimi, “After the Refinancing Boom: Will Consumers Scale Back Their Spending?” December 2003). I believe that in today’s circumstances, however, the relief could be most welcome. Even with all these uncertainties, the combination of aggressive monetary and fiscal stimulus makes us more confident in our call for a mild recession. In fact, third-quarter growth may jump over 3% and some of the stimulus will spill over into the fourth quarter. Likewise, the boost may elevate inflation expectations. But the sustainable boost for the economy that we expect late in 2008 and in 2009 will come from today’s stimulative monetary policy and the playing out of recessionary forces now in train. Indeed, the combination of an aggressive Fed and new fiscal stimulus is likely to promote a healthy economic recovery. As market participants begin to anticipate that outcome, we think it will promote a bearish steepening of the yield curve as long yields back up. Such a bear steepening may not last long, however. When the economy begins to recover, the Fed will need quickly and forcefully to reverse course, flattening the curve.
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Review and Preview
January 28, 2008
By Ted Wieseman/David Greenlaw | New York
After an extraordinarily volatile week that saw global equity and credit markets collapsing initially, helping elicit a front-loading of the Fed’s easing campaign with a 75bp rate cut when US markets reopened Tuesday morning, before rallying back sharply to end stronger on the week, Treasuries wound up with good front-end gains and a significant further steepening of the curve. Both the overall market and, to a lesser extent, the curve, though, came far off early week extremes as markets recovered over the back half of the week. It was an extremely quiet week for economic data, leaving bond market attention squarely focused on trying to figure out the likely path for the Fed in the coming week and beyond, largely by tracking day-to-day swings in extremely volatile global stocks. Ultimately, investors ended the week figuring that the Fed would front-load its easing campaign to a great degree, starting with another 50bp cut next week, but wouldn’t cut all that more in total, lowering the expected trough funds target only a quarter point to 2.25%. And this more aggressive near-term response coupled with the surprisingly quick agreement that is coming together for sizable fiscal stimulus resulted in a bit less pessimism about the prospects for a recovery later this year and into 2009. On the week, benchmark Treasury coupon yields fell 2-14bp and the curve steepened. The 2-year yield fell 14bp to 2.20%, the 5-year 6bp to 2.79%, the 10-year 7bp to 3.58%, and the 30-year 2bp to 4.28%. A strong 20-year auction helped TIPS perform relatively strongly, with the 5-year rallying 8bp to 0.68% and the 10-year 5bp to 1.36%. These relatively modest market moves came only after swings through extreme ranges during the week. In US trading hours, the 5-year yield (the most volatile on a yield basis) moved through a whopping 60bp range through the week, while the long bond traded with seven different handles. Most of this volatility, of course, reflected and was driven by similarly extreme moves across global stock and credit markets. The S&P 500 eventually ended the week up 0.4% after trading through nearly a 100-point range. Although it wasn’t much followed by the Treasury market, credit held in significantly better than stocks when they were hitting their lows and ended with better gains on the week. In late trading Friday, the 5-year HiVol CDX index was 22bp tighter on the week near 242bp and the broad investment grade index 5bp tighter at 105bp. Aside from a mass further rush into very short-dated Treasuries, money market conditions showed some improvement on the week. Flight from the volatility in risk markets helped drive the 4-week bill’s bond equivalent yield down another 53bp the past week on top of a 60bp decline the prior week to 2.08%. Interbank lending pressures eased a bit, though. 3-month LIBOR fell 59bp to 3.31%. Of course, the expected Fed path was repriced massively as well, so the relative improvement was much smaller. The 3-month LIBOR/3-month OIS spread declined 4bp on the week to 38bp, near the low since before the initial money market storm began in Europe on August 9, but still far above normal sub-10bp levels. Forward pricing is pointing to only small additional improvement through mid-year. Meanwhile, the asset-backed CP market continued to show signs of healing, with the size of the market increasing for a fourth straight week following the prior 20 straight declines. Our desk, though, noted that trading was somewhat disrupted at times through the week as investors were whipsawed by rapidly shifting Fed expectations, which led to periods of heavy focus on shorter maturities because of greatly heightened uncertainty about what levels on term rates represented good value. Fed pricing in the futures market moved to price in a much more dovish near-term Fed path, but only a modestly lower terminal funds rate, and actually slightly higher rates in 2009 and beyond on optimism that more aggressive Fed policy now, with some help from the surprisingly fast agreement on fiscal stimulus, would allow more of a recovery down the road from the expected 2008 recession. The February fed funds contract gained 41bp on the week to 3.08%, pricing about a 70% chance of a 50bp rate cut at the upcoming FOMC meeting, though this was way off early week levels that had been moving towards pricing another 75bp move. The April contract gained 35.5bp to 2.795%, May 31bp to 2.61%, July 30.5bp to 2.395%, and August 27.5bp to 2.30%. So the market is favoring a 50bp cut next week to 3.00%, another 25bp at the March meeting to 2.75%, 25bp at the April meeting to 2.50%, and then a final 25bp cut in the summer to 2.25%. So ultimately, the expected trough in the fed funds target was only reduced a quarter point after the market had been pricing in at least 2% and a reasonable chance of 1.75% at the worst of the market panic. Short-dated eurodollar futures posted comparatively big gains, but modest losses began with the Mar 09 contract, with 6-7.5bp drops in the June 09 to Dec 09 contracts the biggest declines. As a result, the spread between the low-rate Sep 08 contract and Sep 09 steepened 21.5bp to 41.5bp, still clearly reflecting a very pessimistic view about the possibility of any significant pick-up in growth in the second half of this year and into 2009, but from our perspective at least moving in the right direction. It was an extremely light week for economic news, with the only major release being existing home sales. Sales fell 2.2% in December to a 4.89 million unit annual rate, a fourth straight reading close to the 5 million level, suggesting that sales may be approaching a bottom now that the subprime borrower has essentially disappeared and the credit crunch in the broader non-agency market has had a number of months to work through the numbers. Even if they are, new construction will likely need to fall much further to bring inventories of unsold homes into line with current sales paces for new and existing homes. We look for about another 25% drop in single-family housing starts over the next few quarters on top of the 57% drop seen so far since the January 2006 peak. The number of unsold homes fell 7.4% in December, causing the months’ supply to decline to 9.6 months from 10.1. The inventory figures, however, are not seasonally adjusted and almost always fall sharply in December, so this did represent any real improvement in the bloated inventory situation. Indeed, the number of unsold homes in December was 13% higher than a year earlier, up from +11%Y in November. After the very quiet past week, the upcoming week’s economic calendar is packed with key data and events. Main focus during the first part of the week will be on the two-day FOMC meeting, with the outcome announced Wednesday afternoon. Though market pricing has shifted more towards the possibility of a smaller 25bp cut to 3.25% instead of the previous expectation for at least a 50bp move to 3%, the bigger cut is still seen by investors as the more likely outcome. We disagree, and think that the FOMC will jump on the chance afforded by more stable markets to slow the pace and ease by another 25bp instead. A little risk management perspective suggests that 100bp of ease in the space of a week – especially given the low level of real interest rates – still constitutes a very aggressive move. In light of this still sharp one-week reduction in rates and the steady stream of negative economic news we expect to see over the next six months as the recession we believe is already underway continues to unfold, we do now think that the Fed will respond with more total easing than we previously anticipated. We now expect the funds rate to trough at 2.50% instead of 3%, with a base case outlook of 25bp cuts at the January, March, April and June FOMC meetings. See US Economics: What Will Be the Trough in Rates? Richard Berner and David Greenlaw, for a full discussion of the Fed outlook. Fiscal policy will also be in focus Wednesday with the Treasury’s quarterly refunding announcement, preceded Monday afternoon by the announcement of the revised borrowing estimate for 1Q and first forecast for 2Q. We’ve upped our FY2008 budget deficit forecast to US$400 billion from US$225 billion, with US$20 billion of the change coming from a more pessimistic economic outlook and US$155 billion from assumed fiscal stimulus, including US$100 billion in what are being called ‘stipend’ checks over the May to July period, which should help support the second half recovery we anticipate after the first half recession. Already agreed to business tax breaks and our expectation that additional measures will be tacked on – increased unemployment insurance, food stamps, infrastructure spending and state Medicaid grants have been pushed for by various members of Congress – before a final bill is passed make up the rest of our assumption. With this likely greatly increased financing need for FY2008, we expect that the US$2 billion increase in Monday’s 2-year auction to US$24 billion and US$1 billion increase in Tuesday’s 5-year auction to US$14 billion announced the past week will be followed by further across-the-board coupon increases over the first half of the year (though likely concentrated in further significant increases in the 2-year and 5-year sizes) along with heavy net bill issuance. We expect this to start at Wednesday’s refunding announcement, where we look for the 10-year and 30-year sizes to each be raised by US$1 billion to US$14 billion and US$10 billion, respectively. See US Economics: US Budget and Financing Outlook: The Check Is in the Mail, David Greenlaw, for a full discussion. On top of the FOMC meeting and Treasury refunding, the economic data calendar is extremely heavy in the coming week, with focus, of course, on Friday’s employment report. We haven’t made any change to our +75,000 forecast for payrolls despite the three-week run of shockingly strong jobless claims reports, since we simply don’t believe the claims numbers. We continue to believe that the claims figures are suffering from seasonal adjustment problems during this period of very large seasonal flows and are not legitimately signaling some sort of huge recent turnaround in the labor market. If claims don’t start to reverse to the upside in Thursday’s report, however, we will probably need to up our employment forecast. Other key releases include new home sales Monday, durable goods and Conference Board consumer confidence Tuesday, GDP Wednesday, personal income and spending and the employment cost index Thursday, and ISM, construction spending and motor vehicle sales Friday: * We forecast December new home sales of 650,000 units annualized. Homebuilder sentiment has held steady over the past several months, suggesting that the 9% drop seen in the November sales figures may have overstated the degree of weakness. Thus, we look for a modest rebound (+1%) in December sales and an accompanying slight downtick in the inventory of unsold new homes. * We look for a 2.5% rise in December durable goods orders. A further climb in the volatile aircraft category accounts for just about all of the anticipated increase. Indeed, the key core component – non-defense capital goods excluding aircraft – is expected to post a decline for the second consecutive month. * We expect the Conference Board’s measure on consumer confidence to drop 4.6 points to 84.0. Given the increasingly widespread discussion of recession risk in the popular media, the early January results for the University of Michigan sentiment survey were surprisingly good. However, while the Michigan index is based on personal experiences, the Conference Board gauge is more closely tied to perceptions of general business conditions. Thus, we expect to see a more noticeable deterioration in the latter. * We look for a sharp moderation in GDP growth in the fourth quarter to +1.0%. Another sizable decline in residential investment seems assured. But the two big swing factors relative to the strong growth seen in 3Q are actually expected to be a sharp reversal in the inventory contribution and a flattening out of net exports. We also anticipate some moderation in consumption and business capital spending. Finally, the chain weight price index is expected to post a modest rebound (+2.2%) following the subdued +1.0% reading seen in 3Q. * We forecast a 0.4% rise in December personal income and a 0.1% rise in spending. The overall tone of the December employment report was certainly disappointing, but the data actually implied only a very slight moderation in income growth. Meanwhile, a decline in retail control points to a moderation in consumer spending as the year came to an end. Finally, the core PCE price index is expected to be +0.22% in December, which should leave the year-on-year rate at +2.2%. * We look for 0.9% rise in the employment cost index in 3Q, a result that would be in line with the recent trend. Average hourly earnings have shown little sign of any noticeable acceleration in recent months – even after adjusting for compositional changes in the labor force. Still, the overall ECI is expected to tick up slightly relative to the third quarter since we suspect that the surprising moderation in the benefits component will not be repeated. Looking forward, we suspect that we will see some further loosening of labor market conditions but do not anticipate any meaningful moderation in wage inflation, which is already running at a relatively low rate. * We forecast a 75,000 increase in January non-farm payrolls. We attribute much of the recent slippage in jobless claims to seasonal distortions. Still, even though the underlying pace of job creation appears to be slowing, weather conditions were relatively favorable during the January survey period and thus we look for a modest uptick in payrolls relative to the subdued gain posted in December. Meanwhile, the household survey’s measure of employment has followed a see-saw pattern in recent months. A continuation of this trend in January would imply at least a slight retracement in the jobless rate following the spike seen in December. Of course, such a swing is likely to prove temporary, and we look for a renewed upward drift in unemployment to emerge in coming months. * We expect the January ISM to fall to 47.5. The latest Philly, Empire and Richmond results would seem to confirm that the sharp deterioration seen in the December ISM was not a fluke. We look for some further slight slippage in January. Note that the ISM organization is changing the methodology used to calculate the headline diffusion index beginning with this month’s report. Going forward, all five components will be equally weighted. Previously, the weights attached to orders and shipments were greater than those for employment, vendor deliveries and inventories. * We expect construction spending to plunge 1.6% in December. The housing starts data point to another very sharp drop in the residential category. We also expect to see some softening in the non-residential component this month. Moreover, activity in the government sector appears to have been on an unsustainably sharp upward trajectory in recent months, and we look for some flattening out in December. * Our autos team expects sales to fall to a six-month low of 15.7 million units annualized after running at a 16.2 million unit pace in both November and December. We look for sales this year to drop to a 12-year low of 15.1 million from 16.1 million in 2007.
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Forecast Change: ZIRP Looms Again
January 28, 2008
By Takehiro Sato | Tokyo
Key message With the collapse of domestic and overseas economic confidence and a sudden shift in stock market conditions, the thrust of monetary policy debate has quickly reversed from a rate hike to a rate cut, pretty much in line with our risk scenario outlined when we revised our economic forecasts on December 11. We are revising our previous scenario of gridlock during 2008, and now calling for a rate cut. We need to seriously consider the possibility of a reversion to ZIRP (zero interest rate policy), given the increasingly rocky outlook for the economy and markets, but this is the move that the BoJ will be most anxious to avoid, and we have not extended our main scenario that far. Neither, of course, have we assumed a restoration of quantitative easing, an approach which has served out its role of support for the financial system. To avoid moving back to ZIRP, however, if and when it does cut rates the BoJ is likely to seriously consider unconventional measures such as reinstating a policy duration commitment or an increased outright buying of JGBs. This latter move would dovetail neatly with its operational need to supply liquidity efficiently, as the balance of banknotes carried as liabilities on its balance sheet mounts, and could be more likely than is generally recognized. What’s new The recent meltdown in markets may well affect economic fundamentals, and we have decided to make a 25bp rate cut part of our main scenario, rather than a risk scenario as before. The timing is likely to be the April-June quarter this year, after new leadership is in place at the BoJ. This is because if Diet approval for the new governor and deputy governors proceeds smoothly, the new figures would be in place from March 20, and various aspects of the old leadership’s policy framework would likely come under review from that point. The first Outlook Report under the new governors released on April 30 will have particular importance as regards retooling of the medium-term scenario for the economy and of policy logic. There is a wide gap between the view of the BoJ and the view of the market on both at the moment, and a rethink is urgently needed in this situation which precludes constructive dialog. We look for three things from the incoming BoJ leadership. First, a re-examination of the bank’s medium-term economic outlook, which, amid the rapidly changing conditions at home and abroad, is now on a different page from that of the market. Second, a review of the policy framework based on its ‘two perspectives’, and especially the role of the second perspective, which while touted as a risk management control, tends to turn into a somewhat fuzzy overall assessment. Third, the positioning of ‘understanding of price stability’, where the relationship with the policy approach is not always clear, needs to be rethought. Once the legacy of the old guard has been synthesized in the Outlook Report, the timing of a decision on whether to cut rates would likely be the end-April or May/June monetary policy meetings. With the policy rate at only 0.5%, there is not much room to play with, so to get the most from the limited scope for cutting interest rates the BoJ may opt to reintroduce a policy duration effect by committing to its policy rate for a certain period (perhaps setting a numerical inflation target), and also to think hard about unconventional methods that were leveraged previously under ZIRP, such as stepping up outright purchasing of JGBs. The latter step is currently being taken as part of the bank’s balance sheet management and would not necessarily encourage long-term yields to come down, but the balance of banknotes that sit as liabilities on the BoJ’s balance sheet has not been notably reduced since ZIRP was ditched in 2006, while the distance to maturity of the long-term JGBs that it holds as assets is getting shorter. This means that JGB buying would dovetail conveniently with the technical objective of achieving greater efficiency in operations to provide short-term funding. For the time being, we are expecting just one cut of 25bp. This is based on our official forecast that negative annualized growth in the US recession will be short of 1% and last for only two quarters, in a mild and brief downturn. Clearly, if the US recession is deeper than this and the externally reliant Japanese economy gets further into trouble, we would have to entertain the possibility of going a step further and reinstating ZIRP. We are maintaining our forecast for a rate hike to come in the July-September quarter of 2009, as we do not see developments that derail our scenario of a relatively sharp rebound in the Japanese and overseas economies in 2009. This leaves us expecting a policy rate of 0.25% at the end of 2008 (and F3/09), and 0.50% at the end of 2009 (and F3/10). For term interest rates and JGB yields, we build a single rate cut coming soon into our existing outlook, making minor modifications. The basic upward trajectory for medium- and long-term interest rates does not change, with a bottom to be found towards the end of the April-June quarter and then a gradual upswing as the economy picks up. Where we differ The OIS market as of January 22 is already pricing a rate cut in the second half of 2008 at a probability of 70-80%. While imbalances in positions in the OIS market may result in unrepresentative pricing at times, this suggests that our call for a relatively early rate cut after new executives are installed at the BoJ diverges from the market consensus. Our stance is based on an outlook for the economy in 2008 (+0.9%) and F3/09 (+1.1%), which is quite a bit more cautious than the consensus. What’s next The government and ruling parties are trying to propose the next governor and deputy governors by early in February. The DPJ is also seeking to decide how to handle the matter in the Diet after seeing the government’s proposal. In principle, the DPJ is not keen on ex-bureaucrats, and there are various names being bandied around, but the point to make is that this reshuffle won’t greatly alter the future path of the policy rate. The course of the economy and prices is more important than the personality of the governor. Even if by some chance a hawkish figure should be appointed, attention to the downside risks for the economy and prices should mean that a rate cut is properly considered, and vice versa. Under the current BoJ leadership, a rate cut does not seem very likely. We say this because in the interim review of the October 2007 Outlook Report contained in the January 22 Monthly Report, the bank did not even refine its view to date that the economy is tracking slightly above its potential growth rate. It takes some effort to gain an internal consensus to change the scenario, so we probably cannot expect quick changes until the top brass is replaced. Risks If events pan out differently, it could be the result of action by the Fed which averts a steep recession in the US, and opens the way for Japan’s economy to perk up in the near term, dispelling our original gloom. Yet there is little reason to abandon the view that risks are still skewed to the downside: economic indicators at home and abroad point to a fairly marked slowdown, and Japan faces its own problems of stagnant housing investment and financing pressure on small and medium-sized businesses (SMEs). We do not think that the housing investment will be easily recovered, as affordability is on the slide and building inspections are creating a bottleneck for condominium starts. On the financing question, there are problems in consumer finance, and the scaling down of the credit guarantee system is a systemic factor that indicates that a mini credit crunch may be on the way for SMEs at the end of March. There is also a risk that the new appointees at the BoJ will not conduct as drastic a reappraisal of the current policy framework as we expect. But it is not impossible for a rate cut to be implemented without any such review. Rethinking the framework is simply a tool that would enhance policy transparency and foster dialog with the markets.
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