Higher US Inflation, Not Stagflation
February 25, 2008
By Richard Berner | New York)
Fears of stagflation — a period of high and rising inflation, low productivity gains, and low earnings growth — are stalking financial markets. Small wonder: Signs that recession has begun are multiplying; that’s been part of our script for some time. But the rising inflation part has not: After declining for much of last year, inflation by any measure is rising again. Headline and core inflation measured by the CPI have rebounded in January to one-year highs of 4.3% and 2.5% respectively. Is it time to break out the bell-bottoms and disco shoes, as my colleague Joachim Fels insists, and usher in a period of economic misery like the stagflationary one we suffered through in the 1970s?
I strongly doubt it. To be sure, there are similarities to that bygone era, and we are revising our 2008 inflation forecast higher by almost a full percentage point, from 2.2% to 3%. As then, soaring energy and food quotes are clear culprits today. Crude prices have touched $100 and are unlikely to retreat significantly. Quotes for grains and other foodstuffs have jumped by anywhere from 10% to 250% from a year ago, and the supply/demand balance favors further increases. Moreover, as in the period when President Ford handed out WIN buttons and Arthur Burns was Federal Reserve Chair, it’s not just energy and food; the persistence of inflation lately has been broad-based. Steve Roach and I worked together under Burns in the 1970s and watched with alarm as monetary policy contributed to an era of stagflation (see “The Curse of Arthur Burns,” Global Economic Forum, October 22, 2004). It’s now clear that bringing inflation back down will require more slack in the economy and more time than we thought previously. But in my view, the similarities with the 1970s are more superficial than real. Here’s why. First, let’s focus on global forces. By now it’s a commonplace, as articulated by former Fed Chairman Alan Greenspan, that globalization for much of his tenure was a disinflationary force, but that Ben Bernanke is unlucky enough to have taken the Fed Chair at just the time when global forces are turning inflationary. I think that view overstates the influence in both directions. While globalization almost surely reduced US inflation over the past decade, domestic forces — inflation expectations, the extent to which costs from all sources are rising, and the degree of slack in the economy that shapes companies’ pricing power —still dominate the inflation prognosis. Conversely, as in the 1970s, US policymakers must now be attentive to the potential for global forces to boost inflation, but I think the influence will be small. Unlike in the 1970s, that’s because global companies now tend to “price to market,” absorbing the effects of currency or import price changes in margins; in other words, the “pass-through” from such cost increases has declined (see “Globalization and Inflation,” Global Economic Forum, June 19, 2006). Nonetheless, two global factors are pushing inflation higher today. First, rising energy, food and commodity prices – the product of still-strong global growth and limited gains in supply – are boosting overall inflation. Energy prices rose by 20.4% over the past year, while retail food quotes rose by 4.9%; the latter is the fastest pace in nearly two decades. While we have long believed that energy quotes must rise persistently over time, we thought the move toward $100/bbl for Brent crude at year-end represented an overshoot. We took comfort from the dip back below $90/bbl last month and thought that prices would decline to an average of around $80/bbl (see Doug Terreson, “Integrated Oil: Raising Oil Price Forecast, Earnings Estimates; Overweight Integrated Oils,” December 3, 2007). That was then. Our energy team and we now think that supply constraints are putting a higher floor under crude and refined product prices. If Brent averages $90/bbl this year, US retail gasoline prices (all grades) seem likely to average about $3.25 for the year, and in the spring driving season could hit $3.50. Likewise, the jump in wholesale food prices has yet to show up fully in retail products, and a continuation of 4-5% food price hikes seems highly likely for the balance of 2008. Agriculture is largely recession proof, global demand is strong, US energy policy continues to pressure grain and land prices, and increases in supply are limited (see Robert Feldman and Hussein Allidina, “Land to Mouth: How to Profit from the Food Chain in Food,” January 15, 2008). A rise in import prices apart from food and energy — the product of a weaker dollar and gains in non-dollar import prices — is a second current source of inflation pressure. Beyond the secular change in global pricing mentioned above, I’ve long thought that the degree to which higher (or lower) import prices affects US retail prices (“pass-through”) depends on the cyclical state of the economy. Put simply, pass-through is weak in recessions and stronger in expansions (for example, see “Is a Weaker Dollar Inflationary?” Global Economic Forum, November 16, 2007). But there are lags between the time the economy weakens and the degree of pass-through declines, and slack hasn’t yet increased by enough to mute the impact of such price hikes by as much I thought a few months ago. And import prices have also risen over the past few months by a bit more than I thought — not solely because of the weaker dollar but also because costs have escalated. The upshot: While pass-through has been incomplete, import price hikes have given a lift to US inflation. 
Domestic factors also have worsened the inflation picture. Inflation expectations, partly reflecting the global forces mentioned above, are moving higher. Measured by the University of Michigan’s consumer canvass, 5-10 year inflation expectations have edged up to 3% in the past few months, and are at the high end of their recent range. Moreover, distant forward (5-year, 5-year) breakeven inflation — a market-based measure of inflation expectations — has moved up by 30 bp to nearly 2.9% in the past few weeks (based on a smoothed yield curve as the Fed calculates it). The relationship between slack in the economy and inflation seems to be looser — in other words, the so-called Phillips curve is flatter — than in the past. A Fed study suggests that the sensitivity of US inflation to measures of domestic slack has fallen by about a third since the mid-1980s (see John Roberts, "Monetary Policy and Inflation Dynamics," FEDS Paper 2004-62, 2004). That works both ways, of course; it means that high operating rates may be less inflationary but that a long period of sub-par growth may be needed to help bring inflation down. Productivity growth slid sharply during 2004-06, falling to an average of just 1.4%, in sharp contrast with the 3.6% clip over 2001-2003, and that has also raised inflation concerns. Lower productivity gains limit the economy’s non-inflationary “speed limit” and boost unit labor costs; both can be inflationary. In my view, the dramatic productivity surge of 2001-2003 was mostly cyclical, partly reflecting the desire of Corporate America to purge the hiring excesses of the 1990s. Correspondingly, the big slowdown in productivity growth in recent years was payback for that surge, as employment caught up to the economy (see “The Coming Productivity Undershoot,” Global Economic Forum, March 20, 2006). But the secular trend in productivity probably has moved down, to about 2¼-2½%, and some of that downshift may have a lingering effect on inflation. Finally, lags also matter. Even when the forces that will begin reducing pricing power and inflation emerge, it can take several months to a year before they show up in the reality of lower inflation. That important fact is usually overlooked when the economy slows and inflation pressures linger. Fears of stagflation are likely to mount until the evidence of lower inflation appears, especially because the jump in oil and food prices is the result of supply constraints or even shocks as much as it is the product of strong demand. That inflation has picked up in emerging markets and remains stubbornly high in several industrial economies is also fueling fears of a global trend. Notwithstanding higher US inflation now, I still think those fears are overblown; the pickup abroad is regional rather than global (see “Global Inflation: False Alarm,” Global Economic Forum, October 22, 2007). In my view, the time-honored forces of increased slack brought about by recession will cause inflation to slowly move lower. In that context, I expect that rising costs will soon have an impact on profit margins instead of prices, as companies are less able to pass them through to consumers. Fed officials are acutely aware of the inflation risks associated with aggressively fighting recession, especially if they overstay their welcome. The FOMC minutes from the January meeting and recent Fed speeches refer to the need to unwind that ease: “[S]ome [members] noted that, when prospects for growth had improved, a reversal of a portion of the recent easing actions, possibly even a rapid reversal, might be appropriate.” Ultimately, my belief that inflation won’t rise significantly further rests on the Fed’s resolve to cap inflation. For now, however, policymakers are committed to limit the damage to the economy from an ongoing credit crunch. And that means they risk allowing inflation expectations (especially longer-dated inflation expectations) to creep higher. A Fed in reflation mode and the risk of higher inflation remain a recipe for a bear steepening in the US yield curve (see “We Still Like the Steepener; Nothing Has Changed,” February 22, 2008). Against this backdrop, buying longer-dated inflation protection (via inflation-linked products) also makes sense.
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Review and Preview
February 25, 2008
By Ted Wieseman | New York
Treasuries ended relatively narrowly mixed over the past week, but modest losses at the front end and gains at the back end extended on net the curve flattening reversal from the multi-year highs hit February 14. This correction, however, appeared as though it might have run its course for now, as there was a substantial re-steepening from the flattest intraday levels hit Thursday morning into Friday’s close that followed another weak Philly Fed manufacturing survey. Prior to that report, there had been a substantial scaling back of Fed rate-cutting expectations underway, with a big move on Tuesday that had no obvious fundamental trigger followed by another big repricing following an upside surprise in the CPI report that lifted the annual rate of core inflation to +2.5%, an 11-month high and up from the recent low of +2.1% hit last summer. This potentially worrisome deterioration had investors thinking that the Fed might feel constrained in responding aggressively further to the deteriorating economic situation. But the recessionary Thursday data – the Philly Fed was by far the main focus, but jobless claims also continued to deteriorate on an underlying basis, and the six-month annualized trend in the index of leading economic indicators at -4.0% has reached a recessionary rate of decline – muted these concerns. Still, while the scaling back of Fed rate-cutting expectations post-CPI was reversed Thursday, there was still a moderation for the week thanks to the Tuesday repricing, with investors now betting that the funds target won’t fall below 2%. Trends across key risk markets were somewhat mixed on the week and, in a recent rarity, were not the major drivers of the Treasury market. Instead, some very big swings in the MBS and swaps markets were the biggest contributors to Treasury volatility through the week. Credit markets continued to worsen for the week as a whole and stocks were down modestly at the 3:00 bond market close Friday, though late reports that a support plan for bond insurer Ambac might be soon announced helped move stocks into slightly positive territory for the week and tightened credit spreads a good bit off their wides late Friday. And two markets that have recently become increasing sources of concern about possible future write-downs – commercial mortgages and leveraged loans – both improved. On the week, 2s-10s flattened 5bp to 181bp and 2s-30s 8bp to 260bp, the first week this year that the curve didn’t steepen. These end of week levels, however, still represented a sizable reversal off the intraday lows of 165bp for 2s-10s and 236bp for 2s-30s hit Thursday morning. The 2-year yield rose 7bp on the week to 1.98%, the 5-year 4bp to 2.80%, the 10-year 1bp to 3.79%, while the 30-year yield dipped 2bp to 4.58%. Surging commodity prices helped TIPS strongly outperform, except at the long end, where outperformance was small. The benchmark 10-year inflation breakeven rose 7bp to 2.36%, a high since November. Through the futures close Friday, stocks were down a bit on the week and credit spreads at new wides, but there was a big late improvement after CNBC reported the news of a possible Ambac support plan to be announced in the coming week. This left the S&P 500 up 0.2% for the week. The 5-year investment grade CDX index was near 152bp late Friday, which was 6bp wider on the week, but well off the all-time wide near 159bp seen just before the Ambac reports. Meanwhile, the leveraged loan and commercial mortgage markets were seeing decent improvement through the week while stocks and credit were softer. Through midday Friday, the leveraged loan LCDX index was 28bp tighter on the week at 508bp after hitting an all-time closing wide at the end of the prior week. Meanwhile, the highest-rated commercial mortgage CMBX indices showed substantial further improvement off the all-time wides hit February 11 after what had been a near freefall over the prior couple of weeks, though the lower-rated indices were relatively little changed. Over the latest week, the AAA CMBX index tightened 28bp to 186bp and the AJ (junior AAA) index 31bp to 486bp. These were a good bit better than the February 11 wides of 228bp and 518bp, but were still way above levels near 65bp and 170bp seen at the end of last year. There was a significant scaling back of Fed rate-cutting expectations in futures markets that swung expectations away from their recent trend towards pricing a 1.75% funds rate trough instead of 2%. The April fed funds contract lost 8bp to 2.495%, May 6bp to 2.285%, July 9bp to 2.13%, and low rate September 15.5bp to 2.07%. Eurodollar futures losses were led by 18-19.5bp sell-offs by the June 08 to Dec 08 contracts, with the low-rate Sep 08 contract losing 19.5bp to 2.52%. Most of these short-end losses reflected the rethinking of the Fed, but they also continued the recent trend towards pricing dislocations in the LIBOR markets continuing for a long time. On the week, the 3-month LIBOR/3-month OIS (expected average fed funds) spread dipped 2bp to a badly dislocated 51bp, and forwards are suggesting little improvement through mid-year. The economic calendar the past week was light, with a worse-than-expected inflation report, a mixed housing starts release and early indications for key upcoming February data that pointed to poor results the focus. The consumer price index rose 0.4% in January for a 4.3%Y gain, boosted by an above-trend 0.3% increase in the core and a 0.7% jump in food prices. This left the annual increase in food inflation at +4.8%, a 17-year high. Energy prices (+0.7%) posted a relatively small gain, as modest upside in gasoline was partly offset by a dip in utility rates. Recent trends in wholesale gasoline prices are clearly pointing to significant upside in energy prices in the coming months. The elevation in the core reflected modest upside in a number of components, including hotels (+1.1%), medical care (+0.5%), education (+0.6%), tobacco (+1.1%) and airfares (+0.8%). The core has now risen at an elevated 3.1% annual rate over the past three months, which has lifted the year-on-year pace by four-tenths since the August and September low to +2.5%. Housing starts rose 0.8% in January to a 1.012 million unit annual rate, rebounding slightly from a 14.2% plunge in December. The upside was accounted for by a 22% jump in the volatile multi-family component to 269,000 after a 39% drop last month. Single-family starts fell another 5.2% to 743,000, a low since January 1991 and before that 1982. Single-family starts are now 60% below the January 2006 peak, but we expect them to fall another 30-35% to record-low levels in the 50-year history of the data before a bottom is hit later this year. Eventually this should help get inventories under control, but first a persistently elevated pipeline of construction underway must be cleared. In this regard, the level of single-family home completions in January was a whopping 36% above the level of starts. Early indications for the upcoming employment and ISM reports pointed to soft results. Initial jobless claims in the latest week, which was the survey week for the February employment report, fell modestly, but the four-week average jumped to its highest level since the autumn 2005 aftermath of Hurricane Katrina. Continuing claims in the prior week also reached a post-Katrina high. Our preliminary forecast for February non-farm payrolls is for a marginal 40,000 gain after last month’s 17,000 decline. Meanwhile, a weak Philly Fed manufacturing survey confirmed previously reported softness in the Empire State report. The headline sentiment index in the Philly Fed survey fell to -24.0 in February from -20.9 in January, a low since February 2001, just ahead of the start of the 2001 recession. On an ISM-comparable weighted average basis, the index declined to 45.9 from 46.6, a low since December 2001. On this basis, the Empire State declined to 48.1 in February from 50.1 in January, a low since November 2002. Based on these results, our preliminary ISM forecast is for a decline to 49.0 from 50.7. After the quiet past week, the economic calendar in the coming week is extremely busy, though the heavy slate of economic data releases is mostly of secondary importance ahead of the key early round of February data to be released the following week. Focus instead will be on Chairman Bernanke’s semi-annual monetary policy testimony on Wednesday and Thursday, though his recent Senate testimony and the early release of the FOMC’s new forecasts in the minutes from the January FOMC meeting reduces the chances of any major market-moving surprises. We would look for Bernanke to acknowledge the recent inflation upside and stress the importance of keeping inflation expectations contained, but still indicate that for now the Fed remains focused on downside risks to growth in setting policy. When the economy turns, however, we think he may give support to the idea expressed by some officials in the January FOMC minutes that “a reversal of a portion of the recent easing actions, possibly even a rapid reversal, might be appropriate”. We will also be interested to hear his analysis of the implications of the broadly based recent worsening in financial market conditions, with the continuing weakness in stocks, credit and, of course, subprime mortgages that has more recently spread substantially into commercial mortgages, leveraged loans and more esoteric markets like auction-rate securities. Data releases due out in the coming week include existing home sales Monday, PPI and consumer confidence Tuesday, durable goods and new home sales Wednesday, revised GDP Thursday and personal income and spending Friday: * We look for another modest 2% decline in January existing home sales to a 4.80 million unit annual rate. On the plus side, the pending home sales index has been relatively steady for the past several months, suggesting that we may be nearing a bottom in the resale market. * We forecast a 1.1% surge in the overall producer price index in January and a 0.3% gain in the core. The newly released weights and seasonal adjustment factors triggered a significant upward adjustment to our expectation for the headline PPI (from +0.5% previously). Indeed, the energy category is now expected to unwind all of the dip seen in December. Meanwhile, the new seasonal factors still do not appear to fully account for the typical start of the year price hikes for a wide range of goods, including drugs and aircraft. So, we expect to see some slight upside in the core relative to the recent trend. * We expect the Conference Board’s measure of consumer confidence to tumble to 79.0 in February. Based on the recent performance of the University of Michigan and ABC surveys, the Conference Board gauge appears due for a sharp fall-off this month. We look for a nearly 10-point decline in February – to the lowest reading since September 2003. * We forecast a 5.7% decline in durable goods orders in January, as a sharp pullback in the volatile aircraft category is likely to lead to an unwind of the sizeable gain in orders seen in December. Also, we look for the key core component – non-defense capital goods ex aircraft – to edge down 0.5%. Finally, we are building in a flat reading for core shipments and only a very slight (+0.1%) rise in overall inventories. * Based on the recent stability evident in the current sales component of the homebuilder survey, we look for new home sales to be little changed in January at a 600,000 unit annual rate. Unusually mild weather conditions in some parts of the nation should provide some modest support this month. * We look for 4Q GDP growth to be revised up slightly to +0.8% from the originally reported reading of +0.6%. Higher net exports and inventories should more than offset lower results for consumption and government. * We forecast a 0.4% gain in January personal income and a 0.2% rise in spending. The January employment report pointed to a sub-par advance in income, even after factoring in the typical start of the year rise in the government sector. Meanwhile, a fall-off in purchases of motor vehicles should help to restrain consumption. Finally, our translation of the CPI data suggests that the core PCE price index will be +0.3% in January, with the year-on-year rate holding at +2.2% (note that we may update our estimate following the release of the PPI data).
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Is Policy Rate Cut Necessary for Growth Recovery?
February 25, 2008
By Chetan Ahya | Singapore
Should the BoT cut policy rates further? Monetary policy has become key point of debate regarding Thailand’s macroeconomic management. Government officials have been indicating their desire for more accommodative monetary policy. We believe that there is more than an even chance that the new government’s pro-growth policies may influence the central bank to cut the policy rate further over the next three months. However, we believe that the growth recovery will continue without further support from monetary policy and that further loosening in monetary policy could add to inflation risks. Hence, we see no need for the further rate cuts. Arguments from proponents of policy rate cuts Thailand’s recent below-potential growth has been a concern to the new government. Over the past few quarters, GDP growth has been averaging below 5%. The proponents of the cut in policy rate argue that current GDP growth is not reflecting the full potential and needs the support of accommodative monetary policy. Core inflation remains at a manageable level of 1.2%. Also, the government is very keen to remove capital controls on debt inflows and property funds. Proponents of the removal of capital controls argue that foreign funding will be necessary for large infrastructure projects. However, if capital controls are removed, there is a risk that capital inflows could cause faster appreciation in the exchange rate. Thailand’s current policy rate at 3.25% is already higher than the US Fed rate of 3.0%. With a strong possibility of the US Fed cutting its policy rate further to 2.5% on March 18, Thailand would attract more rate arbitrage-related capital inflows in the absence of capital controls if the Bank of Thailand does not cut rates further. We do not believe that further rate cuts are necessary Growth is already recovering. Thailand’s GDP grew 5.7%Y in 4Q07. We believe that domestic demand indicators have started bottoming out over the past four months. Some of the key indicators reflecting this recovery include bank credit, imports, value-added tax collection and retail sales growth. The four key drivers for this recovery are (a) increased pent-up demand, (b) a decline in real interest rates, (c) increased government spending, and (d) improving consumer and business sentiment on hopes of a potential improvement in the political environment. In addition to the pick-up in domestic demand, export performance has remained strong. Indeed, exports rose 33% in January 2008 after growing an average 10.2% in 4Q07. We believe that the weak political environment was damaging the Thai economy. As the new government remains stable, we expect domestic demand to continue to recover. Indeed, we expect a relatively expansionary fiscal policy from the government in 2008. The government has already begun to make big spending announcements. In addition to large infrastructure projects, the finance minister announced a plan to provide major debt relief to farmers last Friday. We believe that there is adequate liquidity in the domestic financial system to meet the additional funding requirement of capex. The excess liquidity (sterilized by way of issuance of bonds, reverse repo and currency swaps) has increased to US$68 billion by December 2007. Also, Thailand’s household balance sheet does not appear to be underleveraged. Indeed, despite the weak macro environment, consumer loans grew 16% in 2007, compared with corporate loan growth of just 1.5%. We believe that the low corporate loan growth reflected a lack of business confidence because of a weak political environment in that period. However, that is already changing. We believe that real interest rates are already at reasonable levels. In comparison with countries in the region, Thailand’s nominal interest rates are in line or lower. Hence, there is no compelling need for the aggressive loosening of monetary policy at a time when growth is recovering and inflationary pressures are rising. Inflation risks cannot be ignored Across the region, inflationary pressures are building up. Thailand is not immune from such pressures. Thailand’s headline inflation increased to a high of 4.3% in January 2008 from a low of 1.1% in August 2007. Similarly, core inflation increased to 1.2% in January 2008 from 0.7% in August 2007. The central bank, in its January inflation report, also increased its inflation forecast slightly and expects it to average around 1.3% to 2.3% with 94.3% probability. With domestic demand likely to recover significantly over the next six months, the pass-through from higher costs is likely to increase. Bottom line We maintain our view that Thailand’s domestic demand recovery will continue over the next 12 months. We believe that further policy rate cuts are not necessary, though we believe that the pro-growth policies of the government may influence the central bank to cut rates. Any aggressive reduction in policy rates could push inflation above the central bank’s forecast range, warranting reversal of those rate cuts, in our view.
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