The Response of the Dove
June 20, 2008
By Joachim Fels & Manoj Pradhan | London
All talk, little action? Last week, we discussed the barrage of more hawkish comments by central bankers around the world in response to rising inflation pressures (see “The Return of the Hawks”, The Global Monetary Analyst, June 11, 2008). However, we concluded that, with the notable exception of the ECB, central banks would be unlikely to deliver the monetary tightening that money markets had priced in for the remainder of the year. Since then, policymakers have been toning down their messages, probably in response to what they see as excessive rate hike expectations. Just consider the following examples:
• Unnamed “senior Fed officials” were quoted in several newspapers earlier this week saying that they feel that the market may be pricing in too much tightening too soon. • ECB council member Lorenzo Bini Smaghi told Il Sole-24 Ore newspaper that “an increase, which I would describe as significant even if it was only 25 basis points, should be effective to bring inflation down within the 2% target in the next 18-24 months”. • Bank of England Governor Mervyn King, in a letter to the Chancellor triggered by a rise in CPI inflation to 3.3%, said that the BoE didn’t intend to bring inflation back to the target within 12 months and – contrary to market expectations – avoided signaling that rates would have to rise to arrest inflation. • The minutes of the Reserve Bank of Australia’s policy board meeting on June 3, released earlier this week, suggested that while there are still lingering concerns about inflation, near-term rate hikes look unlikely as evidence of slowing growth is accumulating. • The minutes of the Bank of Japan’s board meeting also stressed significant downside risks to growth along with upside risks to inflation. Against this backdrop, we cannot help but feel that while most central banks are currently willing to fight inflation with hawkish words, many are unwilling to consider drastic policy action anytime soon. This is typical of the dilemma central banks face in a stagflationary environment, and it is a dilemma that won’t go away anytime soon on our economic forecasts. Rather than over-emphasising and over-interpreting what central banks say, we find it instructive to look at what they do and to look at gauges of the monetary policy stance. In that respect, we have been using the concept of the time-varying natural, or neutral, rate of interest for several years now. This is the level of interest rates that would keep the economy growing on trend over time and keep inflation stable. It provides a benchmark against which one can compare the actual rate of interest and thus get a sense of whether monetary policy is expansionary, neutral or restrictive. In “Naturally Below Neutral”, The Global Monetary Analyst, May 7, 2008), we updated our estimate of the US natural rate. We concluded that financial headwinds had lowered the neutral rate by about 40bp, but even so actual rates at 2% were significantly below the neutral rate and monetary policy was thus expansionary. Given the markets’ focus on the ECB following President Trichet’s warning that rates would likely rise in July, we have now updated our estimate of the neutral rate in the euro area. We will spare you the technical details of the estimation as we have described it in earlier work (available upon request) and just focus on the results here. A few points are worth highlighting: • First, we find that in inflation-adjusted (real) terms, the neutral rate has declined somewhat from a temporary high at 1.9% some two years ago to 1.7% now. This decline probably reflects the impact of the credit crisis. • Second, using the current HICP inflation rate of 3.7%, the nominal neutral rate thus currently stands at 5.4% (1.7% + 3.7%). As we use the three-month Euribor rate rather than the ECB’s refi rate in our calculations of the neutral rate, the 5.4% level has to be compared against the current actual three-month Euribor rate of 4.96%. Thus, euro area monetary policy is currently somewhat expansionary on our measure, and the 50bp of tightening that our ECB watcher Elga Bartsch expects for this year would bring the policy stance only back to roughly neutral. • Third, apart from a brief period during 2007, actual short rates have been below our estimate of the neutral rate since 2001. Thus, ECB policy has been expansionary for almost seven years now. Against this backdrop, it is hardly surprising that euro area inflation has been above the target for most of this period. It is interesting to note that on our calculations the neutral rate is higher in the euro area than it is in the US; however, we would not attach too much significance to this, because we use a measure of core inflation (core PCE) in the US while we use headline inflation in the euro area, and we use the fed funds rate in the US while we use the three-month Euribor rate in the euro area. These methodological differences make it difficult to directly compare the neutral rate levels across the Atlantic. Taken together, we conclude that despite hawkish rhetoric and rising inflation, the policy stance in the two main advanced economies, the US and the euro area, remains accommodative. Two rate hikes from the ECB would only bring the policy stance in the euro area back to neutral. In our view, this is unlikely to be sufficient to arrest global inflationary pressures. As we have explained many times before, in addition to the US and Japan, policy remains very expansionary in many EM countries (see “All Easy in EM”, The Global Monetary Analyst, April 9, 2008). Actual policy rates are way below our (admittedly crude) estimates of neutral rates in China, India and Russia. While these central banks are tightening policy to varying degrees at the moment, it would require massive rate hikes (which are unlikely, in our economists’ view) to get even close to a neutral level for rates.
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South Africa: Electricity Tariffs to Push Out SARB Tolerance Period
June 20, 2008
By Michael Kafe, CFA & Andrea Masia | South Africa
Earlier in the week, the National Energy Regulator of South Africa (NERSA) made its ruling on electricity tariff increases for 2008-11. In addition to a 14.2% 2008/9 tariff increase that was awarded to national electricity producer Eskom in December 2007, the regulator approved a further 13.3% increase, taking the total increase for 2008/9 to 27.5%. For the following three years (2009-11), NERSA expects annual tariff increases of 20-25%, “if the current economic climate continues to prevail and Eskom’s capital expenditure program remains as currently stated”. The 2008/9 tariff is somewhat higher than we had expected, although the others were broadly in line with our forecast. More importantly, these increases are likely to lift the SARB’s CPIX forecast by a full percentage point, and force it to extend its tolerance period by an additional four quarters. Consistent with previous policy action, we believe that such a deterioration in its inflation trajectory supports the case for an additional 50bp interest rate hike in August. 2008/9 Tariff Increases: The Devil’s in the Detail Although the headline announcement correctly points out that the average 2008/9 increase will indeed be in the region of some 27.5%, the details show that the relevant increases for CPIX could be as high as 40%, for a number of reasons: • First of all, NERSA’s municipal guideline recommends that municipalities charge their very low income customers (some 2% of the customer base) no more than 14.2%, with the balance to be recovered by charging other customers 32.6%, effective July 1, 2008. Since the low and very low expenditure groups account for less than 4% of the CPIX survey population, it is only reasonable to expect the CPIX energy costs to come in north of 32%, and not the average 27.5% increase that was awarded to Eskom. • Second, the higher-than-average increase to ‘other’ municipal clients stems from the fact that the annual 27.5% increase needs to be recovered over nine months (July-March) and not 12 (April-March). However, the truth is that municipalities have already sent out their billings for July, with tariff increases of some 14-15% in some cases, and are unlikely to send out two separate billings for the same month. In fact, given that most municipalities are process-driven, they may have to go through a separate budgeting exercise in the coming weeks to arrive at an acceptable tariff rate that takes their delivery and other costs into account, while being fully cognizant of NERSA’s municipality guideline recommendations. Typically, this process could take up to a month or so. As a result, we believe that municipalities are unlikely to implement any new tariff increases ahead of their usual bi-annual tariff revisions in September. If this is indeed the case, the actual tariff increases that will be passed on by municipalities could in fact come in higher than the recommended 32.6%, as municipalities will have to recoup their tariff increases over seven months, rather than nine. For our CPIX modeling, we assume a pass-on rate of 35% by September. • Third, the 2c/kWh electricity tax that was levied in the February Budget is likely to be implemented in September. This will lift the cost of electricity by a further 4.0%, bringing the total tariff increase for the year close to 40%. This is higher than our call for a nominal increase of 32%, comprising a 20% real increase, 7% inflation and a 4-5% electricity tax. The tariff increases of 20-25% for the following three years were, however, in line with our call for real increases of 15%, 15%, 15% and 10% in 2009-12, respectively, translating into nominal increases of 26%, 24%, 22% and 16%. Impact of the Tariff Increase on CPIX and Policy The impact of the higher-than-expected tariff increase for 2008/9 should lift our CPIX peak from 12.5% in September to a ‘double-peak’ of 12.9% in September and November. Also, the quarterly average peak rises from 12.4% in 4Q08 to 12.7%, although we still expect CPIX to fall back into the target range by July 2011. Morgan Stanley expects core CPIX to breach 7% by August, reaching 9.3% by year-end. At the upcoming MPC meeting, we expect both the level and the timing of the SARB’s peak to be pushed out from 12% to 12.7% and from 3Q08 to 4Q08, respectively. More importantly, we believe that the MPC reaction function will ascribe a much larger weighting to its tolerance period than the higher inflation peak. This is because the SARB knows very well that another hike in August will have a very limited impact on the 4Q08 CPIX peak. However, the fact that its tolerance period (the duration for which CPIX remains above target) could be extended by another four quarters calls for some policy response. We are therefore inclined to stick with our call for a further 50bp rate hike in August.
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Japan: Mounting Recession Risk: June Tankan Preview
June 20, 2008
By Takehiro Sato | Japan
Tankan Likely to Exacerbate Recession Concerns Notwithstanding current signs of an upturn in some external environments, we expect the content of the June Tankan to show a strong sense of corporate concern about worsening business conditions. One key area to watch will be whether the headline numbers, which fell unexpectedly sharply in the last March Tankan, have gone sub-zero. With the MoF Corporate Statistics and coincident index (CI) already showing signs of recession, besides the headline data we need to look closely at any revisions to targets for profit margins and capex plans to assess whether the Japanese economy is about to enter (or has already entered) a recession. Still, we expect all of these to be sluggish. Yet not all the news should be bad. With land prices dipping, there are signs of a change in banks’ lending attitude on real estate, and there should be opportunities for companies with low leverage and/or plenty of cash to buy. We should also keep an eye on amendments to land acquisition plans for F3/09. Forecasts for Business Conditions DIs Whereas at the time of the last survey for March, vectors for external conditions, such as credit markets, were generally pointing downwards, more positive news has since emerged in some areas, including a US economy which is not looking as bad as we originally expected and an unexpected shift in US currency policy. That said, corporate sentiment according to a range of leading indicators, including the Reuters Tankan and Quick Tankan, is turning ever more cautious due to high energy prices, so we expect the headline DI for large manufacturers to fall sharply, resulting in a cumulative drop far surpassing the lull seen in 2H04 and essentially displaying the characteristics of a recession. We therefore forecast the current conditions DIs for large manufacturers at +2 and large non-manufacturers at +10, respectively, down by 9ppt and 2ppt compared with the March Tankan. For the outlook DIs, we forecast a 3ppt fall for large manufacturers. Still, we should also bear in mind that the outlook DI for manufacturers regularly tends to come out weaker than the view on current conditions, while stronger for non-manufacturers. A rough forecast for the BoJ Tankan based on the Reuters Tankan would be looking for falls of 11ppt for manufacturers to 0, and 3ppt for non-manufacturers to +9, compared to March. However, we do not use these as our unadulterated forecasts, as in formulating actual forecasts we need to consider various factors including production, inventory, exports and corporate earnings. Worsening terms of trade alongside soaring input costs affect sentiment acutely at SMEs along with large corporations, so we expect the manufacturers DI to fall in line with large corporations. This tendency is already visible in the Watchers Survey and Shoko Chukin’s monthly survey on SME business sentiment. Poorer sentiment at SMEs, who employ about 70% of the workforce, is likely to hamper revival of domestic demand. The stock market, meanwhile, is entertaining strong hopes that rising prices will breathe fresh life into the Japanese economy. If inflation does lead to recovery in real wages, we might expect some feedback for domestic demand, but this assumes improved productivity fuelled by a supply shock, and is unlikely to materialize at least over a period of just one year or so. With sticky nominal wages, though lagging prices, worsening real wages are likely to weigh heavily on the economy for the time being. Forecasts for F3/09 Management Plan Revisions 1) Sales and profit targets: In the March Tankan, while large companies (all industries) were aiming for YoY sales growth of +1.8% in F3/09, they expected recurring profit to remain virtually flat at +0.3%. In the upcoming June Tankan, we expect companies to remain conservative in their actual profit targets, albeit external conditions should be a slight tailwind with fewer concerns than in March about a US recession alongside the yen weaker and stock markets stronger. Indeed, given that we are already seeing some forecasts for recurring profit falls of 20-30%, particularly in export-dependent industries like automobiles, overall we anticipate a tendency to revise down rather than up. In the March Tankan, the average F3/09 forex rate assumed in management targets is ¥109.21/US$ (versus a F3/08 average of ¥115.17/$), and although the gap with the spot rate has currently narrowed, we still think that management plans are tight. We are forecasting top-down earnings of -5.5%Y for recurring profit at large corporations in F3/09 (based on MoF corporate statistics). For the forex rate we assume a yearly average of ¥103/$, and we estimate that the outlook for recurring profit growth would pick up by about 3ppt if the yen were to weaken by ¥5 against the dollar as a yearly average. On this point, the shift of US monetary policy towards arresting dollar weakness (and presumably oil price growth) is a heartening development. However, if calculations assume (as opposed to forecast) that the crude oil price remains at current levels, as far as the SNA data are concerned the offshore outflow of real income expands to an annual rate of ¥34 trillion. Assumptions for such matters as how the burden would be apportioned between companies and the household sector, and how large companies and SMEs would work it out, are other variables, but the outcome here is that large companies’ corporate profit growth suffers by about 3ppt for every 10% rise in the oil price. As a result, whereas manufacturers’ top and bottom lines improve when forex rates are more favorable than assumed, when the oil price is higher than assumptions bottom lines worsen at non-manufacturers, and overall we still think that the risk of downward revisions are more likely than upward revisions. 2) Forecasts for F3/09 capex plan revisions: Whereas the pre-results round-up in the March Tankan raised some problems with inclusiveness and reliability of information at a time when corporate disclosure is being tightened up, the June Tankan data should be much more reliable, being a round-up of plans that have now been published. Moreover, in terms of quarterly patterns, large companies tend to make the biggest upward revisions to their plans from the March to June Tankan reports. That said, we expect this year’s upward revisions to be more muted than usual. We forecast upward revisions at large companies of +1.8% (past five-year average: +3.7%) for targeted growth of +3.1%Y (including land but excluding software), made up of +2.8%Y (+2.4% revision) for manufacturers and +3.3%Y (+1.4% revision) for non-manufacturers. Listed companies’ plans in the Nikkei Capex Survey (published May 25, at a time when there had been some progress with corporate disclosure) call for even more muted growth than the previous year, or +3.7%. We do not doubt that shrinking corporate margins resulting from worsening terms of trade lie behind this. According to the MoF corporate statistics, recurring profit at large manufacturers was down for a third straight quarter in January-March, falling about 20%Y, and was also down for a second consecutive quarter on an all-industry, all-size basis. In the past, whenever corporate earnings on this basis have recorded second consecutive quarterly declines, it has always indicated recession. The employment situation is also detrimental to capex. For example, we have tracked the correlation between the job offers-to-applicants ratio and the capex ratio in the past 30 years. This shows that as supply and demand for labor eases and marginal productivity rises, as is happening at the moment, companies have less incentive to make fresh investment in additional capacity and labor saving. The question is how far the replacement demand that non-manufacturers are expected to see, particularly in the transportation and electric power fields, will make up for subdued manufacturers’ spending on increasing production, and we think the answer is that the overall outcome will be more or less flat. Moreover, where SMEs are concerned, banks’ tighter lending attitudes are starting to result in credit contraction, albeit on a small scale, as evidenced for example by tight cash positions. If capex plans at large companies are revised down in the September Tankan, this would complete the line-up of characteristics of recession. Policy and Market Implications BoJ Governor Masaaki Shirakawa said at a regular press conference on June 13 that because of differing situations for individual countries’ economies and prices, monetary policies will naturally differ too, clearly ruling out the possibility of a rate hike to follow overseas central banks, where comments from top ECB and Fed officials have raised such expectations. In fact, amid heightening risk of the economy faltering and prices rising, the BoJ is giving rather more attention to the impact on domestic and external demand arising from worsening terms of trade and a slowdown in Asia, and in making clear its position of prioritizing the economy over prices has frozen the strategy of interest rate normalization. The BoJ says it will maintain this stance until uncertainties are resolved (“until the fog clears”), but we expect the Tankan to point to the possibility of the fog deepening rather than clearing. In this regard, we think the market is going too far when anticipating a rate hike during 2008, and we maintain our stance that the current situation will remain in place for the remainder of the year. What’s more, we even think that a rate ‘cut’ in 1H09 is not totally ruled out. With the possibility of recession showing signs of deepening up ahead, the degree to which the market factors in a rate hike is more likely to lessen despite the core inflation rate rises.
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