Wednesday, April 23, 2014

America’s next problem is inflation

The return of more solid-looking activity data reinforces for me that US economic fundamentals are continuing to improve and that the next problem for the economy is inflation.  That means the next challenge for markets is the inevitable end of the Federal Reserve’s zero interest rate policy – it’s just a question of when.  Right now the best answer to that question is not yet.

There is also an increasing “solidity” to recent inflation outturns.  At the headline inflation level food prices are rising at a solid clip, posting 0.4% m/m increases in both February and March.  That’s on the back of the extreme drought conditions prevailing on the west coast which is impacting on prices for fruit, vegetables and dairy products.

We should be more interested in core inflation.  Prices increases there have looked a little more solid recently too with rising prices for apparel, medical care and airline fares.  But two-thirds of the 0.2% m/m increase in March came from rising shelter costs along with rents and owner occupied rents.  The shelter index is up 2.7% over the past year – its largest annual rate in six years.  We expect the continued improvement in the housing to put a solid floor (the pun was unintentional) under future core inflation outcomes.
While the FOMC has dropped its quantitative guidance with respect to the unemployment rate, we still look to the labour market to provide the clearest and earliest signs of generalised inflationary pressure.  With demand expected to continue to improve in the period ahead hiring will also pick up, as will wage growth.

The conventional wisdom is that the pick-up in the labour market will be gradual and will therefore put only very limited upward pressure on consumer prices given the significant amount of spare capacity in the labour market.  Seems to me the next question is just how much spare capacity is there?  More on that soon.

Tuesday, April 22, 2014

Stronger growth returning to America

Stronger March month activity reinforces that soft data at the start of the year was mostly related to the poor weather.  It will also help take the rough edges off what was shaping up to be a weak GDP report for the first quarter.

Retail sales came in at +1.1% for March, helped along by a sharp increase in automotive sales.  Aside from that sales were solid across most of the other retail groups.  This result along with an upward revision to February should see real consumer spending come in a touch over 2% (annualised rate) in the first quarter of 2014.

Housing starts were up 2.8% to an annualised 946k in March and, as with retail sales, February was revised higher.  Forward looking building permits fell 2.4% but that was on the back of a 7.3% rise in February.  Despite the drop back in permits housing starts should continue to grind higher to around 1.1 million for the year – or around half the rate that prevailed in the lead up to the GFC.
Industrial production was up 0.7% in March which followed a 1.2% gain in February.  Output was up across a broad range of sectors with the 0.5% increase in manufacturing especially pleasing.  We still look to stronger activity in the manufacturing sector to be the catalyst for stronger business investment in the period ahead.

So a good run of data in the last few days. While that should see March quarter still come in a touch under an annualised 1.0%, it gives us confidence we will see a rebound to around 3.5% in the second quarter.  That reinforces for me that the next problem for the US economy is inflation and the next problem for markets is the end of the Fed’s zero interest rate policy – it’s just a question of when.  More on that tomorrow.

Thursday, April 17, 2014

China GDP growth better than expected

March quarter China GDP growth of 7.4% was better than the 7.3% expected by the market but down from the 7.7% recorded for calendar 2013.  Despite the better than expected GDP result  the partial activity indicators were generally on the soft side, suggesting near term growth risks remain to the downside.

Industrial production came in at 8.8% for the year to March, higher than the 8.6% recorded in the January-February period, but a bigger bounce had been expected following the disruptions of the Lunar New Year period.  At 8.7% growth for the quarter we would have expected GDP to be a tad weaker although the service sector posted stronger than expected growth.

Fixed asset investment fell from 17.9% in Jan-Feb to 17.6% in March with the decline most marked in the property sector.  We expect FAI will continue to drift lower in the period ahead.  Retail sales growth was in line with expectations of 12.2% which is up from 11.8% in Jan-Feb, but growth is still best described as sluggish.

I think risks to growth in the near-term remain to the downside.  That is largely a domestic economy story.  We continue to look to exports to provide some impetus to industrial production and GDP growth later in the year.  Recent weak export growth of -6.6% for the year to March has been distorted by inflated data last year.  Adjusting for those distortions shows export growth running closer to +7.0%. Furthermore the strongest (least weak?) components of the recent manufacturing PMI surveys have been new export orders.

While the near-term growth risks remain to the downside the better than expected March GDP out-turn along with continued strong jobs growth suggests there is no need for significant stimulus.  However, if growth does continue to look a bit soft, we expect to see further announcements similar to the “mini-stimulus” we saw two weeks ago.  Low inflation and last week’s sharp drop in M2 from 13.3% in February to a below target 12.1% in March provides plenty of room to ease further in need.

Wednesday, April 16, 2014

NZ CPI lower than expected but tightening to continue

New Zealand’s March quarter CPI came in lower than expected at +0.3% q/q/ for an annual rate of +1.5%.  That’s a tad lower than the 1.6% recorded for the year to December.  Market consensus was for a quarterly increase of +0.5% and an annual rate of 1.7%.  However, we don’t expect the Reserve Bank of New Zealand (RBNZ) to be in any way deterred from continuing the gradual removal of monetary accommodation in the months ahead.

The surprise in the result was the softness in tradeables inflation which came in at -0.7% q/q and -0.6% y/y with the downward pressure on prices coming from the strong New Zealand dollar.  That decline was more than offset by a 1.1% q/q increase in non-tradeables inflation which is now running at an annual rate of 3.0%.  Key contributors on that side of the equation were the expected increase in tobacco excise tax, but also continued strong increases in construction costs which are now running at an annual rate of 5.1%.

We don’t expect this result to deter the RBNZ from pressing ahead with the gradual withdrawal of monetary stimulus.  The reality is that GDP growth is running well ahead of potential, spare capacity is being absorbed and firms are finding it more difficult to find skilled labour and interest rates are still at exceptionally low levels.

Those factors being the case we still expect the RBNZ to lift the Official Cash Rate 25bps in each of April, June, September and December for an OCR of 3.75% by the end of this year, with continued tightening in 2015 taking the OCR to 5.25%.

That said, there are many factors that will ultimately determine the quantum and pace of the tightening cycle.  These include whether the RBNZ has been (and remains) sufficiently pre-emptive, how the economy responds to higher rates, where the neutral OCR is, what New Zealand potential growth rate is and, of course, the path of the exchange rate.

With respect to the exchange rate our interest rate forecasts assume some eventual downside in the New Zealand dollar.  Recent falls in commodity prices haven’t yet proven the catalyst for a weaker currency but we expect that as the Reserve Bank of Australia starts to hike rates later this year and as the US Federal Reserve moves closer to interest rate increases we will see some downside in the NZD.  If none of those work, the catalyst for the lower NZD will likely prove to be a downward revision of our and, more importantly, the Reserve Bank’s interest rate projections! 

But remember exchange rate risks are not one-sided. A sharper than expected fall in the exchange rate could lead to higher inflation and higher interest rates.