Thursday, November 27, 2014

Diverging emerging economy monetary policy

As the year has progressed the global growth outlook has become increasingly mixed.  Amongst the developed economies growth in America is looking increasingly solid while Japan and the Euro zone continue to struggle. That is leading to an increasing divergence in monetary policy as the US Federal Reserve ends its quantitative easing program and looks likely to raise interest rates next year while the Bank of Japan and the European Central Bank are stepping up their asset purchases.  (For more on central bank asset purchases click here for a recent Investment Insights from our Head of Investment Strategy Keith Poore).

With the recent cut in China interest rates and the increasing likelihood of the same in India monetary policy in the key emerging economies is also on a divergent path as Brazil and Russia continue to hike rates in the face of persistent inflation pressures and, in the case of Russia, concerns about financial stability.


The surprise (at least for me) cut in China interest rates is a clear signal that policy makers are concerned the more targeted easing measures to date will be insufficient to achieve the desired growth/inflation outcome.  Indeed the move to cut rates is likely to be on the back of recent low inflation which has led to an increase in real interest rates and the fact that recent measures to lower mortgage interest rates have been ineffective.  Recent appreciation in the exchange rate, especially against the Yen, was probably also a factor.

It remains to be seen what impact this will have on the real economy.  While the rate cut is probably more likely to have an impact on borrowing costs for larger corporates than SMEs (who are more reliant on the shadow banking sector for funding) it is a clear signal that policy makers want to get the cost of capital down.  Having now started, further rate cuts appear more than likely.

Concern that policy-makers are abandoning the reform process in favour of cyclical support for the economy is ameliorated by the move to widen the deposit ceiling from 10% to 20% which, while subtle, is a further step towards interest rate liberalization.

While the recent weakness in the property market is a clear concern, I’ve been pretty comfortable with the broader slowdown in China growth.   I’ll stay comfortable so long as lower growth is a reflection of continuing implementation of the reform program that, while leading to lower growth over time, will make that growth more sustainable.

Interest rate cuts won’t preclude continuing efforts to increase fiscal spending and attempts to get local government to increase infrastructure spending.   These measures were successful in supporting growth earlier this year and will likely do so again, at least once we get past the likely further weakness in industrial production in November reflecting measures to reduce pollution ahead of the November APEC meeting.

Meanwhile the growth/inflation outlook in India is moving increasingly in favour of interest rate cuts. Inflation has moved sharply lower over recent months Inflation fell in India during October primarily reflecting a drop in food price inflation.  The lower inflation outturns will ease the pressure on the Reserve Bank of India, which recently introduced an inflation targeting regime.  That said, interest rate cuts are probably more a 2015 story and require the new Government to maintain a strong fiscal discipline.


The Central Bank of Russia (CBR) has been raising its policy rate aggressively to offset the inflationary impact of the weakness in the currency. While currency weakness is a good thing when adjusting to an external shock, it can move too far too fast.  Growth has held up surprisingly well so far (+0.4% qoq in Q3, +0.7% yoy) although we don’t expect that will last.  The uncertainty of the political/sanctions environment will continue to be a drag on business investment, consumers are feeling the impact of higher inflation through lower real incomes and the oil price is sharply lower.

CBR is taking the right approach however by ensuring financial stability while at the same time managing a decline in the currency that allows the economy to adjust gradually.  The bank also appears keen to build its inflation fighting credentials in the lead in to the adoption of a formal inflation targeting regime next year.

In Brazil the central bank resumed interest rate hikes at the end of October with a 0.25% increase in the Selic rate to 11.25%.  As I’ve said many times before Brazils inflation problem is largely structural – the good news is the central bank is responding appropriately which throws down the challenge to the freshly re-elected President to engage in meaningful structural reform of the labour market and network industries in particular.  I expect the Selic rate will be closer to 12% before long.

As an economist with rather conventional (old fashioned?) views about the role of central bank’s and monetary policy it is encouraging that the key emerging market central banks are responding to their own set of circumstances in a quite orthodox fashion.  While worrying about much needed structural reform in many countries, including the key emerging economies, my concern was emerging market central banks would take their eye off the inflation ball.  You will be pleased to know I’m becoming increasingly less worried about the central banks although I’m still worried about the politicians…

Monday, November 17, 2014

Japan GDP - truly awful

I’m going to be out of the office later this week so thought I should get a post done before I head off.  That only left me to decide what to write about.  Then Japan GDP came out.  Problem solved.

What a truly awful number.  Japan’s third quarter GDP contracted at an annual pace of -1.6%.  Remember this was the quarter activity was meant to bounce back following the June quarter fallout from the consumption tax increase when GDP contracted at a -7.3% annualised pace.  Average market expectations were for an increase of 2.2%.

The detail of the result didn’t provide any silver linings.  Inventories contracted more than expected over the quarter but they were always going to be negative following the big positive contribution in the June quarter.

The real disappointment was the weak increase in consumer spending of +1.5% (annualised).  That followed a whopping -18.6% contraction in the June quarter.  I’ve been at the pessimistic end of Japan growth all year, especially with respect to how the economy would come through the tax increase, but even I’m disappointed in that result.

It seems highly likely the second tax hike scheduled for late next year will now be postponed.  That raises another important question beyond the obvious of the near-term growth outlook: how is Japan to achieve any semblance of fiscal sustainability?

Raising revenue is proving too damaging to the economy.  Cutting spending would have the same effect.  You know what I’m going to say next.  So far meaningful structural reform has proven to be too difficult politically.  Time to get on with the job.

Thursday, November 13, 2014

US wages, inflation and monetary policy

The recent spike higher in the US Employment Cost Index (ECI) has received a bit of attention recently.  With markets attuned to any nascent display of inflation the rise in the annual rate of increase from 1.8% in the year to March this year to 2.2% in the year to September has not gone unnoticed.

A couple of points.  Firstly, the ECI is a broader measure of worker compensation as it also captures the cost of benefits.  Benefit costs are rising at an annual rate of 2.4% - faster than wage growth which, while higher also than six months ago, is running at an annual rate of 2.1%.

Secondly it appears the recent rise in the wages component of the ECI just brings it back into line with average hourly earnings, the annual rate of increase in which has been tracking a little over 2% in the past few months.  In that respect there is little new news in the ECI to get excited about.
But as I’ve said on numerous occasions before; it’s ultimately unit labour costs (ULCs) that matter most to the inflation outlook.  ULC are clearly trending higher’ although admittedly it requires a 24-month moving average to find a nice fit with core inflation.


The upshot is that wage growth is off its lows and ULCs are trending higher.  Core inflation remains subdued and may indeed continue to be subdued for a while yet.  Core inflation excludes direct commodity price effects by excluding food and energy prices but second round effects of lower oil prices in particular are likely to keep core inflation pressures subdued in the near term.  The higher USD will also keep inflation subdued.

But monetary policy must retain a medium term focus. The ECI is just the latest in a number of indicators that suggest continued monetary policy normalisation is warranted in America.  We continue to expect the FOMC will leave interest rates unchanged into next year with the first interest rate increase likely in mid-2015.

Monday, November 3, 2014

More easing from the Bank of Japan

The Bank of Japan (BoJ) faced an important credibility test last week.  On Friday they released their semi-annual outlook report on the econony in which they had no option but to lower both their growth and inflation forecasts.  But in announcing new easing measures they were able to leave their growth forecasts at the optimistic end of market expectations and retain some hope their 2% inflation target would be met.

In their previous forecasts the BoJ was projecting annual growth of 1.0% in fiscal year (FY) 2014.  That had become increasingly unrealistic as the economy was hit harder by the consumption tax increase in April.  Market consensus growth for that period is now around 0.2% with our forecast at 0.0%.  With lower growth and weaker commodity (i.e. oil) prices their inflation forecasts had also taken on an aura of make-believe about them.

In announcing new easing measures the BoJ has been able to keep their growth forecasts at the optimistic end of expectations by dropping it to 0.5%.  That’s the BoJ’s assumed rate of trend growth.  Lowering their forecast below trend would have made forecasting rising inflation an even more challenging communications exercise.

Their inflation forecasts are only slightly reduced.  The Bank is now expecting annual inflation (excluding consumption tax increases) of 1.7% in FY 2015 (down from 1.9%) and 2.1% in FY2016 (unchanged).  Furthermore the timeframe for achieving their 2.0% target is now open-ended.

As for the easing itself – it was a mix of both qualitative and quantitative.  The key feature was the increased pace of expansion of the monetary base by ¥10-20 trillion to ¥80 trillion per annum.  It is probably no coincidence this was announced the same day the Government Pension Investment Fund announced a new target asset incorporating a reduced allocation to domestic bonds and higher allocations to domestic and global equities.  In addition to the expanded purchases of JGBs, the BoJ also announced increased purchases of both ETFs and REITs.

Will this work?  You know what I’m going to say.  Without a commitment to considerable productivity enhancing structural reform, the growth and inflation outlook in Japan is likely to remain very challenging.  At least I’m consistent!!