Friday, April 11, 2014

When Doves Cry: monetary policy in the G3

A key theme for us this year was that despite the improved global growth outlook, monetary conditions in the key developed economies would remain highly stimulatory and in two cases – the Euro area and Japan – possibly become easier.  Recent statements from the G3 central banks have not altered that view.

After the March Federal Open Market Committee (FOMC) meeting increases in interest rate projections (the dots in the central tendency projections) along with Chair Janet Yellen’s apparent definition of "considerable time" as six-months in the post-meeting press conference left markets concerned, overly in our view, that interest rate increases were closer than appeared likely before the meeting.

The release this week of the minutes from the March meeting should have left markets in no doubt as to the continued dovish bias of the Committee.  That followed an equally dovish speech from Yellen last week that, along with the minutes, consigns “dot-gate” and “six-months” to history as communication wobbles.

While the weather cops most (though not all) of the flak for the recent weakness in activity data, there was an interesting and important discussion about the degree of slack in the labour market. "Several" members of the committee thought there might be more slack in the labour market than suggested by the unemployment rate alone while “a couple” saw slack as more limited.

The weight of opinion in that discussion is consistent with Yellen’s speech last week in which she observed that the economy and the job market are not back to normal health and that the US economy needs extraordinary support for some time.  The discussion is not suggestive of a committee that is going to be in a rush to remove monetary accommodation.  That said the focus on the labour market reinforces for me that wages, more precisely unit labour costs, holds the key to the Fed’s next move.

The Euro zone economy is at a fascinating stage.  Growth is clearly better, but remains insufficiently robust to make any significant dent in spare capacity.  The complicating factor for the ECB is that the amount of spare capacity differs across the region, most notably between Germany where the output gap is small and closing and in the likes of Spain Italy and France where output gaps remain large.  On balance, risks to inflation remain to the downside.

The ECB left conditions unchanged at their meeting last week but clearly maintained an easing bias which was, if anything, reinforced by the comment that the Governing Council  is "unanimous in its commitment to also use the unconventional methods within its mandate in order to cope effectively with risks of a too prolonged period of low inflation".

All options remain on the table for the ECB including quantitative easing (QE).  Bank President Mario Draghi said the discussion was continuing around QE including determining which of private and public purchases would be most effective.

Just as there is a high hurdle for altering tapering in the US, there is a high hurdle to its introduction in the Euro zone and I'm not convinced the ECB is fully there yet.  But it can’t be ruled out either with high unemployment, continued corporate deleveraging and the risk of lower inflation.

The Japanese economy is also at a critical stage.  The Bank of Japan (BoJ) also left conditions unchanged this week but at the post meeting press conference Governor Haruhiko Kuroda acknowledged there was room for further easing, although he also said there is room to adjust conditions in the opposite direction i.e tighten.

While the BoJ was somewhat more cautious about the economic outlook this month, perhaps in response to the weaker than expected Tankan survey, I think they are being a tad optimistic about how well the economy will come through the April 1st consumption tax increase.

As discussed in the post below I think Japan is in for a period of low growth which along with the waning impact of the recent currency depreciation will see inflation turn down again in the months ahead.  That will force the BoJ’s hand if they remain committed to their 2% inflation target.

Friday, April 4, 2014

Mini-stimulus in China

This post started off yesterday as a discussion of the policy options open to the Chinese authorities should  they feel the need to do something to stimulate the economy and at what point they might do that.   After yesterday's announcement we know the answers to those questions are that fiscal stimulus is the first cab off the rank and they are worried about it now.

At issue is the weaker than expected activity data at the start of 2014 with industrial production, exports and retail sales all coming in below the bottom end of consensus expectations.  Our forecast growth track for this year assumed a soft start to the year on the back of domestic weakness, stabilisation in the middle of the year and some upside in the second half of the year on the back of renewed impetus to exports as global growth improves.

Data for the first two months of the year shifted the forecast risk to our March 2014 GDP forecast of 7.4% to the downside and forward looking data such as the PMI, while supporting our thesis of a soft domestic start to the year bolstered by exports later on, suggests growth would most likely deteriorate further in the year to June, to perhaps as low as 7.0%.

That’s all in the context of a 7.5% growth target and a strong commitment to structural reform.  There has been a high degree of equivocation over this year’s growth target with various members of the leadership talking at various times about the target not being a hard target and commenting that growth of 7.2% or 7.3% is “close to” 7.5%.

The prospect of a number closer to 7.0% in Q2 has been sufficient for them to act.  Remember the Chinese authorities have been able to continue to focus on structural reform because the labour market has been holding up well.  But there was always going to come a point at which they would become concerned about low growth and its implications for the labour market and opt for some cyclical support for the economy.

The good news is that with inflation running at 2.0% and a forecast budget deficit for 2014 of 2.1% of GDP, there is ample room to move on both monetary and fiscal policy.  The inflation target for 2014 is 3.5%.

As we suspected the initial step has been fiscal.  Yesterday’s stimulus package focussed on infrastructure (railway) and housing spending.  It also offered tax breaks to small business.    There is plenty more ammunition should it be required.  There is more room for fiscal stimulus, which we expect will remain targeted at infrastructure spending (more rail, social housing, energy saving initiatives, environmental protection).  On the monetary side of the equation PBoC has tool at its disposal to provide liquidity to keep the cost of capital down such as suspending repos and cutting the reserve ratio.

While the size of the package was relatively small by China standards the more important point, at least for financial markets, is that it has removed the uncertainty about at what point the authorities would step in and support growth.

Tuesday, April 1, 2014

Critical period ahead for Japan

There's an ongoing debate in Japan about the success or otherwise of “Abenomics”.  Regular readers will know I'm less than convinced that Japan is on a path to sustainable growth and out of deflation.  That still requires a good dose of the third arrow of Abenomics: structural reform.

We now also throw the scheduled increase in the consumption tax into the mix.  The tax increases from 5% to 8% today.  How the economy comes through the next few months will be a key determinant of what work is still left to do to for the Bank of Japan to meet its 2% inflation target.

Recent data out of Japan has been relatively good, at least by recent Japanese standards.  GDP growth came in at an annual rate of 2.6% in December although the quarterly rate disappointed on the back of soft net exports.  Since then activity data has strengthened as household spending picked up into the tax increase.  Retail sales came in at 3.6% for the year to February – still a solid increase even if it was lower than the 4.4% recorded for the year to January.

It's not rocket science to expect retail sales will be sharply lower in the period immediately after the tax increase. Indeed industrial production is already heading lower as the “rush demand” abates from retailers.  Production was down -2.8% in the month of February for an annual growth rate of 6.9%, down from 10.3% in the year to January.
The critical question is what happens after that?  While Japan is better placed now than it was at the time of the last hike in 1997 which pushed the economy into recession, we are still cautious about the outlook.  Firstly, beyond the initial slump in consumption spending, it seems to me retail sales will continue to be constrained by the decline in real incomes post the tax increase.
Secondly, recent export performance has been disappointing and can’t be expected to fill the gap, at least not in the short term.  Exports have not fired on the back of the depreciation in the exchange rate due to insufficient demand, particularly from Asia.  Stronger global growth, particularly out of Europe and America should help that later in the year.
The ¥5.5 trillion supplementary budget will also assist, although it remains to be seen how quickly projects can be implemented.  I also question how successful incentives for capital spending will be; I think business is looking for progress on structural reform before committing to new investment.
On balance I think we are in for a soft period of growth in Japan, with stronger growth reliant on a recovery in exports later in the year.  That appears likely to put a dent in the other success story of Abenomics: reflation.  Headline inflation appears to have stabilised at around 1.5% per annum recently while core inflation (excluding both food and energy) is running at 0.8%.
Much of the recent rise in inflation has been due to energy prices and the exchange rate depreciation.  In the near term we don't expect growth will be strong enough to sustain inflation at its current level let alone move it further towards the BoJ target of 2% (excluding the tax increase).  Of course the other tool Japan has now is quantitative easing.  If we do see a prolonged soft patch in growth and a drift lower in inflation, I expect we will see more action from the BoJ.

Tuesday, March 25, 2014

Weak flash PMI in China

The March flash HSBC PMI for China came in weaker than expected at 48.1.  The market consensus was looking for a modest rebound from the 48.5 recorded in February.  The further softening of the data confirms our suspicions there has been more to the recent soft data than just the usual New Year volatility.

The production sub-index moved to an 18-month low.  But despite the overall weakness in the index the new exports orders sub-index moved back into expansion in March.   That’s consistent with our story of a soft start to the year from a growth perspective on domestic weakness, but with some strength in exports emerging as the year progresses.  On balance though this result has put further downside risk on our year to March 2014 GDP forecast of 7.4%.

Perhaps the biggest surprise in the result was the rebound in the employment sub-index from 47.2 to 49.3.  The labour market remains a key determinant in the leadership determining the balance between pushing on with the reform agenda or cyclical support for the economy.  A March GDP result much below our estimate will likely lead to new measures to support growth which we expect would be focussed on fiscal stimulus (infrastructure) and liquidity provision.

The official PMI index is released next week (April 1st).  The HSBC index is narrower focussed than the official index and tends to be more volatile.  Importantly the official index captures the larger state owned enterprises.  That release will be the next critical piece of data to help inform the extent of the slowdown at the start of the year and the likelihood of any policy intervention.  Watch this space.