Monday, February 28, 2011

EU "Pact for Competitiveness"

Macro-economic coordination across the Eurozone is essential for the long-term stability of the region and the survival of the Euro. EU officials are currently working on a revised “Pact for Competitiveness” ahead of the next EU Summit in March. This follows the rejection of the initial pact, jointly proposed by Germany and France. This called for a whole range of initiatives aimed at improving the competitiveness of Europe and reducing the degree of economic diversity across the Eurozone.

Initiatives included raising retirement ages across the Eurozone, harmonizing corporate and other tax rates, implementation of a “debt brake” to limit the ability of governments to fund spending via borrowing and a monitoring system for wage a productivity levels that would force countries to lower employment costs (for example by forcing countries to end the indexation of wages to inflation) if they rise too fast.

Probably the most contentious issue was the mention in the original pact of the need for a “sanctions mechanism” or, in other words, details of the punishment for breaking the rules, and the obvious question: who does the punishing?

It is perhaps not surprising that the revision of the plan that will go forward for discussion on March 11 is being prepared by EU officials. It appears many of the initiatives remain the same, including the “debt brake” and the monitoring system for state pensions. The key difference is that the implementation of the plan will would be run by the European Commission rather than national capitals. That will allay fears of many of the smaller Eurozone countries.

It is true the immediate concern for markets remains fiscal policy and the look and feel of the new European Stability Mechanism that will replace the European Financial Stability Facility from mid-2013. However, that question cannot be answered satisfactorily without knowing the answer to the broader question of the go-forward governance framework for Europe. That’s why there hasn’t been satisfactory answers to date and why debt initiatives to placate markets have had to be reactive rather than proactive. It’s now time for Europe to get in front of the problem.

For further discussion on this topic and others, watch out for the March issue of QSO, coming to an email inbox near you on or about Friday March 11.

Wednesday, February 23, 2011

G20 progress, or lack thereof

The challenging thing about commitments made on behalf of the world’s largest economies at G20 forums was always going to be the extent to which those commitments translated into policy actions at home. The intentions are in the right place. A stronger global economy needs a co-ordinated approach to tackle structural global imbalances and to determine the future look and feel of the international monetary system.

The communiqué from the Paris meeting of G20 finance ministers was full of good intentions, but the multi-clause sentences belie the difficulty of committing to a firm course of action. As each clause was added to appease the various G20 members, the sentences became less meaningful, and less committed to a course of action.

It will, for example, be difficult to fix global imbalances when consensus on how to measure them necessitates leaving out one critical element: foreign currency reserves, and a significant watering down of another, real effective exchange rates.

If you subscribe to the argument of the so-called “savings glut” as the genesis of the global financial crisis, then high foreign reserves, predominantly in emerging markets, were at the heart of the crisis. And monitoring of exchange rates was replaced in the communiqué with a far broader and therefore softer commitment to “take due consideration of exchange rate, fiscal, monetary and other policies”.

Progress is being made, but it is at a snail’s pace, but at least critically important issues are being discussed. At some point, meaningful progress needs to be made. One of our fears in the aftermath of the recession was a return to Great Depression style competitive devaluation protectionist policies. This must be avoided and it seems to me the best way to do so is for each of the G20 to walk the talk that is being delivered on the global stage.

To be fair to the G20, some of the critics need to have a bit of a think about the consistency of their arguments. China comes in for the most heavy criticism, but if one is to be consistent, Germany should wear a bit at well. China isn’t the only large surplus country that needs to rebalance away from tradebales to non-tradeables.

Financial reform seems the best place for some early G20 wins. Some good work has been done on bringing international accounting standards into line and they must continue to push for the adoption of the Basel III banking standards.

Another issue that needs more discussion is the potential use of IMF Special Drawing Rights (SDRs) as a global currency at the heart of a stronger international monetary system. For that to happen the composition of SDRs needs to be reconsidered in the light of the growing global importance of the Chinese economy. The Yuan must have an allocation for SDRs to be in any way meaningful. But for that to happen, the Yuan would have to become a freely convertible currency. Is that a carrot I see dangling?

Wednesday, February 16, 2011

US normal rate of unemployment

In another story about a post-GFC “new normal”, the good folk at the Federal Reserve Bank of San Francisco (FRBSF) have done a bit of thinking about the new “normal” rate of unemployment in the US.

In more technical terms, this is what economists call the NAIRU or “non-accelerating inflation rate of unemployment”. This is the rate of unemployment, give or take a bit, that the Federal Reserve Board would see as being consistent with the part of its mandate relating to full employment. In the pre-GFC world, the natural rate of unemployment was thought to be around 5%.

The FRBSF research suggests the current normal rate of unemployment in the US is around 6.7%. That sounds reasonable to us. They also attribute some (half) of the rise to the extension of unemployment welfare payments. Not sure about that bit, especially the quantum.

It seems sensible that the normal rate of unemployment is now higher than it was pre-GFC. We are strong believers in the structural nature of the recession in the US (and just about every other country for that matter).

In the US, large numbers of people have lost their jobs in sectors such as finance, real estate, residential construction and retailing. That’s not where the new jobs will be, at least not in the short term. The new jobs need to be in export oriented manufacturing sector. There is clearly a skills mis-match between the newly unemployed and the new jobs. That will take time to fix.

That’s why we warned early on in the recovery that at least some of the excess capacity in the global economy could actually turn out to be redundant, or at least not easily deployed in the new world. The upshot of that is lower potential GDP growth as capacity constraints get hit earlier on in the cycle.

This will be most obvious in the labour market with skills shortages likely to emerge while unemployment remains elevated, or at least at a higher rate than we previously thought consistent with full employment.

It’s interesting that the Federal Reserve, in its decisions to go ahead with QE2, discounted this argument to some extent, believing that the current high unemployment rate in the US is largely cyclical. Time will tell.

Tuesday, February 15, 2011

US makes a "down payment" on fiscal consolidation

The US Administration has presented a Budget to Congress that represents, in the President’s own words, a “down payment” on fiscal consolidation. The Budget includes measures that are expected to reduce the deficit by US$1.1 trillion over 10 years. Despite this, the deficit will still be a record $1.6 trillion (10.9% of GDP) this year, $1.1 trillion in 2012 (7% of GDP). The deficit is projected to be $0.6 trillion (3.2% of GDP) by 2015.

We agree with the President’s assessment that this is a good start (I’m sure he’ll be relieved to know that). Fiscal consolidation was always going to be a difficult but necessary part of normalising post-GFC economic conditions in developed markets. However it was going to be necessary to strike an important balance: it is necessary to continue to support growth in the early part of the process. To that end, the Budget seems to strike a good balance.

Consolidation also means that fiscal policy can be relied upon to do some of the stimulus unwinding, which reduces the amount of work that interest rates will inevitably have to do.

It still remains to be seen the extent to which the very large Budget deficit this year – 10.9% of GDP – is split between its cyclical and structural components. Obama’s political opponents are arguing that he has not made any dent in the items that will really impact on the long-term fiscal outlook – Medicare, Medicaid and Social Security – which collectively make up about 40% of federal government expenditure.

We have made similar observations regarding New Zealand’s fiscal outlook. In last year’s Budget we gave the Government high marks for turning the deficit and debt trajectories around and for the growth-enhancing structural changes they made to the tax system.
However, we gave them low marks for not doing enough to tackle the big long-term structural issues like New Zealand Superannuation. The upshot is we think the pathway back to fiscal surplus will be more fraught than currently projected.

I think the same will prove to be the case in the US. The Administration expects the deficit to be back to around 3% of GDP by 2015, meeting the Toronto G20 commitments on fiscal policy. At this point, the projections seem to relying on much of that improvement being cyclical. That’s probably a tall order.

It seems to me that further structural work will be required. That means more tough decisions on spending and revenue to come. Doing that work also supports our view of only modest US economic growth ahead while the federal books get put back in order, on top of the good work already being done by households.

Monday, February 14, 2011

Japan GDP "normalises"

The expected normalising of Japan GDP growth occurred in the fourth quarter of 2010. GDP contracted 0.3% in the quarter (annualised 1.1%). Weakness was centred in consumption rreflecting the end of subsidies to buy fuel efficient cars in the September quarter. A further incentive programme to boost purchases of electronic home appliances was scaled back in December and will end in March.

From an annual rate of growth of 4.9% in the year to September, growth has dropped back to 2.2% for the year to December. We expect growth to slow further to around 1.5% by mid-year, in line with official Government forecasts.

Further out, activity is expected to recover again but only modestly so. Robust global growth will be good for exports and as the labour market begins to recover into the second half of 2011, consumption should also pick-up. However, we still only see 2011 growth of 2%.

China interest rates: more to come?

Last week’s interest rate rise was the third since October and it is likely there will be more. Inflation, and the control thereof, is the key theme for emerging markets this year.

Recall our post GFC story: growth would be strongest in emerging markets and it would be productive sector led. That would put upward pressure on commodity prices and, given their share in emerging market CPI baskets, inflation. Any lack of commitment on the part of monetary authorities to control inflation would be negative for the economic stability and prosperity in those countries.

China has become the poster child for the emerging market inflation fight, although the battle is being fought on a number of fronts. India tightened monetary conditions six times last year and still posted a China-like 8.9% growth rate for the year to September 2010.

The first tightening in China in October was met with disappointment by global equity markets. At that point the fear was that the US was going into a double-dip (not our view) and that China was providing about the only source of true private sector led demand. Now that US growth is looking more assured, we can take a more medium-term view of China monetary policy: that keeping inflation in check is a good thing and will lead to stable, albeit lower, growth than might have otherwise been the case.

Further interest rate hikes seem inevitable. The borrowing rate has been raised to 6.06%. The pre-GFC high was 7.47% so there is scope to move. The lending rate is 3.0%. With inflation at 5%, that’s a negative real rate, telling people they’re better off spending than saving.

Increases in bank Required Reserve Ratio’s has been an important part of the equation to stem excesses in asset (housing) markets. The RRR has been raised progressively in recent months, with a higher level for larger banks. Late last week China announced new reserve requirements for various city-level commercial banks, but did not announce the specific ratios. This could signal the beginning of a more targeted approach to setting the RRR.

There is a third tool at the disposal of the authorities that they are not yet using enough – an appreciating exchange rate. An appreciation in the CNY lowers the cost of imports. It takes the heat out of inflation and encourages households to buy more imports. It also encourages the necessary shift of resources from the tradeable to non-tradeable sectors. That’s good for China consumers, the China economy and the global economy.

Saturday, February 5, 2011

What is happening in the US labour market?

We know from New Zealand data this week that labour market data is requiring a bit of careful interpretation at the moment. The United States is no exception.

In data released overnight, the US unemployment rate dropped another 0.4 percentage points to 9.0% in January. It is now down 0.8 percentage points over the last two months. This is, however, despite apparent sluggish jobs growth. Non-farm payrolls rose only 36k in January, well below average market expectations of +150k. Poor weather copped the blame for the poor result.

The drop in the unemployment rate over the last two months has been driven by a significant drop in the participation rate. That is essentially telling us that people have "dropped out" of the labour force, 162k of them in January alone.

It is not unusual in times of high unemployment for people to drop out of the labour force. People become disenfranchised with the state of the labour market and give up looking for work. Or is there something else going on here?

The lacklustre jobs growth in this survey of employers is at odds with surveys of households which are showing significantly stronger job growth. The Labor Department survey of households showed jobs growth of 589k in the month! That is significantly different from 39k!

So what should we believe? Or is the more important question: What should Ben Bernanke believe about what is happening in the labour market when he considers the desirability (or not) of continuing on with the current programme of asset purchases, a.k.a. QE2. That's a really big and important question. Remember, 50% of the reason QE2 was launched was due to persistently weak jobs growth and high unemployment (the other 50% was price stability).

Could it be the case that, given the structural nature of the recession and the subsequent recovery, that surveys of employers are a poor indicator of current labour market activity? That's because old employers have disappeared, and the surveys havent' yet caught up with new employers or a large number of people who may have become self-employed in the aftermath of the recession.

So perhaps we are due some stronger employment numbers as the payrolls data plays catch-up. It's interesting that recently, as each subsequent payrolls number gets released, the two preceding month's employment numbers get revised up. With the release of this report, December and November got revised up a collective 40k. When the December data was released in early January, November and October were revised up a collective 70k.

And perhaps this helps explain stronger-than-expected consumption at the end of last year?

I tend to focus on employment trends more than unemployment when assessing the labour market data. That's because of the inherent difficulties in measuring unemployment. Over time, any disparities between the two tend to come out in the wash.

Policymakers are right to continue to focus policy actions on weak payrolls job-growth. But there's something else going on here that will become obvious soon. Perhaps we will be talking about stimulus exit strategies a bit sooner than we thought. Fascinating.

Thursday, February 3, 2011

New Zealand Update

The release this week of labour market data showing a rise in the unemployment rate to 6.8% and housing permit data showing the value of permits at their lowest level since early 2009 (and the number of permits for a December month at the lowest level in recorded history!!) are a reminder of the challenges still facing the New Zealand economy.

It is now universally accepted this is a non-traditional New Zealand recovery. Consumption and residential housing were never going to be driving forces of the next wave of growth. Remember our comment at last year’s Roadshow: If New Zealand doesn’t have an export-led recovery this time we probably won’t have a recovery.

That was said largely for dramatic effect. At that time we were still expecting growth of around 0.5% per quarter, or 2% per annum, over the course of 2010 and early 2011. Over the last 6-months even these miserly forecasts have proven to be wildly optimistic and will probably prove to be optimistic for the December 2010 quarter as well. So our dramatic comment has actually turned out to be somewhat prophetic. I’ll now claim that as a win!

The news is not all bad however. If people aren’t spending, they are saving or at least retiring debt. While that’s bad for growth and jobs right now, it strengthens the medium term outlook. It is also important in terms of reducing the financial and economic vulnerabilities the Savings Working Group was talking about in its report also released this week.
According to statistics compiled by the Reserve Bank of New Zealand, household indebtedness is on the way down. After peaking at 159.3% in Q4 of 2008, household claims as a percentage of nominal disposable income is down to 153.5% as at Q3 2010. That’s a modest improvement but at least it’s heading in the right direction: This ratio was only 57.9% in 1991.


Household’s focusing on retiring debt makes it tough out there for the retail and residential building sectors, and it is likely to remain tough for some time. The Rugby World Cup and rebuilding in Canterbury following the earthquake will provide a boost to activity later this year.
It remains to be seen whether those growth-positive factors will provide a kick-start to growth or if it comes back to a lower level afterwards. That will depend on household behaviour at the time, especially with regards to the comfort or otherwise of individual households with their balance sheet positions.
At this point I’m taking a conservative view on post-RWC and Canterbury rebuilding growth by assuming that household deleveraging will still have further to play out. That doesn’t mean we go back to no growth like the last six months, but it seems to me that it will remain tough going once those positive factors begin to wane.
For stronger growth we are reliant on exports – more so than ever before. That’s good for rebalancing of the economy as resources inevitably shift from the non-traded to the traded goods sector. The reality is that transition would always take time and there would be casualties along the way.
It seems to us that an important part of that process is strong growth in business investment. Here’s another reason to be optimistic: As we said at the release of the disappointing Q3 2010 GDP result just before Christmas, the only positive piece of news that day was strong business investment. More recent merchandise trade data shows strong growth in imports of capital goods. I like that.
Export values have been strong recently, but that has been a price (terms of trade) rather than a volume phenomenon. Strong terms of trade helps incomes (i.e. nominal rather than real GDP). Strong incomes mean strong profits. That’s good for investment.
The obvious question is what does this mean for monetary policy? I’ve given up trying to predict when the tightening resumes, but some things we said a year ago still hold. Given the nature of the recovery, both in terms of pace and sectoral mix, a lower interest rate cycle appears likely this time around.
We also said last year that a level of around 4.5% on the Official Cash Rate, its pre-Global Financial Crisis low, was a good place to head for. We still think that’s the case. Critically, whether that turns out to be enough will depend on the extent to which the Reserve Bank is sufficiently pre-emptive in hiking rates. That’s inevitably going to be a tough call.
All we really have to guide us at this point is the assumption that potential GDP is now lower than it was before, meaning inflationary pressures will start to build at a lower level of growth. That’s some help in working it out, but not much. At this point all we can really say is second half of this year seems likely for the next hike in rates. It’s impossible to be more precise than that at this point.
We have believed right from the start of the GFC recovery that given the recession was structural, the recovery would also be structural. That means some of spare capacity out there in the economy may well be redundant capacity. In particular, we think skills shortages will emerge earlier (i.e. at lower level of growth and a higher level of unemployment) than we saw in the previous cycle. But after today’s labour market result, we won’t have to worry about that for a while yet.
The other unknown is the extent to which fiscal policy does some of the stimulus-reduction work when required. The more work fiscal policy does, the less work monetary policy has to do via interest rates. This will, in turn, keep pressure off the exchange rate. The May Budget will provide further guidance in that regard.
In summary – if you think it’s tough out there, you’d be right.