Tuesday, April 26, 2011

Don't forget fiscal policy!

The most interesting aspect of this week’s FOMC meeting is the next instalment of the evolving debate about the timing and method of the withdrawal of the extraordinary monetary measures that were put in place during the GFC to support the US economy and (global) financial system.

There seems little doubt that QE2 will play out as scheduled, ending in June. That was unanimously agreed to at the last FOMC meeting and since then, economic data has been soft, leading to many economists revising down their Q1 2011 growth expectations (see post below). There therefore seems no need to change the QE2 plan so close to its natural conclusion.

But as we turn our minds to exiting the stimulus, it has amused me from time-to-time as some commentators have waxed lyrical about the success of Quantitative Easing. Hang on a minute - we’re only half-way through the experiment! Let’s reserve judgment until the full cycle of stimulus injection and withdrawal is complete.

The Fed has already outlined the tools at its disposal when the time comes. They include reverse repurchase agreements and the paying of interest on bank reserves. The key question is how effective these measures will be at preventing around US$1.4 trillion in excess bank reserves from stoking inflation in a gradually improving economic environment. This seems to me the far greater threat to inflation than the level of the Fed Funds rate.

Nevertheless some commentators are predicting a rise in the Fed Funds rate as early as late this year. I think that’s too early. I’m happy with current market pricing suggesting a rate rise in early 2012. In fact that expected tightening has shifted out slightly over the last couple of weeks from March to April 2012, no doubt reflecting the downward revisions to near-term growth and the quantum of cuts to the Budget deficit planned by both the Democrats and the Republicans over the next decade.

That is something worth keeping in mind as the stimulus withdrawal debate gathers momentum over the next few months: Fiscal policy will be a critical factor in all of this. We have become used, over the last two or three decades, to monetary policy being the only game in town. That’s the opposite of the 1930s when fiscal policy was the only policy instrument that mattered.

Over the next few years fiscal austerity as a result of large structural budget deficits SHOULD be a key factor in determining, and done right limiting, the level of interest rates. “Co-ordinated fiscal and monetary policy” will be the buzz-phrase of the next decade.

Sunday, April 17, 2011

Reminder of the "non-linear" US recovery

Right from the start of the recovery in developed markets we knew it would be hard work and that it would progress in a non-linear fashion, i.e. there would be good months and quarters followed by some not-so-good months and quarters.

This would be especially the case with regard to consumption as household's focussed on debt retirement at the same time as they faced head-on into the dual headwinds of high unemployment and a housing market that was, and still is, struggling to find a base. With that in mind, consumption would remain sensitive to further shocks.

Q1 2011 US GDP looks like being a stark reminder of these factors. It was only a couple of weeks ago that I was thinking about the 2011 quarterly growth trajectory and was comfortable with my pick of a 2.5% seasonally adjusted annual rate (saar) increase for Q1. I now find myself thinking it will be considerably lower.

Going back to the end of last year, I did not believe the 4% increase in consumption expenditure in Q4 2010 would be sustained. Remember we attributed at least some of that strength to year-end deleveraging fatigue. Households went on a little splurge at Christmas, but we thought consumption growth would come back a bit into the new year. This would be exacerbated (in volume terms) by higher commodity prices, but these factors would be somewhat offset by some better jobs growth.

As it turns out it looks like Q1 consumpion expenditure will come in at less than half the 4% annual pace of Q4 at around 1.7%. Add that to stronger imports over the quarter and the resultant negative contribution from net exports, it looks like Q1 GDP will come in around 1.5% (saar). That compares with 3.1% in Q4.

So let's just remind ourselves of some of our 2009 messages: The US recovery will be hard work; it will be "non-linear" and sensitive to further shocks (especially if those shocks are to household budgets).

I'm still leaving my full-year 2011 GDP forecast at 3.0%, only mildly regretting (at this stage) that I revised it up from 2.5% at the end of last year....

Saturday, April 16, 2011

China slowdown "moderate"

March quarter China GDP came in slightly stronger than expected, but nevertheless marked what is best described as a modest slowdown from the previous quarter.

The economy expanded 9.7% y/y in Q1, down slightly from the 9.8% in Q4. I had expected something closer to 9.5%. The new bit of news is that China is now releasing quarterly data. In quarterly annualised terms (to do things the American way), Q1 growth slowed to an annualised 8.7%, compared with 10% in Q4 2010. Warning: these are the only two data points available, so best not read too much into them.

However, some of the partial activity data ended the quarter stronger in y/y terms, including industrial output, fixed investment and retail sales. There is new seasonally adjusted m/m data for these indicators, but with only two data points, as with GDP, it's difficult to read too much into the data.

To further complicate matters, we also got details on the GDP components. Consumption added 5.9 percentage points to Q1 growth, up from 3.9 points over 2010. If that's sustained, that would be good news for global rebalancing. But that is at odds with retail sales data showing the lowest rate of inflation adjusted sales in over 3 years. Hmmmmm.......

Inflation came in a bit higher than expected at 5.4% for the year to March. The market consensus was for an outcome of 5.2%. Again, food prices are the primary culprit, although non-food inflation also rose.

The good news is that the rate of increase in inflation appears to be slowing. Assuming no further big increases in food prices, expect headline inflation to stay around current levels for a few months before starting to fall as we head into the end of the year.

Finally, China foreign reserves rose to over $US3 trillion for the first time in March. That's despite a trade deficit over the quarter. This is indicative of the level of intervention required for keep the Chinese Yuan (CNY) artificially low.

In summary - we think China is slowing moidestly. I'm still happy with my expectation of 9% GDP growth for calendar 2011. But I still think further interest rate increases are required. And it remains the case that a faster appreciaton in the CNY would be good for China and the global economy.

Thursday, April 14, 2011

That’s more like it, Mr President

In one of the best political speeches I’ve read in a long time, the US President has outlined his proposal to cut US$4 trillion from budget deficits over the next 12 years. This is a combination of US$3 trillion in spending cuts (including savings on interest costs of a lower debt burden) and US$1 trillion in higher taxes.

The President’s plan compares with a Republican proposal to cut the deficit by US$4.4 trillion over 10 years, solely through spending cuts. The political battle lines for the 2012 election are being drawn.

The President’s Budget proposal will see the budget deficit down from 10.9% of GDP this year to 2.5% of GDP by 2015 and then to around 2% by 2020. This meets the commitments made by the G20, of which the US is of course one, to reduce budget deficits to under 3% of GDP by 2015.

Hopefully, now that both the Democrats and the Republicans are talking medium-term plans, it will move us out of the petty squabbling over the more immediate, but less important given the bigger challenge at hand, conversations like the $38 billion in spending cuts agreed to last week. It would be premature to completely discount further squabbles, however. The next challenge is to agree the raising of the legislated US debt ceiling, the breaching of which is fast approaching.

It’s the medium term outlook that is most important. When we first started talking about exit strategies (yep, in 2009) we said governments with big deficits and high debt needed to articulate credible medium-term strategies for fiscal consolidation to soothe market concerns about the outlook. This did not mean that big budgets cuts needed to happen immediately, but markets needed to understand what the plan was. It was some European government’s inability to articulate such plans that has contributed to bond market nervousness in recent times.

Fiscal consolidation is still a balancing act. Some will argue that the proposed deficit reduction is not fast enough and that spending cuts are not deep enough. Others will argue that further stimulus is still required to support a still fragile economy. I’m happy to sit in the middle. Growth is becoming increasingly private sector led but will be able to sustain a gradual withdrawal of fiscal stimulus.

It’s also important the Government plots its own course to fiscal consolidation before bond markets start to fret and request more immediate action. Better to do it to yourself than have it done to you!! The US can only rely on its position as having the reserve currency for the world while there is still appetite for its debt instruments.

It is also important the Federal Reserve understands the outlook for fiscal policy. This will be an important factor in the FOMCs monetary policy considerations. One of our themes for 2011 is the interplay between fiscal and monetary policy. Stimulus withdrawal (when the time is right) needs to be a highly collaborative exercise. Well articulated fiscal plans will enable better co-ordination and better monetary policy decisions and outcomes.

Friday, April 8, 2011

Re-post of US mid-term election comment

In yesterday's post on the politics of structural budget deficits I referred to a post I made after the US mid-term elections last year. A number (well, 2 actually) of you have asked where to find that commentary. It was posted in the old blog, so here it is again...

From November 2010:

Markets have taken some comfort out of the gains made by the Republicans in the United States mid-term elections - the theory being that this will curb some of the regulatory excesses of the current Democrat administration. That rationale from markets is somewhat short-sighted.

I have some sympathy for President Obama. He was elected on a platform of change. But here we are, two years later with unemployment at 9.6%, the recovery struggling to gain traction and 23% of households with mortgages in negative equity.

This is the legacy of the most challenging set of economic and financial circumstances since the Great Depression. This situation was not of Obama’s making. Perhaps his only mistake was creating too much euphoria for change at election time in 2008 and, in so-doing, over-promising.

With the Republicans having taken control of the House, I am pleased that they did not also take the Senate. Not because I necessarily favour the GOPs over the Democrats or vice-versa, but because now is the time for strong US leadership.

That’s because another thing changed as the GFC took hold in the US and other western democracies – the end of the experiment with unfettered deregulated capitalism that began in the late 1970s era of Ronald Reagan and Margaret Thatcher. That reinvention of capitalism itself grew out of dissatisfaction with economic progress, especially as inflation took hold in the 1970s, during the more fettered post-WWII, Keynesian, “New Deal” period.

Now, in 2010, the next model of capitalism is starting to be defined. This is happening at a time when western capitalist democratic governments are suffering the wrath of a vengeful public. And this also a time when the more authoritarian model of Chinese capitalism is in the ascendancy.

At the multi-lateral level, the leadership mantle has already been passed from the G7to the G20. Given the range of views around the meeting table, we will soon be going through a process of questioning and challenging what we have to come to accept as economic orthodoxy. Indeed this has already started in the guise of the G20 Mutual Assessment Process.

In my view, this is not the time for a lame-duck US President, regardless of party affiliation.

November 2010

ECB pulls the trigger

As was widely expected, because they told us they were going to do it, the European Central Bank (ECB) raised interest rates overnight. The Bank raised the benchmark rate 25 basis points from 1.0% to 1.25%.

In terms of where to from here, the key phrase was "(while) we did not decide it was the first in a series of interest rate increases, you know from our own doctrine that we always do what is necessary to deliver price stability over the medium term."

As you know we have been in favour of an early and gradual approach to the withdrawal of monetary stimulus in the various markets where monetary conditions were eased agressively during the Great Recession. The qualification we added to that was "when the time is right."

I like the gradual approach the ECB wants to take to what you could also call the "normalisation" of monetary policy. Agressive tightenings in monetary conditions are not required at this stage. But we do worry that the Bank may have started the process a tad too early. Financial and economic conditions are still fragile in Europe, especially in the periphery. Starting now is a risky strategy. Furthermore, fiscal policy is playing a significant part in the withdrawal of stimulus.

One of the biggest risks is the ECB is putting too much weight on economic developments in Germany. In so doing they are under-estimating the impact of higher interest rates in the weaker parts of Europe. When Trichet says that "It is essential that recent price developments do not give rise to broad-based inflationary pressures over the medium term," he seems to me to be talking specifically about Germany.

While the Bank has stated this is not neceassarily the start of a series of interest rate increases, you don't start a process like this without thinking you want to get interest rates somewhere higher than just 25bp away. But they can take a gradual approach. At this point I wouldn't expect to see another tightening until June.

In other monetary policy developments this week, the increase in Europe interest rates came just a few days after a fourth increase in rates in China. There are clear signs that the pace of economic growth in China is slowing, however we think there is more tightening to come. Interest rates were left unchanged by the Bank of England and the Bank of Japan. Strong jobs growth data in Australia released yesterday suggests further monetary policy tighteing will be required there this year.

Thursday, April 7, 2011

The politics of fixing structural budget deficits

Without a political agreement by the end of the week on US government spending for the remainder of the 2011 fiscal year, all non-essential US government services will cease. Welcome to the politics of “dealing to” large structural budget deficits.

You might recall at the time of the US mid-term elections last year that amongst the market positive reaction to the election outcome, we warned the Administration’s loss of control of the House would be problematic as they sought to deal with the long list of economic and financial challenges. Luckily the Democrats only lost control of the House, not the Senate.

Now representatives of both sides of the House that are trying to cobble together a spending plan to get to the end of the fiscal year (September). At the centre of the debate is an extra US$7 billion of spending cuts the Republicans want to see on top of the US$33 billion already proposed by the Administration to get them through to the end of Fiscal 2011.

Let’s remind ourselves that a discussion over US$7 billion is the tip of the iceberg. The US Budget deficit this year is likely to be around US$1600 billion, or US$1.6 trillion. US$7 billion in fiscal 2011 is a side issue to the real debate about the long-term sustainability of US fiscal policy. Indeed the Republicans are currently working on their plan to cut the deficit by three-quarters or a cumulative US$6 trillion over the next decade.

If talks fail in the next 24 hours should we be worried about a partial shutdown of the US Government? I’d argue “No”. The US has been here before, and not that long ago, in 1995. So while this is not a common event, neither is it a new experience.

Furthermore, no one really wins from these sorts of political games. In fact if any government shutdown becomes too long and/or too disruptive, phrases such as “holding the country to ransom” will quickly (re)enter the popular political vernacular. That’s a no-win situation for any political party. That means any impasse should be quickly resolved once all sides think they have won something.

The current (small) problem is symptomatic of the political road ahead as Governments realise that big budget deficits are structural and that current forecasts of fiscal consolidation are overestimating the likely positive impact of the improving economic cycle. Big spending cuts and/or tax increases will be required. That makes for tough politics. Remember footage of rioting over Budget cuts in Europe where many countries are ahead of the US in the austerity cycle (albeit out of necessity).

This is made all the harder by the fact that given the size of current budget deficits, cuts will have to be made in the larger spending items – entitlements.

There is a tough political road ahead. The upside is that done well, fiscal consolidation will reduce the amount of work that needs to be done by interest rates in the period ahead.

Portugal bailout

As an addendum to the post below, Portugal has asked the European Union for financial assistance. Following the rejection of tough austerity measures by the Portuguese parliament two weeks ago, forcing the resignation of Prime Minister Socrates, a bailout was the inevitable conclusion.

Importantly, funding costs have risen sharply since the rejection of the Budget with 10-year bond yields rising to 8.8% yesterday. In an auction of bonds yesterday, 1-year debt was sold at a yield of 5.9%, higher than German 30-year bonds.

Estimates are that a Portugal bailout will require about 80 billion Euro. This will likely be met out of the EFSF with contributions from the IMF (as was the solution for Greece and Ireland). These loans will come with austerity conditions.

There is sufficient headroom in the EFSF to support Portugal without having to wait for the ratification of the face-value lending capacity of the facility. We only worry about that if another country (Spain?) requires a bailout before June.

More on Europe tomorrow after the ECB meeting.

Sunday, April 3, 2011

Towards financial stability in the Euro Area

The European Summit held over March 24th and 25th ratified the creation of a permanent financial stability facility. Beginning in mid-2013, the European Stability Mechanism (ESM) will replace the European Financial Stability Fund (EFSF). The ESM will have a lending capacity of 500 billion Euro, backed by guarantees and cash.

However, the summit failed to endorse the full 440 billion Euro lending capacity of the EFSF. Elections in Finland due mid-April will delay the signing of this agreement until the next Summit in June. In the meantime, the EFSF will remain sufficient for a bailout of Portugal, but further emergency measures would be required if another country (e.g. Spain) were to require assistance.

The ESM has been established to finance EMU countries who get get themselves into financial difficulty. It will be activated by mutual agreement of the member states to preserve the stability of the European Monetary Union (EMU). Each Euro Area member has a right of veto. Mutual agreement is also required on the key components of any assistance including: whether or not financial assistance is granted, the terms and conditions of the assistance and the size of the loan.

From June 2013, Collective Action Clauses (CAC) in all new bond issues will allow for the possibility of public debt restructuring. How this will work will not be determined until later this year. The participation of the private sector in resolving financial crises via the restructuring of debt will occur when a country is deemed to be insolvent. Whether a country is insolvent will be based on analysis of the sustainable level of public debt undertaken by the European Commission and the IMF in liaison with the ECB.

That's all fine for debt issued from 2013, but what about Greece? We have said all along that we believe there will be a restructuring of unsustainably high debt levels in Greece, and this may have to happen prior to 2013. In the meantime we would not be surprised if Greece has to request further assistance as it's initial 110 billion Euro package is used up.

Progress was made around what is now called the "Euro Plus Pact". This is the third iteration of what started life as the "Pact for Competitiveness" a few Summits ago. Importantly, the member countries of the EMU (and a handful of others) have agreed to take on EU budgetary rules into domestic legislation. While this will take time to implement and the nature of the legal form is up to individual states, the criteria include a brake on debt, and rules on the primary balance and expenditure. This is a significant breakthrough and is an important step towards fiscal convergence across Europe.

There is no doubt this is a painfully slow process and at times the problem has almost got away on the politicians, but this latest outcome gives some hope that an enduring solution is in the making.