Monday, May 30, 2011
That means increases in prices have completely offset the boost to nominal incomes of recent better jobs growth and the payroll tax cuts that took effect in January. What that means is that households had to reduce their savings rate to generate the modest 2.2% seasonally adjusted annual rate (saar) increase in consumption in the first quarter of the year. Indeed the savings rate fell from 5.4% in January to 4.9% in March and April.
This confirms a weak outlook for consumption as strong increases in real incomes are unlikely anytime soon, although if the downward trend in oil and petrol prices continues, there may be some respite later in the year.
With the release of the second estimate of first quarter 2011 GDP at 1.8% saar and the soft start to the second quarter, our full-year 2011 GDP forecast is now back down to 2.6%. We continue to expect 2.5% in 2012 reflecting tighter fiscal policy. These forecasts make us even more comfortable with our expectation of no tightening in monetary policy in the US this year.
Wednesday, May 25, 2011
In terms of timing, the majority of the committee does not see a tightening this year with some (but not all) participants concerned that “an early exit could unnecessarily damp the ongoing economic recovery.” We concur. We don’t see a tightening in conditions until 2012.
The committee recognises the ongoing weak nature of the recovery but has also ruled that out as a sufficient reason for any further loosening in conditions. Some members made the point that “there would need to be a significant change in the economic outlook…before another program of asset purchases would be warranted”.
The discussion about how to go about the tightening, in particular the phasing of the different aspects, is fascinating and appears to remain unresolved at this point. That’s not necessarily a bad thing. There is still a bit of time on the committee’s side and the transparent nature of the discussion is conditioning the market to the full range of possibilities.
There is a growing consensus around the first step at least. This will most likely be ceasing to reinvest principal repayments on the Fed’s MBS holdings. This would most likely happen around the time the Fed drops its commitment to leave the fed funds rate on hold “for an extended period”.
The next step would be to start draining reserves using the term deposit and reverse repo facilities. The Fed have been flagging these as “exit tools” since we first started talking about exit strategies (prematurely) in 2009. When that starts to happen, especially with regard to when to raise interest rates, and then whether the emphasis on tightening should be on asset sales or interest rate increases, is a still evolving story.
The committee seems to be in favour, at least at this point, in leaving asset sales until after short-term interest rates are rising. This is not what I had been thinking. My assumption has been the Fed would want to be a good way through its balance sheet normalisation process before raising rates. However, the argument that in raising rates first then allows the committee to use interest rates as their primary policy tool should an easing become warranted is compelling. It also means the committee can undertake its asset sales on a “largely predetermined and preannounced” path. Hmmmmm. Looks like I’ve got more musing to do too.
Tuesday, May 24, 2011
China is clearly slowing, but at this point we remain comfortable with a gradual slowdown to a soft landing rather than a sharper hard landing. In general, the data is consistent with our view of 9% GDP growth in 2011, although the PMI data does shift the balance of risks to the downside. If the PMI consolidates around this latest level we will likely shift that forecast down to 8.5%. The China slowdown is a real fundamental behind recent and expected future weakness in commodity prices, especially industrial metals.
This data supports our view of no further interest rate increases this year. Further exchange rate appreciation remains desirable, but this is more to do with the necessary rebalancing in the economy rather than the overall level of demand. China growth is still overly reliant on exports and investment and needs to rebalance towards consumption if growth rates are to be sustained at current levels into the future.
Thursday, May 19, 2011
Many governments in developed countries have been grappling with the solution to large budget deficits and the need to consolidate their fiscal positions. At the same time they have had to balance that with supporting what have remained fragile economic recoveries. What has been making the situation challenging is that in many countries, budget deficits have a high structural component. That means governments cannot simply rely on an improving economic cycle to close up these large deficits and are having to cut spending and/or raise revenue to bring their finances back into order.
Underlying Economic Assumptions
Key Policy Decisions
The KiwiSaver member tax credit will be halved, effective from July 1 2011. From 1 April 2013 both the minimum employee contribution rate and the compulsory employer contribution rate will rise from 2% to 3%. However, from 1 April 2012, the tax-free status of employer contribution will end. Government will make $2.6b in fiscal savings.
The approach to funding new operational spending out of the reprioritisation of existing spending significantly changes the expenditure profile over the forecast horizon. Core Crown Expenses are now forecast to be lower than forecast in the HYEFU despite the additional costs the Government now faces as a result of the second earthquake and the weaker starting point for the economy.
This approach to spending combined with freeing up capital by extending the mixed ownership model to other state assets means over the forecast period, debt will be around $10b lower than would have otherwise been the case.
The phasing in of those policies over time strikes an appropriate balance between articulating a pathway to fiscal sustainability at the same time as supporting economic activity. Without the Christchurch rebuild, economic growth would remain subdued.
It is worth remembering that low growth now is not necessarily a bad thing. It reflects the good balance sheet repair work that is going on behind the scenes in household and businesses. That bodes well for a more sustained economic recovery.
In terms of support for economic growth, this Budget was more about the health of the broader macro-economic environment than micro-economic measures to support growth and innovation. Fiscal consolidation makes a considerable contribution to ensuring a stable low interest rate environment.
Monday, May 16, 2011
That shouldn’t detract from the fact that real spending is only crawling ahead at the beginning of Q2 as higher food and energy prices impact on household spending. With the CPI up 0.4% on the month (3.2% y/y) real sales only just nudged ahead over the month. However, with commodity prices (especially oil) now lower, that may provide some respite to household budgets in the months ahead, especially if a downward trend is established.
The inflation report also showed core prices rising 0.2% m/m in April. That takes the annual rate of increase to 1.3%, up from 1.2% in March. Over the last two months, rising motor vehicle prices has been a significant contributor to the increase in core prices. Some US commentators are suggesting this is due to supply disruptions following the Japan earthquake. That seems like a reasonable call to me and if true, this will prove to be a temporary factor likely to reverse out later this year.
In short, there doesn’t appear to be anything in the inflation data to cause anyone on the FOMC any sleepless nights.
The bigger surprise was in the activity data where the slowdown in most indicators was more marked than expected. In particular retail sales growth continued to decline with growth in real terms now at its lowest level in 6 years. Industrial output fell from 14.8% y/y in March to 13.4% in April – the market had been expecting a decline to 14.6%. Fixed investment spending was the only indicator to post an increase in annual growth from 25.0% to 25.4%.
The data releases were quickly followed by a further rise in the Required Reserve Ratio (RRR) to 21% (for the larger banks). However, the weakness in the activity data has me thinking the PBC may call a halt on further interest rate increases. Recall we were surprised by the very modest decline in GDP growth from Q4 2010 to Q1 2011 (9.8% to 9.7%). This was despite the evident slowdown in a number of indicators. This more recent slowdown in the activity indicators suggest the GDP slowdown has accelerated into Q2.
A halt to interest rate increases would not be the end of the inflation battle. We still expect further increases in the RRR (two or three more?) to offset the expansionary impact of purchases of foreign exchange reserves.
Furthermore, with retail sales slowing at the same time exporters remain in fine fettle (as indicated by recent trade data), further appreciation in the CNY is increasingly desirable. Exporters would then get to make their contribution to the adjustment and households would get a reprieve via higher real incomes. From a global rebalancing perspective, it is desirable for resources to shift from the tradeable to the non-tradeable sector.
Wednesday, May 11, 2011
The Budget deficit is expected to be larger this year with a forecast now of 3.6% of GDP. That largely reflects the upfront impact of the recent natural disasters and subdued household spending. A larger deficit is now also projected for 2011/2012. Nevertheless a small surplus is expected the following year.
Underlying real economy forecasts appear reasonable. GDP is forecast to expand 2.5% in 2010/11, rise to 4.0% in 2011/12 and then remain above trend in 2012/13 at 3.75%. With this robust growth the Government is expecting the labour market to tighten, wage growth to pick up and for inflation to rise to the top end of the RBA’s 2-3% target range in 2013.
The RBA will no doubt be welcoming a tighter fiscal stance as it will inevitably reduce the work that monetary policy has to do. However, in light of the real economy projections in the Budget, which we agree with, and the recent more hawkish tone from the RBA, we expect monetary policy to tighten further this year. I’m still happy with the view that the Australian cash rate will be at 5.5% (currently 4.75%) by year-end.
Tuesday, May 10, 2011
Some Greek and German authorities have recently floated the concept of a “voluntary restructuring” or “re-profiling” of Greek debt. This would involve extending debt maturities, meaning debt holders would get paid back, but at a later date. Standard & Poor’s today said that approach amounted to “selective default”.
There is no easy win for Greece. As we have noted since Europe debt issues surfaced early last year, we believe a restructuring of Greek debt is inevitable. The debt to GDP ratio is approaching 150%, the Budget Deficit was recently revised down to 10.5% of GDP in 2010 and the improvement in the current account deficit is largely due to financing inflows from the EU. The only issues are how and when a debt restructuring happens.
Today, there appear to be two options, neither of them overly palatable. The first is to give Greece more time for reforms, those already made and those still needed, to have an impact on the economy.
This would necessitate Euro Area members and the IMF agreeing to a new loan to cover Greece’s borrowing needs out to, say, 2013. The terms of the original bail-out package did not include the necessary refinancing of existing debt in the order of €25b in early 2012. At the time it was expected Greece would be able to re-enter capital markets in 2012. That appears unlikely. Such an approach would also most likely require a softening of deficit reduction targets. Restructuring of debt could then occur later in a more orderly fashion.
The big downside of this approach is political. There is already negative public opinion in some lender countries towards bailouts. Public opinion will most likely balk at the suggestion of another loan to Greece.
Which brings me to the second option – that debt restructuring happens now. I can’t see any upside in this scenario. At a stretch, it could lead to Greece being able to put its debt issues behind it and to move on to a more prosperous future. Like I said – it’s a stretch.
There is political downside here as well, including for the very same sovereign lenders who may be against a second loan to Greece. Debt restructuring implies losses on the loans issued just last year. That’s not likely to lead to a “win” in the court of public opinion either.
In the finance sector, bank’s that hold large quantities of Greek debt are not likely to be sufficiently well capitalised to wear large losses now. In order to prevent a credit crunch, these banks would have to be recapitalised. Under the first option, these banks will have longer to build capital to protect themselves from losses further down the track.
It’s time to drag out a well worn phrase: There’s no such thing as a free lunch. The Greece debt issue is best approached as a “loss minimisation” exercise. It’s also the case that whatever path Greece ends up going down, or gets forced into going down, it must lead to economic growth. In that regard the first option must be preferred. It also seems to me to be the option that minimises the risk of contagion. Here’s the “but”: but such an outcome requires politicians to start singing from the same song-sheet….
Sunday, May 8, 2011
Even better, private payrolls were up 268k. That's the biggest monthly gain in 5 years. Yep, that's what I said - 5 years! Furthermore, the growth was broad-based. Our favourite sector, manufacturing, saw 29k jobs added in the month. Retail was up 57k, professional and business services 51k and education and health 49k.
Public sector employment continued to shrink, with jobs in that sector down 24k. This is currently largely being driven by budget cuts at the State and local level. Expect this trend to continue, especially as planned Federal budget cuts start to impact.
There was also a non-subtle reminder of the still huge task ahead in the labour market with the unemployment rate rising back to 9%.
The unemployment rate is calculated from the household survey which has been showing stronger employment growth than the payrolls data. We have attributed much of that divergence to the structural nature of the recession and the challenge for the payrolls data of keeping up with dynamic change in the labour market, especially as old firms close and new ones open up. This month, some of that gap closed with a fall in the household survey employment numbers, leading to the rise in the unemployment rate.
Given the weakness in recent initial claims data, we wouldnt be surprised to still see a weak monthly payrolls out-turn in the next month our two. On a more medium-term basis, one factor that bodes well for future jobs growth in the US is the recent slowdown in productivity growth. Non-farm productivity rose at a reasonably healthy seasonally adjusted annual rate of 1.6% in Q1, but is up only 1.3% over the year to March 2011. That is well down on the 6.7% recorded for the previous March year.
Our read on what is happening here is that during the recession and the early stages of the recovery, firms were cutting costs by cutting labour and finding better more efficient ways of doing things. That means over that period, jobs fell faster than output, so output per worker (productivity) rose. Perhaps now firms are finding it difficult to drive more efficiencies out of their existing people, and are now moving to the next phase of hiring new people to meet the albeit gradual improvement in economic activity.
That does not mean that employees are back in the driving seat when it comes to wage demands. The unemployment rate is, after all, still at 9.0%. But as with New Zealand (see post below), the labour market is one of the areas we would expect capacity constraints to show up first, especially in demand for skilled labour.
In our view, wage data will be critical in helping the Fed work out when they need to start the "monetary policy normalisation" process. Indeed unit labour costs are already ticking up, but at still low levels (1.2% for the year to March 2011) are not an immediate threat to the Fed.
Thursday, May 5, 2011
There are, however, some important messages in the data. The better than expected employment growth (1.4% in the quarter) and resulting lower than expected unemployment rate (6.6%) tell us the labour market was improving into the early part of 2011 – with much of that growth coming from full-time employment. That’s consistent with our view of a gradual pick-up in economic activity, at least before the earthquake. Hours work data counts against that to some extent, but I’m still happy with Q1 2011 GDP increase of 0.4%.
Yesterdays LCI wage data also had an important message. You will recall our view that given the structural nature of the GFC recession, potential growth in many developed countries is mostly likely lower than it was previously, including here in New Zealand. That means that capacity constraints would get hit earlier in the cycle. Furthermore, those constraints would most likely be evident in the labour market first.
Indeed nominal wages have risen at a reasonable clip over the past 12-months, up 3.9% using the unadjusted LCI data. Some have made the erroneous assumption that given the 4.5% increase in the CPI over the same period that purchasing power is now lower. That’s not the case. Roughly half the increase in the CPI was due to the increase in GST and the increase in nominal wages is gross of tax. Wage earners were compensated for the increase in GST with income tax reductions i.e. increase in after-tax income.
The more important message in the LCI data is that unit labour costs are also on the rise. The 0.4% increase in the private sector LCI increase over the quarter took the annual rate of increase to 2% - bang on the mid-point of the Reserve Bank’s inflation target. While that’s not a reason to panic, it’s an important consideration in the context of ultra-loose monetary conditions.
So, if it wasn’t for the earthquake, the message for the RBNZ would have been: “Start getting ye to neutral!” But the February earthquake was a game-changer. With the scale of the immediate disruption unknown, the RBNZ chose to take out “insurance” by lowering the OCR by 50bps to 2.5% in March.
Following the initial earthquake in September 2010, we had assumed some GDP growth impetus from the rebuild late this year. Following the second earthquake, we shifted that out to 2012. The RBNZ therefore has a bit of monetary policy wriggle-room – but not as much as a cursory glance of the indicators would suggest. We still expect a 50bp tightening in December this year, with the OCR up to 4.5% by Q3 2012.
Wednesday, May 4, 2011
In India the break from the pattern of a series of 25bp increases in the repo rate is a tacit admission from the Reserve Bank of India (RBI) that they are struggling to get in front of the inflation problem. In the accompanying statement from the RBI, they admit they have “systemically under-predicted year-end inflation during 2010/11”. In January they had expected the rate of increase in the Wholesale Price Index (WPI) to fall to 5% by March – the number printed at 9%.
The problem for the RBI is that core inflation has got a way on them and economic activity remains strong. The annual rate of increase in core wholesale prices (using the manufacturing WPI) is currently running at 6.2% and growth in GDP is forecast to slow only modestly to 8.0% this year. That makes the (unofficial) WPI expectation of 6% by March 2012 a tad optimistic
Understandably then the tone of the RBI statement was more hawkish than previously. Further tightening seems a done deal. A repo rate of 8-8.5% by the end of the year is not out of the question.
Meanwhile, the Reserve Bank of Australia (RBA) has left interest rates unchanged at 4.75%. This was widely expected.
The RBA has to balance a number of factors: a core inflation result for March that surprised on the upside, the short- and medium-term impacts of the recent natural disasters, the rapid appreciation of the AUD, significantly higher terms of trade boosting nominal national income, and a trend decline in the unemployment rate that, if continued, will soon begin to assert upward pressure on wages.
While some of those factors are clearly offsetting, we believe the RBA was right to assume a more hawkish tone by asserting that core inflation is passed the low point in the cycle. At the same time, they are anticipating GDP growth to be above trend in the medium term. That seems to be a recipe for tighter monetary policy.
The RBA is, however, in the fortunate position of having done a reasonable amount of tightening work already. The current 4.75% level of the cash rate is 175bp above the GFC low of 3%. We think the RBA will start to tighten again in the next few months with the cash rate likely to be 5.5% by year-end.
Tuesday, May 3, 2011
The US ISM manufacturing index fell slightly from 61.9 in March to 60.4 in April. A reading over 50 tells us manufacturing is expanding. Despite the softening, this is the fourth consecutive month in which the index has recorded a level over 60. In more normal times, this would be consistent with GDP growth of around 4.5%, but these are not normal times. In other sectors low or negative growth, most notably consumption and residential construction are constraining the overall recovery.
The key sub-indices of production, new orders and employment all declined by varying degrees, but all remain at high levels. The prices paid index remains elevated at 85.5 (up from 85 in March), reflecting high commodity prices. The survey doesn’t tell us anything about the extent to which higher prices are being passed on to end-consumers but it seems reasonable to assume that soft final demand is making this difficult. That’s good for inflation but bad for profitability.
In Europe, the Markit Economics 17-country manufacturing index rose from 57.5 to 58. Germany and France are leading the charge. For Germany strong demand from China (largely for motor vehicles) is one of the key factors behind the strong growth. This of course makes the sector vulnerable to any slowdown in demand from China.
Manufacturing remained weak in the European periphery, again indicating the high degree of divergence in economic performance across Europe. This in turn highlights the risky approach taken by the ECB to raise interest rates recently, but supports the line that this won’t be an aggressive tightening cycle.
The China Purchasing Managers Index fell to 52.9 in April. This is down on the 53.4 recorded in March and well below the median expectation of 53.9.
This is consistent with a moderation in China GDP growth this year. To-date that slowdown has been less than expected – year to March 2011 GDP growth came in ahead of forecast at 9.7%, down only slightly on the 9.8% for the year to December 2010.
A slowdown in growth in China is a good thing. Monetary conditions have been tightened on a number of fronts since 2010 with numerous increases in the required reserve ratio, four increases in interest rates since October last year and an over 5% appreciation in the Chinese Yuan (CNY) versus the US dollar.
With the economy running at capacity, we still think further monetary tightening will be required. In particular, further appreciation of the CNY will aid the fight against inflation but also assist the reduction in global imbalances.
Monday, May 2, 2011
Around the world, many countries are struggling to successfully navigate the pathway to fiscal sustainability. Even where economies are technically recovering their overall fiscal situation usually remains fragile. This means that higher growth as the economic cycle matures is not guaranteed to close budget deficits. Because those deficits are structural in nature, they will require cuts in Government spending and/or increases in revenue to bring them back to at least more sustainable levels or, preferably, put the country’s accounts back into surplus.
The challenge and the imperative to get this job done properly was recently demonstrated by rating agency Standard & Poor’s putting the AAA credit rating of the United States on “negative watch”. While not a credit downgrade yet, the agency has signalled a 33% chance of going down that track.
It is well worth remembering this downgrade happened to a country whose dollar is the world’s reserve currency. Because of that status, there is always strong demand for United States debt instruments but there are limits - even for America.
The timing of the announcement was unusual in one respect. President Obama, in one of his best political speeches yet, had recently signalled his intention to cut the US budget deficit by $US4 trillion over the next 12 years. That’s just a tad shy of the $US4.4 trillion the Republicans wanted to cut off the deficit over the next 10 years.
Superficially, that may sound like political agreement but that is certainly not the case. The Democrat’s program includes spending cuts and tax increases while the Republicans would rely solely on spending cuts. More than eighteen months out, the first shots have been fired in the 2012 Presidential election.
On reflection, that is why the timing of Standard & Poor’s announcement perhaps made more sense than first thought. They were sending politicians a clear message to just get on with it.
Our own Budget is scheduled for May 19. Over the last two years, we have given the government, in the wake of the Global Financial Crisis, high marks for turning around the deteriorating trajectory of the budget deficit and key debt ratios. They have also managed to pass some important reforms of the tax system since being elected.
We have, however, given them low marks for recognising far less dealing with our long-term fiscal challenges. This is essentially the long-term sustainability, or more crucially the unsustainability, of some of the larger expenditure items. The scale and urgency of those challenges are increasing because the economy remains soft, the devastating Christchurch earthquakes hit and the well-reported finance and insurance sector bailouts impacted.
Now appears to be the ideal time to get on with the critical job of ensuring greater sustainability around expenditure. “Reprioritisation” has already become the 2011 budget buzzword. That will inevitably mean compromise which is always challenging in a highly charged political environment. As demonstrated in America, this is not a time for political pragmatism here – it is a time for hard decisions to be made in a timely fashion. 2011 is not the year for simply Budget tweaks.
The National-led Government is signalling they get it. Carefully managed pre-Budget hints indicate high-cost policies such as Working For Families, Student Loans and KiwiSaver are all in for some change.
I want to focus on another area of government expenditure – support for economic growth.
Globally, governments struggle to articulate their role in supporting economic growth. As a result, many countries end up with a multitude of agencies and programs providing nothing more than an uncoordinated scatter-gun approach to economic intervention, the sum of which doesn’t really add to economic growth. New Zealand is no exception.
“Re-prioritising” some of these programs seems a no-brainer. However, reprioritisation needs a framework to work out what is and what isn’t a priority. That framework is lacking in New Zealand.
In terms of supporting the innovation system, politicians need to understand how it works and what appropriate roles the government can play to support it.
Here is a starter-for-ten. Innovation happens in firms, not in government. The role of government is simply to create the right environment for innovation and for entrepreneurs to be able to commercialise those innovations. The strength of the individual parts of the innovation system is important, but so too are the linkages between the system and the wider business community.
In that regard, one of the best announcements in Budget 2010 was the $20m allocated to building those connections. Support for economic growth does not necessarily have to be expensive.
Traditionally, every Budget gets a nickname though usually for the wrong reasons, as demonstrated by the so-called “Black Budget” and “Mother of All Budgets.” The 2011 Budget needs to buck that trend. Given the circumstances, the electorate will respect a government which makes hard decisions provided they are consistent with a well articulated plan for a better future.
Sunday, May 1, 2011
The slowdown from the Q4 2010 GDP increase of 3.1% was due to the significant increase in energy prices, bad weather, and a decline in government spending. These factors should prove to be at least partly temporary.
While higher energy prices was largely responsible for the slowdown in consumption from a saar of 4.0% in Q4 2010 to 2.7% in Q1 2011, this was not as marked as monthly retail sales data had suggested. Having said that, monthly personal spending figures tells us that real spending was losing momentum over the quarter. After rising 0.5% in February, real spending rose just 0.2% in March.
The recent rapid increase in prices has absorbed much of the increase in disposable income that came with the cut in payroll taxes that took effect on January 1st. Nominal disposable income rose 6.8% over the quarter, but only 2.9% in real terms. For the month of March, nominal incomes rose 0.5%, but real disposable income rose only 0.1%.
Business investment rose a saar of 1.8% over the quarter, held down largely by a weather related 2.1% decline in non-residential building. Weather was also likely to have had a hand in the 4.1% decline in residential construction over the quarter. On a more pleasing note, investment in equipment and software posted a solid 11.6% gain.
Net exports were roughly neutral which was better than I was expecting. Exports were up 4.9% while imports rose 4.4%.
Government spending contracted a saar of 5.2% over the quarter, largely due to an 11.7% drop in defence spending which is expected to at least partially reverse next quarter. However the 3.3% decline in state and local government spending is reflective of the hard work going into reining in budget deficts at this level of government. This is likely to be an ongoing feature for some time. In time, significant and long-term reductions in Federal government spending will provide a drag on growth.
As I said a week ago when I was previewing this result, I'm mildly regretting the fact I revised my full-year 2011 US GDP forecast up to 3.0% from 2.5% previously. 3.0% looks to be a stretch, but I'll leave the forecast there for the meantime, but signal the risks are biased to the downside. And by the way, I'm even more convinced that monetary policy remains unchanged this year.