Friday, March 30, 2012

Well-founded optimism or wishful thinking?

The latest National Bank Business Outlook was a little ripper. New Zealand business confidence, particularly respondents read on the outlook for their own business, is consistent with GDP growth in excess of 4%. While that’s great to see and adds an element of upside risk to our expectations for GDP growth this year, there is room for businesses to be disappointed.



As you know, we believe New Zealand GDP growth will move higher over the course of this year, but will continue to be constrained by a number of factors. These include the high New Zealand dollar, lower commodity prices, tighter fiscal policy and continued caution by households towards spending. However, following the lower than expected December quarter GDP data, we went into 2012 from a lower base. That means despite the negatives, GDP growth could well be approaching 3% toward the end of this year, but over 4% will be too much of a stretch.

It’s good to see that businesses are internally consistent with their views. The higher general confidence has flowed through into increased employment and pricing intentions. While we think those pricing pressures will inevitably emerge, we still think the Reserve Bank has most of this year before they need to start responding to those sorts of pressures.

The increase in confidence was across all sectors of the economy. The construction sector is the happiest, which supports the view the housing market is coming off its lows and the sector’s recovery is not solely dependent on the Christchurch rebuild.

More generally we wonder if the improvement in confidence is more a sigh of relief following the global economic angst we had to endure last year. That means part of the recent increase in confidence could be put down to wishful thinking rather than well-founded optimism – they don’t call economics the dismal science for nothing. That means confidence could still come off a little bit and still be consistent with our more modest expectations for growth this year.

Thursday, March 29, 2012

Further China slowdown in Q1, but still a soft landing

China GDP growth has been slowing since the first quarter of 2010 when annual GDP growth peaked at 11.9%. By December 2011 it had slowed to 8.9%. Recent activity data indicates the China economy slowed further into the first quarter of 2012. We continue to believe China is experiencing a “soft landing”.

The current quarter is hard to read because of the data volatility around the Chinese New Year. However, looking through the volatility it appears momentum has slowed further into the current quarter. In particular, industrial production for the two months of the quarter to February has slowed to 11.4%, down from 12.8% in the December quarter. The rate of annual growth in exports (on a 3-month moving average basis) has halved from around 20% a year ago to 10% currently, reflecting the recent weaker global (esp. Europe) growth environment.

Tighter monetary policy has had a significant impact on growth as well. Monetary policy was tightened to reflect the sharp rise in inflation and property prices last year. Property prices are now starting to move lower and general inflationary pressures have also receded. Annual core (non-food) inflation has fallen from a most recent peak of 3.0% in August 2011 to 1.7% in February 2012.

There is, therefore, scope for authorities to ease monetary conditions. Indeed there have already been moves to loosen up on banking sector reserve requirements which we believe will lead to a stabilisation of lending growth at the current 15% level. The authorities have targeted money supply growth of 14% this year, up from the current annual growth rate of 13%. We believe interest rate reductions will follow later this year.

However, we believe there is greater scope to move on fiscal policy. The recently announced 2012 Budget is expansionary with the fiscal deficit moving to 2% of GDP in 2012 from 1% in 2011. Spending on social housing and social measures that will, in time, lead to a drop in precautionary households savings are supportive of consumption growth and the necessary rebalancing in the Chinese economy.

We see annual China growth dipping below 8% in the March 2012 quarter, but then heading back towards 8.5% as the year progresses. That’s a soft landing by any definition...



Monday, March 26, 2012

America: keeping an eye on fiscal policy

With the recent run of more positive US economic data it could be tempting to start thinking about raising our GDP forecast for 2012. That would, in normal times, be a signal to start becoming more hawkish, or at least less dovish, on monetary policy. But these are not normal times.

Stronger job growth now appears to be leading to the virtuous cycle of stronger wage growth leading to higher spending which is in turn leading to more jobs. Also, the housing market appears to be forming a more solid base. These are both significant developments but we still don't expect either consumption or residential construction to become driving forces of US economic growth any time soon. That job remains strongly in the realm of exports and investment.

What stronger consumption and construction does is reduce some of the downside risk to the growth outlook. In particular, it makes us tentatively optimistic that we will not go through a third consecutive mid-year US double-dip scare. The risks to the US growth outlook are becoming more evenly balanced, but we are still happy with our forecast of 2% for 2012.



There is a monetary policy implication to the better run of data but it's of the "less dovish" variety: QE3 has become less likely. As you know we've never been great fans of the concept of a third round of quantitative easing (sterilized or not) on the basis that the problem of building a stronger more sustainable growth and jobs environment should not be laid solely at the feet of the Chairman of the Federal Reserve.

It's also the case that current labour market dynamics of zero productivity and rising unit labour costs do not support the case for more easing. However, we don't expect the Federal Reserve to change its forward guidance of an extended period of low interest rates anytime soon. That won't stop the bond market from testing that commitment from time-to-time, especially if activity data continues its good run.


The big unknown is fiscal policy. We know fiscal policy is going to be an economic headwind over the next few years, but we don’t know what the profile over time of the fiscal consolidation. Fiscal decisions made over the next few months will have a significant impact on growth and monetary settings in 2013.

There are a number of fiscal measures that are due to expire at the end of this year including the payroll tax cuts and the Bush tax cuts. According to the US Congressional Budget Office (CBO) if those measures are allowed to expire, the US fiscal deficit will shrink from 7.6% of GDP in 2012 to 3.8% in 2013.

That might sound like a good thing in a world worried about deficits and debt, but that degree of fiscal tightening represents a significant negative fiscal impulse and, if it were to play out, a likely return to recession. Recall when we first raised our concerns about QE3, we said the most likely scenario for it to be warranted would be if fiscal contraction was front-loaded and looked like pushing the US back into recession.

The “good” news is that degree of fiscal contraction is not likely to happen. The CBO's analysis of President Obama's 2013 Budget would see a deficit of 6.1% of GDP (note the 2012 starting point is different in each scenario). But there are the not insignificant issues of a President who does not control the House (although he has the Senate) and an upcoming election. It will be therefore difficult for the President to get his Budget measures through and there could be a new President in office in January.


The US growth environment is looking more robust. While that has implications for monetary policy, we need to get used to the fact that during this cycle, when the time comes for less stimulatory policy settings, monetary and fiscal policies will be working in the same direction. That will have implications for the amount of work monetary policy needs to do, and when it needs to start doing it.

Friday, March 23, 2012

New Zealand Growth

Fourth quarter 2011 New Zealand GDP growth was worse...and better...than expected. Headline growth came in lower than expected at 0.3% for the quarter (market expectation was +0.6%), with annual growth at 1.8% (2.2%). In particular the manufacturing sector was weaker than expected posting a decline of 2.5% over the quarter. But domestic demand was stronger than expected, so the news was not all bad.



The good news is that some of the weakness in Q4 was due to timing, some of which will wash out in the current March quarter. This is especially the case in the manufacturing sector where the processing of some livestock was delayed due to good grass growth – yes, we are still largely an agricultural economy. Grass growing conditions matter!

We also saw the reversing of the large build-up in inventories that occurred during the third quarter of the year. This de-stocking is occurring at a faster-than-expected pace which bodes well for production in the period ahead.

For us the major positive in the release was the strength of domestic demand over the quarter. That was of course partly due to the Rugby World Cup with private consumption up 0.8% in the quarter following a 1.6% gain in Q3. However, we expect the annual growth rate will slow from the current 3.3% into 2012 as the RWC effect washes out. Both residential and non-residential construction posted solid gains over the quarter, but remember this is off a low base.

The weaker-than-expected headline rate hasn’t dramatically changed our view about the growth outlook for the year ahead. In fact given the timing and destocking issues, we have bumped up our March quarter GDP pick from +0.6% for the quarter to +0.8%. In terms of the Reserve Bank and monetary policy, this result does not change our view of a tightening in monetary conditions from later this year.

Wednesday, March 14, 2012

The US labour market and the new structural rate of unemployment

The last three months has seen 734k new jobs in the US, the largest three-month increase since 2006 (excluding the temporary Census jobs in 2010). The unemployment rate is now down to 8.3% and after two months of decline, the participation rate also staged a small recovery in February. That’s all welcome news.



One of the missing features of the recovery thus far has been the mutually reinforcing cycle of stronger growth leading to jobs growth which in turn leads to higher growth via consumer spending. The constraining factor for the economy generally has been the structural nature of the recovery. Households have been deleveraging and consumption and residential construction have been subdued.


In that environment we have looked to exports and investment to be the driving force in the recovery. That would also require a change in fortune for the US manufacturing sector after many years of decline. Indeed manufacturing has been punching above its weight in terms of jobs growth. While manufacturing represents 10% of the US economy, it has accounted for closer to 15% of the jobs growth since the trough in the labour market at the beginning of 2010.


It is no coincidence that this latest purple patch for jobs growth has coincided with a levelling off in labour productivity growth. The labour market goes through various stages as an economy moves through the cycle. Typically as an economy goes into recession jobs are lost, both as a result of lower sales and as firms look to shore-up profitability by cutting costs.


Those efficiency gains are eventually exhausted meaning that as the economy grows again, firms have to turn to hiring again to meet demand. This is the point the US economy now appears to be at. After productivity gains in excess of 6% in year to March 2010, growth has now slowed to only 0.4% in the 2011 calendar year.




Our assumption is that US firms have exhausted the productivity gains to be made from their existing workforce and are now turning to hiring new staff to meet (albeit soft) demand. While that’s a positive story for the labour market, it has negative implications for margins and earnings.

The next phase as the labour market continues to grow will be for wage pressures to start to emerge as skills shortages develop. With still elevated rates of unemployment (and underemployment) across the developed world that appears to be some way off.

However, it may not be as far away as a simple glance at unemployment rates might suggest. To cut a long story short, our thinking on the US (and other developed economies) labour market goes like this: given the structural nature of the recovery there is likely to be larger-than-usual mismatch between the skills of the available workforce and the new jobs that are being created. Structural unemployment (or as Milton Freidman called it: the non-accelerating inflation rate of unemployment or NAIRU) is likely to higher than it was pre-GFC. That means skill shortages and wage pressures will emerge earlier in the cycle.

The big question is where is the structural rate now? The easy answer is: “higher than it used to be”. In the US the pre-GFC NAIRU was generally thought to be around 4.5%. There are a couple of estimates of where it sits now. The Federal Reserve’s long-term unemployment rate forecast is in the range 5.2% to 6.0%. The International Monetary Fund thinks the structural unemployment rate in the US could be as high as 7% (see “Has the Great Recession Raised US Structural Unemployment?” WP/11/105). I think it’s closer to the IMF estimate.

The reality is we are not really going to know where it is until we get there. How we know when we are getting close is therefore going to be quite critical, especially for central banks and the setting of monetary conditions. To that end we will be watching wage and skills shortage data closely over the months ahead. It is most likely going to be a while before we have to start to fret. In the meantime, many central banks are likely to continue easing, but we believe that the first signs the easing is over, and the tightening is about to begin, will come from the labour market.

Friday, March 9, 2012

China GDP: target vs. forecast

This week’s announcement that China had lowered its target growth rate to 7.5% for 2012 caused some consternation in markets. We don’t see this as a forecast: we view it more as a “lower bound”, or the rate at which the authorities would not want growth to fall below. The new 7.5% target is down from the previous target of 8% which was in place over the period in which actual GDP growth averaged in excess of 10%.

We are still happy with our China GDP forecast of 8.5% for 2012. We expect growth to dip below 8% in the first half of the year on the back of the global slowdown and the continued transmission through the economy of the previous tightening in monetary conditions. However we expect growth to be recovering in the second half of the year on the back of further expected monetary policy easing and a return to (very modest) growth in Europe which will assist exports.

The lower GDP target is, however, a useful reminder of the structural challenges ahead for China. Notwithstanding our near-term GDP forecast, our estimate of long-term potential (or trend) GDP is 7.0%. That reflects the ageing of the Chinese population on the back of the one-child policy, the resultant decline in the savings rate, and the closing up of China’s competitive advantage as incomes rise.

Thursday, March 8, 2012

New Zealand Monetary Policy

Unsurprisingly, the Reserve Bank of New Zealand (RBNZ) left the Official Cash Rate (OCR) on hold at 2.5% this morning. However, they pushed out the expected timing of the first hike to the end of this year and reduced the extent of projected interest rate increases.

That’s all fine by us. Our somewhat imprecise expectation (we’ve given up being precise about the start of interest rates hikes, having shifted our timing half-a-dozen times over the last 18-months or so) has, most recently, been for the increase in the OCR to begin towards the end of this year.

What hasn’t changed is our view on the extent of interest rate increases we expect to see over the next cycle. Assuming a start to the tightening cycle late this year, we expect the OCR to be at around 4.5% by late 2013.

That’s more aggressive than the RBNZ is currently projecting. The Bank has lowered its forecast track in each of the last two Monetary Policy Statements: in December in response to higher bank funding costs and in this latest MPS because of the rise in the New Zealand dollar since the last Statement and the lower than expected December quarter CPI out-turn. But when the time comes, we don’t think the RBNZ’s projected track will be sufficient.

While our forecast interest rate track is more aggressive than the RBNZ’s, it is still for a relatively modest interest rate cycle this time, at least by New Zealand standards. A move up to 4.5% takes the OCR back to its previous low, and a peak at that level would be well below the 8.25% peak immediately before the GFC.

The lower cycle going forward is not just about the lower expected growth profile ahead. That’s because potential growth is also lower. That, in turn, means capacity constraints are likely to emerge earlier in the growth cycle. In economist-speak, the “output gap” might not be as big as some measures currently have it. That’s especially the case in the labour market where we believe capacity constraints (skill shortages) will emerge first. Watch this space.

The more important factor is that fiscal policy is expected to be contractionary over the next few years. That will reduce the amount of work monetary policy needs to do when the time comes to start removing some of the stimulus. That’s not just a New Zealand story – that phenomenon is likely for most of the developed world.

Of course there remains a higher-than-usual degree of uncertainty around the economic and monetary policy outlook. We have considerable sympathy for the RBNZ as it carefully constructs the messages in each MPS, especially the highly sensitive forward interest rate track. Transparency is a great thing, but it can’t be easy in times of heightened uncertainty. We think the Bank’s doing a pretty good job.

Thursday, March 1, 2012

India: monetary vs. fiscal policy

December 2011 India GDP came in at an annual 6.1%, lower than market expectations and down on the 6.9% recorded in the September quarter. The slowdown is in line with recent soft industrial production data with the weakness centred in the manufacturing and mining sectors.



The slowdown in India is consistent with the recent slowing in growth across the other key emerging markets which is, in turn, partly due to the broader global growth slowdown over 2011. In most emerging markets however, that has been accompanied by a waning in inflation pressures and, to varying degrees, an easing in monetary conditions.

The India story is somewhat different. While inflation has eased recently in India, it remains at elevated levels. Wholesale price inflation currently stands at 6.55%, down from 9% over most of 2011. It remains the case that of the emerging economies, higher commodity price inflation has had the greatest spill-over into more generalised inflation in India.

India is also unusual for emerging markets in that it runs a budget deficit. Importantly, it is failing to meet deficit reduction targets. The deficit target for the current fiscal year (ending March 2012) is 4.6%, but it is expected to come in at over 5%. The deficit target for 2014 is 3.5% of GDP.

So, despite the lower than expected growth, the scope for monetary policy to ease is constrained by still (relatively) high inflation and loose fiscal policy. The Reserve Bank of India next considers monetary settings on March 15. It is possible they will further ease the bank reserve ratio (following an initial reduction in January), but will wait to see the outcome of the federal budget on March 16 before considering any move on interest rates.