Monday, March 30, 2015

US rates to rise only gradually - Yellen

In a speech delivered over the weekend US Federal Reserve Chair Janet Yellen reaffirmed the likely start of US interest rate hikes this year and an only gradual pace of increases thereafter.  There’s not a lot new in that but the speech makes an interesting read in highlighting the FOMC’s thinking about the factors likely to determine the interest rate cycle this time around.

On the outlook for the economy Ms Yellen’s comments were mostly in line with the March FOMC statement.  Lower energy prices continue to get most of the blame for recent inflation weakness with those effects likely to prove transitory.  She acknowledged the impact of the strength in the US dollar in restraining net exports and appears unconcerned about recent weakness in retail sales, expecting consumer spending to grow at a “good clip” this year.  With respect to the labour market she says there has been considerable progress on the maximum employment leg of the dual mandate but “appreciable slack” remains.

On interest rates Ms Yellen says the appropriate time for increasing interest rates has not yet arrived but conditions may warrant an increase sometime this year.  She points out that policymaker cannot wait until they have achieved their objectives to begin adjusting policy.  Leaving interest rates too low for too long risks over-shooting their objectives of maximum sustainable employment and 2% inflation as well as creating risks for financial stability.

Furthermore Ms Yellen stated that neither a pick-up in wage growth nor core inflation are needed before the FOMC decides to begin raising rates.  As I’ve said before, waiting for that to happen may leave the Fed having to play catch-up with more aggressive rate hikes  The Committee “simply”(my emphasis)  needs to believe that conditions are in place for its dual mandate to be met before hiking rates.  That said were core inflation or wage measures to weaken, or were inflation expectations to soften, she would be left “uncomfortable” in raising interest rates.

Ms Yellen is clearly attempting to deflect focus from the timing of the first interest rate increase to the shape of the interest rate cycle.  Indeed the most important aspect of the interest rate cycle for businesses and households is the cost of capital over the cycle, not the timing of the first hike.

In that respect she spends a considerable part of the speech alluding to the reason why an only gradual rise in the Fed funds rate is likely:

  • Firstly, the equilibrium fed funds rate may not recover as quickly as anticipated.  That means the ability of the economy to adjust to higher interest rates is uncertain.  Ms Yellen highlights the experience of Japan with a tightening of monetary conditions when the equilibrium rate remains low has considerable costs.
  • The second factor is the asymmetry in the effectiveness of monetary policy in the vicinity of the lower bound.  While interest rates are expected to move higher as the economy improves, should the economy falter as rates rise, there is limited room to stimulate the economy without resorting to further asset purchases with all the risks that would entail.
  • Third, she makes the observation that a prompt return to the FOMC’s 2% inflation could be advanced by allowing the unemployment rate to decline below its long run sustainable level for a while.

While all of these are valid reasons for the Fed to move only gradually, it wouldn’t be a balanced speech without highlighting the risk of proceeding too slowly, letting inflation get away, thus undermining the Committee’s inflation fighting credibility.  That seems to me to especially relate to the third point above.

In short there’s nothing in this speech to alter our view of a likely September “lift-off” for interest rates in the US and an only gradual removal of monetary accommodation thereafter.  But the speech is a more than useful dissertation of what the Fed is thinking about and what they will be watching as the cycle unfolds and the uncertainties that entails.

Regular readers may recall the point we made before the start of the interest rate tightening cycle last year that to some extent the RBNZ (and markets) were on a voyage of discovery with a number of uncertainties about the post-GFC New Zealand economy including the level of the neutral cash rate, the rate of potential GDP, the level of the equilibrium unemployment rate and how businesses and households would respond to higher interest rates.

Ms Yellen concludes her speech with similar thoughts.  She reiterates the Committee’s decisions will be data dependent, but that “We cannot be certain about the underlying strength of the expansion, the maximum level of employment consistent with price stability, or the longer run level of interest rates consistent with maximum employment. Policy must adjust as our understanding of these factors changes.”  New Zealand’s experience certainly supports that.

Thursday, March 19, 2015

Data Insight: NZ GDP

  • New Zealand’s December 2014 quarter GDP growth came in at +0.8% qoq, bang on market expectations and a little stronger than our own forecast of +0.7%.  Annual growth came in at +3.5% with annual average at +3.3%, the strongest since 2007.
  • The sectoral breakdown was much as expected with strong growth recorded over the quarter in retail trade and accommodation, financial and insurance services and manufacturing.
  • The growth outlook remains one of plusses and minuses.  Plusses will continue to be residential construction (particularly in Christchurch and Auckland), population growth via net migration, still relatively low interest rates, strong business investment on the back of robust confidence and the low cost of capital, strong consumption growth underpinned by strong employment growth and higher real incomes as headline inflation approaches zero and, further out, accelerating average trading partner growth. 
  • The minuses will be the still strong New Zealand dollar (especially against those currencies where central banks are easing monetary policy such as the Euro zone, Japan and Australia), fiscal drag as the Government continues to keep fiscal conditions tight in pursuit of fiscal balance, drought and lower dairy prices.
  • That mix of factors has the New Zealand economy set to maintain growth of around 3% per annum for the next two years.  Compared to our previous forecasts that means we see 3% growth being maintained for longer as interest rates remain on hold for a period of time and we see a more muted than expected decline in the terms of trade.  We expect annual average growth of 3.1% in 2015 followed by 3.2% in 2016.  The cycle then turns down further out as interest rates rise further, we pass the peak in the Canterbury rebuild and the migration cycle turns.
  • For a more fulsome commentary on the outlook for the New Zealand economy and the implications for interest rates and the share market, have a read of our latest New Zealand Insights which you can find here.

FOMC completes shift to data dependence

As was widely expected the FOMC’s March Statement removed “patient” form its forward guidance on the timing of the first increase in interest rates in the US.  The Committee has now completed the shift in its guidance from time dependence to data dependence.

On the whole this morning’s statement was at the dovish end of expectations – at least if the market reaction is anything to go by.  The Committee’s assessment of economic activity was softened somewhat with growth having “moderated somewhat” with weaker export growth mentioned specifically.

The new Summary of Economic Projections (SEP) lowered forecasts for real GDP growth and inflation over the 2015-17 period.  As we expected they also lowered the range for the long-term unemployment rate from 5.2-5.5% to 5.0-5.2%.  With the unemployment rate already at 5.5% it would prove difficult from a communications perspective to persist with zero interest rates with the unemployment rate already at trend.

The Committee stated a rate hike in April was unlikely and they would hike “when it has seen further improvement in the labour market and is reasonably confident that inflation will move back to its 2 percent objective over the medium term”. So an increase in interest rates is coming – it’s just question of when.

Recent inflation data seemed to us to shift the timing of the first rate increase out from June to September as there appeared to be an element of spill-over from  lower fuel prices into core inflation.   At the same time the recent strong labour market data appeared to not completely dismiss the possibility of a June “lift-off”.
We have also been unconcerned about recent weakness in retail sales as stronger employment, hours worked and (albeit modest) wage gains suggests strength in consumer spending in the period ahead.

Today’s press statement appears to shift the balance of probabilities for the first rate hike further towards September (or later?).  But with the Fed now completely data dependent, it’s a case of watch this space... 

Thursday, March 12, 2015

RBNZ March Monetary Policy Statement: Neutral means NEUTRAL

Key points:
  • As expected there was no change in the Official Cash Rate today with the RBNZ leaving it unchanged at 3.5%.  In addition the Bank’s interest rate track now shows a completely flat track, reinforcing its neutral stance.  
  • That said, the interest rate projections are the best part of a year shorter than normal, lopping off the period in which we thought the Bank would show a further modest increase in interest rates.
  • The Bank’s forecasts look perfectly reasonable with their GDP forecasts still modestly higher than ours and with an output gap that is more positive than previously forecast.  Technically that means more inflationary, though their inflation forecasts show inflation remaining below 2% for longer thanks to lower petrol prices.
  • So neutral clearly means NEUTRAL with interest rates on hold for the foreseeable future.  The key paragraph from the policy assessment is as follows: “Our central projection is consistent with a period of stability in the OCR.  Future interest rate adjustment, either up or down, will depend on the emerging flow of economic data.”
  • It could well be that we don’t need interest rates any higher than they are today.  That will require the economy to be able to continue to grow at an above trend rate without generating inflation.   The key data going forward will be the labour market, particularly wages as the unemployment rate continues to track lower.  
  • For more on the outlook for the New Zealand economy and interest rates watch out for the upcoming March edition of New Zealand Insights - coming to your inbox soon.

Monday, March 9, 2015

Data Insight: US payrolls

Key points:
  • US payrolls put in another solid month of gains with a rise of +295k in February.  This result gives a 3-month moving average of +288 per month indicating the jobs growth is becoming increasingly sustained.  Furthermore it has also become increasingly broad-based over recent months.
  • Wage growth was soft over the month with average hourly earnings up 0.1% m/m for an annual rate that is still stuck at not much over 2%.  As I’ve said before, surprise at continued low wage growth needs to be tempered with the fact that labour productivity growth in the US in currently trending at around 1% per annum.
  • Solid jobs growth, increasing hours worked (+3.7% yoy 3-month moving average) and continued, albeit modest, wage gains underpin our expectation of solid consumption growth in 2015 and overall GDP of 3.0-3.5% in 2015.
  • The unemployment rate dropped to 5.5%.  This is now at the top end of the Federal Reserve’s range estimate of the trend unemployment rate.  This will give the Fed increasing comfort with the view that their zero interest rate policy will soon be no longer appropriate.
  • Recent inflation outcomes with signs that lower oil prices have had a dampening impact on core inflation has suggested to me that September was the likely starting point for US rate hikes.  This data tells us June is still very much a possibility.  

Friday, March 6, 2015

Brazil - Challenging times

Having written recently on the economic resurgence underway in India, it seems only fair to compare and contrast with another large emerging economy where the economic environment is more challenging.  So let’s have a look at Brazil.  This is made more timely with the decision this week by the interest rate setting committee of the central bank (COPOM) to raise interest rates despite the poor growth environment.

2014 was a challenging year for the Brazil economy with growth coming in at an estimated annual average 0% for the calendar year.  Into 2015 the headwinds are increasing.  A combination of fiscal tightening, higher interest rates, low business and consumer confidence and the possibility of power rationing later this year will conspire to keep growth low in the foreseeable future with recession a possibility in 2015.

Like India, Brazil was one of the fragile five in 2013.  The Real has depreciated 20% since its peak in 2011 and should be a boost to the external sector and growth generally but the current account deficit is yet to improve.  

Gains in competitiveness are most helpful to manufactured exports and Brazil has a relatively low share of manufactures as a share of total merchandise exports at 36% (2013 data from the Word Bank).  That compares with 62% in India and 94% in China.  Weak commodity prices along with soft external markets are proving to be a drag on any improvement in Brazil’s external position.

Inflation remains problematic largely thanks to the currency depreciation.  That said the annual inflation rate at 7.1% for the year to January has only just moved out of the top end of the central bank’s target band (4.5% +/- 2%).  We expect it will move higher still in the next few months.  COPOM has raised the benchmark Selic rate from a low of 7.25% in 2012 to 12.75% currently to help keep inflation expectations in check.  Further interest rate increases appear likely.

 After a tumultuous election campaign Dilma Rousseff was re-elected President at the end of 2014.  She has appointed Joaquim Levy Finance Minister.  One of his first jobs is to rein in the first primary budget deficit in 2014 since the mid-1990s.  A number of tax and spending measures have been introduced to turn the Government’s finances around.  This will also have a negative impact on growth and is also adding to inflation through higher charges.

The challenges facing Brazil are difficult but not insurmountable.  Like many emerging economies its demographics are favourable, although not as good as India’s.  The United Nations is projecting strong growth in Brazil’s working age population over the next decade before its starts to level off from about 2025.  As with India higher productivity via stronger investment is the other part of the growth equation.  In terms of an investment friendly business environment, Brazil is on the back foot.

Brazil’s starting point today is higher per capita GDP than both India and China.  Over the last few years a significant proportion of Brazil’s population has moved into the middle class.  Failure to raise productivity and keep inflation in check risks pushing the new middle calls back into poverty.

Ms. Rousseff is making the right noises about reform and the appointment of Mr Levy into the finance role is a positive move.  The right polices, implemented quickly, could soon see Brazil back to sustained GDP growth of 3.0-3.5% per annum.

Wednesday, March 4, 2015

Data Insight: Australia GDP

Key points from the AMP Capital team in Sydney:
  • Australia's economic growth remained modest in the final quarter of 2014 with the economy expanding by +0.5%.This is only a marginal acceleration of the previous quarter’s +0.4% growth rate. This accords with the RBA’s March meeting statement that Australia’s “growth is continuing at a below trend pace”.
  • There were some positives in the December quarter GDP report. Consumer spending was solid (+0.8%) with the household saving ratio remain elevated at 9.0%.
  • Housing construction is robust (+2.5%). There was  sharp positive GDP contribution from Net Exports (+0.7% to GDP) given solid exports (+1.0%) outweighing the sharp fall in imports (-2.5%). This import slump reflects the end of the mining investment boom curtailing capital imports.
  • However business investment was weak (-0.4%) given the mining downturn while inventories fell sharply (-0.6% percentage point contribution), indicating a degree of caution in the corporate sector. Notably public spending was flat (+0.1) given the Federal Budget’s fiscal consolidation.
  • Australia's real economic growth for the past year now stands at a modest 2.5%.  This growth rate  is well below the past 20 year average of 3.3% and below the 2.8% average for last 10 years. So the Australian economy is recording a “below trend” performance with accompanying mild inflation pressure and a gradually rising unemployment rate. 
  • Given this sub par economic performance , the December quarter GDP result will only reinforce the case for a further easing in monetary policy.  We expect the RBA will cut the official cash interest rate by a further 0.25% to 2.0 % in April or May.

Tuesday, March 3, 2015

India’s budget and China’s rate cut

In my post on India’s Economic Resurgence last week I said that fiscal consolidation would prove difficult.  Indeed in the Modi Government’s first Budget the fiscal consolidation target of a deficit of 3.0% of GDP has been pushed out a year to 2018 in exchange for higher spending on infrastructure.  In general though the budget has much in it to applaud but there were also a couple of missed opportunities.

Economic growth will get a boost from increased investment in roads, railways and power plants.  In total the capital expenditure budget is projected to be 25% higher in the new fiscal year (FY).  Implementation will be challenging and makes proposed changes to land acquisition rules all the more critical.  The higher spending means the FY16 deficit of 3.9% of GDP will be higher than the previously expected 3.6%, although will still be lower than the estimated 4.1% of GDP in FY15.

One area of disappointment on the spending front was subsidies.  While spending in this area will be lower in FY16 that’s mostly due to lower commodity prices.  Subsidy spending is ripe for a significant structural overhaul and the best time to do that is when growth is strong.

Changes on the revenue side were all positive and include the phasing in of a lower corporate tax rate from 30% to 25% over the next four years and the planned implementation of a Goods and Services Tax from April next year.

There was nothing in the budget on labour market reform.  As I said last week this is a critical area for the Government to make progress if it wants to meet its growth aspirations.  But on balance this is a good budget and supports our argument of an economic resurgence under way in India. 

While we’re on the subject of emerging markets China’s second rate cut announced over the weekend was a clear signal the government  is keen to put a floor under the growth slowdown.  Despite trying to suggest that its monetary stance remains unchanged, two rate cuts and a reduction in the required reserve ratio argues a shift away from PBoC’s previously stated neutral position.  Further rate cuts seem likely.

Monday, March 2, 2015

Data Insight: New Zealand Terms of Trade

Key Points:
  • New Zealand’s terms of trade fell -1.9% in the December quarter, the combined result of a -1.8% decline in export prices and a +0.2% rise in import prices.  The index has now fallen 6.4% from the peak of June 2014.
  • Dairy prices led the decline falling -14.8% over the quarter.  This was offset by healthy price increases in other key commodity exports such as meat (+12.4%), forestry (+8.4%) and aluminium (+7.8%). 
  • Prices rose in a number of import categories (mechanical machinery, transport equipment) over the quarter, largely due to the weaker currency.  However this was almost entirely offset by a decline of 10.0% in petroleum products.
  • Given the decline in dairy prices over the 2014 the terms of trade has remained surprisingly robust, assisted by the strength in prices of other commodity exports and, more recently, the sharp drop in the price of oil.  
  • Since December oil prices have recovered and dairy prices are also higher, although the latter won’t be captured in the terms of trade until the June quarter.  But right now it appears the worst of the decline in the terms of trade is behind us.