Stronger productivity gains and increased slack in labor markets also prompted us to reduce our 2010 inflation forecast. We now see the unemployment rate peaking at 10.5% in the first quarter, and productivity growth averaging 3.8% over the course of 2009-10, both half a point higher than last month. As a result, we expect core inflation measured by the CPI to run at 1.4% over the four quarters of next year, compared with 1.7% last month. We still believe the Fed will begin raising short-term interest rates in 3Q next year, reflecting greatly improved financial conditions and a sustainable recovery. However, that lower inflation outlook prompted us to trim our Fed call for 2011. We now see the Fed pausing over much of 2011 after lifting the funds rate to 2% early in the year. Together with heavy Treasury coupon issuance, that stance should promote a resteepening of the yield curve over the course of 2011.
Incoming data stronger, speak to sustainability. Third-quarter growth was in line with our expectations, but incoming data for consumer spending have been significantly stronger than expected. Last month, we expected paybacks from cash-for-clunkers to linger and weak income to hold growth in spending to an anemic 1% rate in 4Q. But a better-than-expected ramp tied to surprising strength in non-vehicle spending in September and stepped-up October retail and vehicle sales prompt us to boost our estimate for 4Q consumer spending growth significantly to +2½%, even with very conservative end-of-year spending assumptions. However, we still see tepid income gains continuing to exert some restraint on spending and expect a desire to rebuild saving to cap gains through 2011 and beyond, so we've made no changes to our growth projections for 2010-11.
The weakness in labor markets threatens the sustainability of recovery. Payrolls tumbled by 190,000 in October and the unemployment rate posted a big jump to 10.2% - the highest since early 1983. To be sure, the October decline is in line with the 188,000 average monthly drop over the past three months, the smallest since August 2008. However, job loss in important sectors such as construction, manufacturing and retail trade was heavy in October. Moreover, including forthcoming revisions to the payroll data, it brings the decline over the 22 months since the recession began to a record 5.9%, eclipsed only by the collapse following the end of war production in 1945. And the private workweek remained at a record-low 33 hours. We see this weakness as mainly cyclical, exaggerating the time-honored, early-stage surge in productivity that has characterized every expansion. But there is also a secular component: We think US trend productivity growth is still running at around 2%, in contrast with concerns of a relapse. We explore reasons for this weaker relationship between the economy and labor markets in the accompanying box.
Despite that changed relationship, we continue to expect that job growth will appear in early 2010. The key reason is that past job cuts have virtually eliminated what were minimal hiring excesses, and a growing economy has produced a hiring deficit. One way to measure the extent of hiring excess or shortfall involves cumulating the errors made by a relatively standard relationship used to forecast labor hours worked (and, with a projection for the average workweek, employment). The explanatory variables include the outlook for output, factors that affect productivity such as the services from capital, other variables aimed at capturing changes in trend productivity, and a dynamic adjustment process that captures the typical pro-cyclical surge in productivity early in recovery. If positive, the cumulative differences between actual hours and those predicted by the relationship suggest that there is an overhang of labor to work off. As it turns out, the errors over the course of the expansion that ended in December 2007 were small, reflecting business caution about hiring. And through the second quarter of 2009, the errors cumulate to zero, suggesting that the aggressive job cuts seen in this recession have eliminated any excess. Declines through the third quarter have pushed those cumulative errors sharply negative, implying some underlying pent-up demand for labor that should materialize at some point down the road. Looked at another way, the recession has taken the level of private payrolls about 500,000 below the trough of the previous recession in mid 2003, while the economy has since grown by nearly 11%.
Encouragingly, there are scattered signs that the long slide in employment and hours may be nearing an end. Notably, temporary help payrolls, often considered to be a leading indicator of labor demand, jumped by 40,000 in the past two months, the largest such rise since 2005. In addition, the August and September levels for overall payrolls were revised up by an unusually large 90,000; upward revisions are often a sign of improvement. Other leading indicators are also improving: Initial and continued claims for unemployment insurance benefits have declined steadily since peaking in June; the employment components of the two ISM Indexes and stability in the private job openings rate over the past three months seem consistent with smaller declines in payrolls; and surveys of hiring and hiring plans such as those from our own Business Conditions Survey (the MSBCI) in early October improved noticeably (for more details, see Consumer Spending: Slow Growth - Not No Growth - Ahead, November 2, 2009). And factory regular and overtime hours have risen steadily since the spring. Encouragingly for income, average hourly earnings rose by 0.3% in October, so we expect a 0.2% gain in overall personal income for 4Q.
Unemployment worries. Nonetheless, the sharp jump in the unemployment rate is worrying, and we now expect that the unemployment rate will peak at 10.5% in the first quarter of 2010, half a point higher than a month ago. Rising joblessness typically erodes credit quality and makes lenders cautious. Long spells of joblessness erode worker skills and thus the odds of being rehired, as well as consumer confidence. Moreover, declining labor-force participation had until October held the unemployment rate down; in the past three months, the household survey measure of employment declined by an average 589,000. That string of large employment declines represents an important source of concern. Of course, the household survey is based on a very small statistical sample (60,000 households - or about 0.06% of the total) and thus can be quite volatile from month to month or even over 6-month spans. In contrast, the payroll survey covers about 33% of the universe of employment and is a far more reliable gauge. In that context, it is worth noting that the decline in household employment jobs was less than that in payrolls in the spring and summer (especially when adjusted for conceptual and coverage differences). Payrolls declined by 864,000 more than household employment in the six months ended in July, so the recent relative weakness in the household measure is merely catching up to payrolls.
Policy risks: One plus, one minus. Catch-up or not, the sharp jump in the unemployment rate is likely to spur policymakers to consider new measures to stimulate job creation. For example, after the September report, talk of enacting a new job tax credit surfaced in Washington. We believe that such a measure - if designed correctly - could be an important temporary source of effective stimulus. However, this is a politically divisive initiative. Liberals find such tax credits distasteful because they involve government writing a check to corporations, and conservatives see such measures as more government meddling in the private sector. Last week, in a meeting between Larry Summers and House Democrats, Summers reportedly raised the possibility of a new job tax credit but members of Congress quickly shot down the idea. Coupled with the results of last week's elections, the jump in the jobless rate may alter the political dynamics, but it's unclear how the policy debate will play out.
On a related front, we are becoming increasingly concerned that uncertainty tied to healthcare reform may be restraining hiring at small and medium-sized businesses. Under the just-passed House plan, would-be employers who do not currently offer healthcare benefits to their employees are required to choose between introducing a plan and paying a hefty tax. In contrast, the Senate plans do not include such an employer tax. Why hire until the dust settles on those proposals? Employers needing more labor input could respond by boosting the workweek and avoiding full-time hires (the former will probably happen over the next couple of months anyway, and the recent pickup in temp hiring may reflect those concerns). Unfortunately, given the sharp differences between House and Senate healthcare bills, it appears that this uncertainty won't be resolved any time soon.
Fed to start raising rates in 2010, but expected to pause for much of 2011. Reflecting a sustainable recovery and a bottoming in inflation by mid 2010, we expect the Fed to begin raising rates in 3Q 2010. But instead of continuing to raise rates, we now expect the Fed to pause early in 2011, after lifting the funds rate to 2% early in the year. Among the reasons: improved productivity growth, correspondingly more slack in labor markets, and a lower 2010 inflation trajectory. That's consistent with the Fed's conditional promise to keep rates exceptionally low for an extended period. Indeed, the Fed last week added explicit conditions to that promise, noted in italics: "The Committee will maintain the target range for the federal funds rate at 0 to 1/4 percent and continues to anticipate that economic conditions, including low rates of resource utilization, subdued inflation trends, and stable inflation expectations, are likely to warrant exceptionally low levels of the federal funds rate for an extended period." Given our outlook, even the move to 2% would keep the real federal funds rate at or below zero through 2011, which we think of as exceptionally low.
Looming supply-demand imbalance and shift to longer maturities will push yields higher. Rising private credit demands and higher Treasury coupon issuance will push real yields higher in 2010 and 2011. Private credit demands will revive when businesses' external financing needs - at a record-low minus 2.5% of GDP in the second quarter - turn positive and when household deleveraging gives way to new mortgage and other borrowing, if only at a moderate pace. When companies switch from inventory liquidation to accumulation, and when capital spending revives, corporate spending will outstrip cash flow again. Then the combination of reviving credit demands and still-high Treasury supply will push up real rates.
Although the US federal budget deficit may have peaked in F2009 (both in dollar terms and as a percent of GDP), Treasury coupon issuance will continue to be pushed higher. This reflects an attempt to gradually boost the average maturity of the Treasury debt outstanding from its current level of about 4 years up to 6 to 7 years. Such a swing would take the average maturity from a historically low level at present to a level that is historically quite high. Thus, not only is gross coupon issuance poised for another sharp jump in F2010, but the average maturity of the issuance will have to move higher if the Treasury is to move toward a 6- to 7-year average maturity for the outstanding debt.
In short, we expect upcoming auctions to tilt steadily toward longer maturities - much as has occurred in the most recent announcements. The shift from 20-year to 30-year TIPS also supported efforts to boost maturities. Such a trend is likely to continue through mid-2010. Beyond that point, we suspect that short-dated issuance (2s and 3s) may be reduced while longer-dated supply remains elevated.
Why does the Treasury want to lengthen the duration of their debt? Treasury bill issuance soared in recent years and the average maturity of the debt fell. Such a development is typical when there is a sharp and sudden spike in the borrowing need. The Treasury now wants to rein in bill supply and begin to normalize the maturity profile of the debt. Why are they planning to go beyond historical norms? Treasury officials appear to want to create a cushion of borrowing capability at the front end of the curve in case there is a sudden need for short-term funding. Moreover, even though the Treasury's public position is that they are not an opportunistic borrower - that is, they don't try to time the market - it appears advantageous to attempt to lock in low long-term borrowing costs at present.
But, doesn't the Treasury's desire to increase long-dated issuance conflict with the Fed's desire to hold down long-term mortgage rates? Yes, but such conflicts are hardly unprecedented. And it's worth noting that the associated reduction in bill supply implies less of a conflict with Fed drain operations once they start to exit. Finally, it's clear that Treasury officials are very worried about the looming battle in Congress over the debt ceiling. We continue to believe that there could be significant disruption to Treasury auctions beginning in late-December - or more likely - in January 2010.
Introduction
We highlight in this research note the pros and cons of renminbi de-peg and appreciation in the format of a hypothetical debate between a policy advisor who defends the status quo and a fund manager who argues that the current arrangement is unsustainable.
A Conversation on Renminbi
An overseas fund manager recently visited Beijing as part of his regular macro due diligence trip to China. He had a one-on-one meeting with an influential policy advisor from a local think tank, the purpose of which is to understand better the outlook for the renminbi exchange rate. The following is a dialogue between the policy advisor (or ‘Ms. P') and the fund manager (or ‘Mr. M'):
Mr. M: Professor, thank you for sparing time to meet me. In the interest of time and if you do not mind, may I start with a question by showing you this chart. The chart shows that since March this year, a number of currencies among emerging market (EM) economies have appreciated substantially against the USD. However, the renminbi is among a handful of EM currencies that did not appreciate against the USD, making it one of the weakest currencies in the EM space. Shouldn't we expect the renminbi to appreciate soon?
Ms. P: I beg to disagree. Your observation is correct if one only focuses on the developments in the past 4-5 months. However, before I answer your question, I also would like to present a chart. This chart shows the change in the exchange rates of the same set of EM economies between September 2008 - when the global financial crisis broke out - and March 2009 when the global economic and financial situation started to stabilize. This chart shows that the renminbi was the strongest EM currency, because it was the only EM currency that did not depreciate against the US dollar in the wake of the global financial turmoil.
I recall that, back then, many market observers predicted that the renminbi would depreciate against the USD by following the footsteps of other EM currencies. I believe that, had China allowed renminbi depreciation, the depreciation pressures on other EM currencies would have been even stronger.
Your observation that the renminbi is the weakest EM currency is valid only as far as the past 6-7 months is concerned. If we take a slightly longer view, examining the cumulative performance since the crisis (i.e., August 2008), the renminbi is still stronger than most other EM currencies.
Mr. M: These are fair points. However, when I suggest the renminbi should appreciate, my arguments are based not only on the developments of the past few months but also the fact that China has, and is expected to continue to have, large and persistent current account surpluses, which suggest that the renminbi is undervalued and should appreciate. This is International Economics 101, isn't it?
Ms. P: I do not disagree with you in principle. I think the large and persistent current account surpluses in China have reflected a structural saving-investment imbalance as well as an undervalued exchange rate. Renminbi appreciation should be part of the solution but not the only solution to reduce current account surpluses, especially given its structural nature. That said, from a policymaker's perspective, any macroeconomic policy decision needs to take into account both the cyclical and structural conditions of the economy. While renminbi appreciation makes lots of sense in view of structurally high current account surpluses, the case for renminbi appreciation is far from compelling from a cyclical point of view.
In theory, currency appreciation helps dampen export growth and contain inflation pressures. The reality is that the Chinese economy is currently suffering deflation and a sharp decline in exports. At the current juncture, it does not make any sense for the policymaker to take policy action that would serve to exacerbate either deflation or weak exports. This is Macroeconomic Policymaking 101, isn't it?
Mr. M: I understand what you're saying, but the current situation is not sustainable. The conditions for a renminbi appreciation will never be perfect; there will always be some sort of downside. I am afraid that the longer the necessary adjustment is postponed, the stronger the appreciation pressures will be.
Ms. P: Exchange rate adjustment is important, but I caution against over-emphasizing its role in rebalancing the economy. The experience in 1H09 is a case in point. China registered a current account surplus of US$134 billion in 1H09, a 30% decline compared to the level in same period in 2008. This is because while China's exports declined by 25%Y in 1H09 due to a collapse in external demand, imports declined by only 21%Y, reflecting relatively strong domestic demand underpinned by aggressive policy stimulus. Both Morgan Stanley and consensus forecasts expect the current account surplus to shrink further in 2010, as a result of stronger import than export growth due to robust domestic demand but a tepid recovery in external demand. If these forecasts were to materialize, it would suggest the underlying external imbalances are improving toward a more sustainable situation. Don't you agree?
Mr. M: Well, yes, but even according to these forecasts, China's current account surplus would still be over 5% of GDP in 2010. As long as a current account surplus of this magnitude persists, the expectation of renminbi appreciation is bound to remain strong and will surely lead to significant ‘hot money' inflows, which contribute to large and persistent FX reserve accumulation despite potentially narrowing current account surpluses. And large FX reserve accumulation will constitute a major challenge to monetary policy implementation, namely the loss of monetary policy independence. Aren't Chinese policymakers concerned?
Ms. P: You are absolutely right on this point. In fact, I think this is by far the strongest argument for a flexible exchange rate arrangement in China, which is a pre-condition to independent monetary policy according to the theory of the ‘Impossible Trinity'.
Mr. M: I am glad we finally agree on something. Indeed, for such a large economy as China, independent monetary policy is critical to domestic macroeconomic and financial stability. Isn't this alone a sufficiently strong rationale for renminbi appreciation?
Ms. P: This is indeed a theoretically sound argument, but it has proven to be very difficult to implement in practice. For instance, while the renminbi was allowed to appreciate against the USD by over 20% between July 2005 and July 2008, it does not seem to me that the appreciation brought about any genuine monetary policy independence during that period. On the contrary, I would argue that persistent FX reserve accumulation, in part driven by strong appreciation expectations, has further complicated monetary policy execution. Do you not agree?
Mr. M: True. But I think it is precisely because the renminbi appreciation was too little and too slow to change expectations. A sufficiently large appreciation would generate two-way risks and therefore impart meaningful flexibility to the exchange rate.
Ms. P: How much does the renminbi need to appreciate in order to generate two-way risks in the short run -10%, 30% or 50%? Does anyone really know? As an expert in the internal capital market, do you believe a 10% one-off revaluation of the renminbi could bring about meaningful two-way risks? Even if you can make a case that a 30% one-off revaluation will do the trick, do you think Chinese authorities - who are known for their hallmark gradualist approach reform - would take such a risk, given that a 30% revaluation of the exchange rate could potentially put many Chinese exporters out of business overnight? Also bear in mind that the exchange rate is not just a relative price between tradable and non-tradable goods but a type of asset price, and it could easily overshoot, as every other asset price does.
Mr. M: Your arguments make sense. However, as a market participant, I strongly believe that government is unable to avoid a market-driven adjustment. It is inevitable. One cannot control everything. Something has to give. You seem to be suggesting the ‘law of gravity' does not apply to China. Am I missing something here?
Ms. P: Yes, something is indeed missing in our discussion, which has so far focused on the role of renminbi nominal exchange rate. In theory, when a currency is considered to be undervalued and needs to appreciate, the exchange rate concept here is the real exchange rate, namely the nominal exchange rate between two currencies adjusted for the inflation rate differentials between the two economies. In practice, country A's real exchange rate is estimated by calculating its real effective exchange rate (REER), which is defined as the trade-weighted nominal exchange rate against a currency basket - also called the nominal effective exchange rate (NEER) - adjusted for the inflation rate differentials between country A and its trading partner economies. A real appreciation of country A's exchange rate can be achieved through the nominal appreciation of country A's currency or by a higher inflation rate in country A than in its trading partner countries, or a combination of both.
I agree with you that ‘something has to give'. In this context, the ‘something' would be higher domestic inflation rate in China relative to other trading partner countries if the appreciation of renminbi nominal exchange rate is slow.
Mr. M: Higher inflation in China? But China is suffering deflation now? It may take another 12-18 months before inflationary pressure emerges in China. Relying on higher inflation as part of the solution will be a long process.
Ms. P: This is where the point about cyclical versus structural conditions of the economy that I made earlier becomes relevant again. Renminbi appreciation in real terms is justified over the medium term, namely if appreciation of the nominal exchange rate is slow, inflation pressures will eventually show. In fact, I would advise that, in view of the high level of growth in China, the norm for annual inflation rate in China should be in the range of 4-6% instead of the 2-3% to which many Chinese seem to have become used to. However, the current cyclical condition of the economy dictates that there are deflationary pressures.
Mr. M: I think the relatively low inflation in China largely reflects strong supply capacity and thus fierce competition in the downstream manufacturing sector. I doubt this situation will change any time soon.
Ms. P: It also has to do with the low price of energy and natural resources, as well as low environmental costs. Deregulating these prices and making them reflect their true opportunity costs are the key. More generally, China needs to rationalize the relative price structure between energy and raw materials on the one hand and downstream manufactured goods on the other hand. While this relative price normalization is likely to cause broad-based inflation, I believe that this type of inflation is what China needs and, when it materializes, should be tolerated.
Mr. M: Inflationary pressures seem already to have been reflected in the upward pressures on asset prices.
Ms. P: The post-crisis asset price reflation is a global phenomenon. Indeed, preventing an asset price bubble will perhaps be of high policy priority. But conventional monetary policy tools are ill-suited for this task. I suggest that ‘containing financial leverage' in the system be made a key policy objective with a view to minimizing systematic risks in the event of a bursting of the asset price bubble. This will entail strict mortgage rules for homebuyers, strict restrictions on margin trading in stock market, strict capital adequacy requirements for banks, asymmetric liberalization of external capital account controls that induce capital outflows and discourage capital inflows, and preventing a one-way bet on the renminbi exchange rate that would induce hot money inflows.
Mr. M: Professor, I appreciate the discussion and your answers to my questions. After hearing what you have to say, I now have a better understanding of the arguments in favor of the status quo. And I do see the validity of many of your arguments. At the same time, it seems to me that most of the points you have made are out of consideration of designing a course of policy action that serves the best interest of the Chinese economy itself. However, when it comes to exchange rates, it always involves more than one party. Other countries that are negatively impacted by China's exchange rate policy would complain and call on China to change its current practice. Won't these international peer pressures change the mind of Chinese policymakers?
Ms. P: A strong Chinese economy should help the global economic recovery. While I do not work for the government, I know the Chinese government's position on this issue is that the choice of exchange rate regime is in the domain of a country's sovereign decision. That said, you seem to be suggesting that there are now strong and broad-based international pressures on China to change its exchange rate policy. This is not my impression, however. For instance, while the last G7 statement singled out the renminbi and called for its appreciation, as it did in the past, recent statements issued by G20 have been completely silent on the exchange rate issue, let alone singling out the renminbi. As you know, the G20 has now replaced the G7 as the main international forum for discussing global policy coordination among major economies. Take a look at the recent trends of trade-weighted exchange rates (or NEER) for Russia, Brazil and Korea and compare them to that for China, you should understand why G20's position on this issue is much softer.
As the expert, please correct me if I am wrong. I do not even think it is in the interest of the US to put pressure on China to allow the renminbi to de-peg from and appreciate against the US dollar at the current juncture when the US dollar is already under enormous downward pressure. Wouldn't the perception that ‘even the Chinese are starting to abandon the US dollar' cause more USD selling in the FX market?
Mr. M: Interesting observations. On your last point, the current views of the market seem divided: while some share your view, others actually believe that a strong renminbi will eventually help strengthen the US dollar.
Well, professor, I really appreciate your time and I certainly enjoyed the discussion and have learnt a lot. I hope to stay in touch. Please do let me know if you change your view.
Ms. P: I also greatly appreciate your sharing your view from your perspective of an international capital market participant. Understanding of the market is critical to formulating good policies. Best of luck with your investments.
Our Takeaways from This Dialogue
First, given the fact that the renminbi exchange rate is still a policy tool instead of a market-determined price variable, one needs to think more like a policymaker than a hedge fund manager to gauge the likelihood of a potential policy shift on the renminbi.
Second, we maintain our long-standing view that the current renminbi exchange rate arrangement will remain unchanged at least through mid-2010. While an exit from the current regime of a de facto peg against the USD may occur in 2H10, any subsequent renminbi appreciation against the USD will likely be modest and gradual.
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