We still see that as the most likely outcome. But we also think that new uncertainty around economic policies at home and abroad is creating downside risks to US and global growth through two channels. First, consumers and businesses could hesitate to commit to spending and hiring decisions until policy uncertainty diminishes. Second, prolonged uncertainty and consequent significant renewed weakness in asset prices would reverse some of the easing in financial conditions that has revived economic activity. Conversely, however, more clarity about some of these policy issues could reduce both of those headwinds.
Domestic and global policy limbo. That such hesitation by households and businesses and weakness in asset prices can be traced to uncertainty around economic policies is hard to prove. But there is no mistaking the growing list of domestic and global policy issues that has left investors in limbo. At home, there is uncertainty about coming tax hikes, more stringent banking regulations, and who will shoulder the costs of healthcare. Uncertainty around taxes could promote higher consumer saving, uncertainty about needed regulatory reform could stymie willingness to lend, and uncertainty about health care reform may be a hurdle to hiring. So far we see little evidence of those concerns in saving behavior, in lender surveys, or in our business conditions canvass - but we will monitor these closely.
Global fears center on the impact on growth of policy tightening in Asia and the potential contagion from sovereign credit risks. Strong Asian growth is a key ingredient in our view that US exports and earnings will outpace domestic demand, and the policy tightening we have seen and expect to see there is consistent with the rapid rebound in the region. Indeed, we now see Asian growth this year even stronger than just a month ago. Additional weakness in Europe would have only a small impact; we continue to expect tepid growth.
Looking backward, surveys seem to evince little evidence of such uncertainty, at least through January. For example, measures of consumer confidence rose to two-year highs, and our own business conditions survey moved close to record-high levels. The Fed's January Senior Loan Officer Survey showed a further easing in financial conditions; that is good news for growth. To be sure, the cumulative tightening in standards over the past two years means that credit is still tighter than before the crisis began. But we think it's the pace of tightening that matters for growth. Tight lending standards are still depressing the level of lending and thus output, but their effect on growth is abating significantly. And indicators that have recently slipped - for example, the NFIB small business optimism index - are still close to recent highs.
Looking ahead, however, uncertainty could depress those measures. To assess some of them, we update three metrics that might help quantify uncertainty and its influence on the economy and markets: The gap between consumer expectations and current conditions; the residual between consumer sentiment and its determinants; and the extent to which real variables in recovery explain stock market volatility. We first looked at two of these seven years ago (see The Metrics of Uncertainty, February 21, 2003); none of them in updated form yet shows signs of deterioration that would trigger a change in view. But in coming weeks we will explore these and other measures to validate these tentative conclusions.
Mind the sentiment gap. Surveys of consumer sentiment ask respondents how they assess current business conditions and their personal finances, plus their expectations for each of these over the next year or so. The gap between these two indexes is one simple measure of uncertainty or risk-aversion. For example, a persistently negative gap between expectations and current conditions would suggest a high degree of risk-aversion. At present, the gap between the index of expectations and that for current economic conditions compiled by the University of Michigan stands at plus 11 - about 8 points below the mean - and 3 points above year-ago levels when the economy was tanking. That gap suggests little change to uncertainty, but it is flawed because it does not control for macro factors that account for fluctuations over the business cycle.
Model-based measure. A better gauge of uncertainty or risk-aversion, therefore, is the extent to which measured consumer sentiment deviates persistently from what its key macro determinants predict it would be. Persistently positive errors in such a relationship suggest low uncertainty, while persistently negative errors indicate high (and possibly rising) uncertainty and risk-aversion. We estimated relationships using both the Michigan consumer sentiment index and the Conference Board's index of consumer confidence. These are not causal or behavioral relationships; rather, we are simply trying to control for cyclical factors. The relationships between these indexes and unemployment, stock prices, inflation and real income are close - explaining more than 90% of their variance - and the errors tell a consistent story. Those errors went sharply negative in the financial crisis, just as one would expect. And the errors in both equations went from strongly negative (up to 30 points) to or near zero as the crisis abated and as the new Administration took office, suggesting that risk-aversion declined.
Importantly, however, this measure has deteriorated even as the economy has improved over the past four months. That recent deterioration is echoed in surveys assessing opinions about government economic policy: The Michigan index of consumers' opinions of government economic policy has slipped about 25% since the euphoria recorded in the May canvass. In our view, this deterioration has not reached a critical level; it's still well above the lows of a year ago. But it bears watching.
Determinants of volatility. Volatility in equity markets is often viewed as a measure of uncertainty, but it arises from many sources. And parsing the sources of volatility is hard. To determine what economic environment drives a high or low volatility market, our colleagues Sivan Mahadevan, Chris Metli and Matthew Evans have tried to determine how economic variables like the ISM drove volatility in the past six economic recoveries since 1970, using data from just after the market bottom in each recession through roughly one-and-a-half years after (see Volatility in a Recovery - Views for a Turning Cycle, September 16, 2009). What's striking is that while economic factors helped drive volatility lower over the past year, their explanatory power in this cycle is poor, largely underestimating realized volatility until June. That's no surprise; volatility was clearly elevated in October 2008 as policy uncertainty and systemic risk dominated markets. Indeed, in our view, it underscores how important policy uncertainty can be to determine economic and financial market outcomes. So, while policy choices and results may be slow in coming, any reduction in uncertainty could play a constructive and self-reinforcing role for both.
Reducing policy uncertainty would be a plus. That uncertainty is a headwind to growth makes intuitive sense, and seems to be borne out empirically. Recent work confirms this intuition, underlining how uncertainty produces negative growth shocks. Nicholas Bloom shows how a rise in uncertainty makes it optimal for firms and consumers to hesitate, which results in a decline in spending, hiring and activity (see Nicholas Bloom, "The Impact of Uncertainty Shocks", Econometrica, vol. 77(3), pages 623-685, May 5, 2009). In effect, the rise in uncertainty increases the option value of waiting as volatility rises. Moreover, this line of reasoning suggests that uncertainty reduces the potency of policy stimulus. That's because the uncertainty can swamp the effects of lower interest rates, transfers or tax cuts. In effect, uncertainty raises the threshold that must be cleared to make a business choice worthwhile, and as uncertainty declines, the threshold falls with it. That squares with our long-held view that policy traction from easier monetary policy, improving financial conditions and fiscal stimulus was lacking through much of last year, but improved as uncertainty fell.
These results suggest that reducing policy uncertainty now could be a tonic for growth. That won't be easy or come quickly at home, given the political backdrop in this election year. Nor will it be simple in Asia, given the need to reduce policy stimulus, or in Europe, given the depth of the fiscal problems faced by the countries on the periphery. But even some incremental clarity on policies in any of these three theatres would offer investors a chance to assess the fundamentals again - fundamentals that we still see as improving.
Last week we published a note that called attention to the long-run challenges confronting US policy makers seeking to rein in the federal budget deficit to a sustainable level (see US Budget Forecast Update: The Song Remains the Same, January 29, 2010). In particular, even if the US economy achieves full employment by 2020, the budget deficit is likely to be running in excess of 5% of GDP assuming current polices remain in place. And the situation gets dramatically worse from there over ensuing decades due to the aging of the population and the associated elevation in entitlement commitments. Also, we called attention to the fact that 85% of the current budget consists of defense, entitlements and interest on the debt - implying that it is very difficult to achieve meaningful deficit reduction on the spending side alone. Similarly, it is difficult to make significant progress by tinkering with tax rates on upper-income individuals. President Obama's FY 2011 budget proposes to extend tax cuts for those at the 28% marginal bracket or below while allowing rates to revert to pre-2001 (higher) levels for those currently in the 33% and 35% brackets.
Crunching the numbers. We analyzed some calculations produced by the Urban Institute (a highly regarded, non-partisan think tank in Washington DC). They pose the question: How much would tax rates have to rise in order to achieve a 3% budget deficit-to-GDP ratio by 2020? The starting point for their analysis is a baseline budget forecast that shows a deficit/GDP ratio of 6.5% of GDP at the end of the current decade. Admittedly, this is somewhat higher than our own estimate of 5.2%, mainly because the Urban Institute baseline does not include the impact of tax hikes on higher-income individuals recently proposed by the president and which we deem likely to be adopted by Congress. But, even though the Urban Institute study is based on a somewhat more pessimistic budget outlook, the results are still quite useful in demonstrating the magnitude of tax hikes that would be required in order to achieve fiscal sustainability.
The conclusion is that the top marginal rate would need to rise to about 75% if tax rates are to be held steady for households earning US$250,000 or less, as pledged by President Obama (note: to be precise, the 33% bracket currently kicks in at about US$210,000). This arithmetic reflects the fact that only about one-third of taxable income is concentrated in the two upper brackets. So, you have to raise rates a lot at the top in order to generate the required revenue. Moreover, it's important to note that this is a static model. Surely, there would be significant behavioral response at such high tax rates that would greatly limit the actual amount of revenue that was raised.
It's worth noting that the 3% deficit/GDP ratio was selected because it represents the upper end of the threshold at which policy is perceived to be sustainable over the long run. The Urban Institute study also included separate calculations for a 2% target. Not surprisingly, the required rates would be much higher. Specifically, under the scenario in which the rates are adjusted for only the top two brackets, the required rate at the top end would be a whopping 91%.
One alternative solution to our fiscal woes might be a value-added tax. On my recent trip to Toronto, I learned that you can add the GST (the federal goods and services sales tax, which is a value-added tax) and PST (provincial sales tax) and round up to get an appropriate restaurant tip. That's the kind of helpful information that might come in handy some day.
Substantial gains in the short and intermediate part of the curve and little change at the long end caused the Treasury yield curve to steepen back to near record levels over the past week as pressure on the market from a run of overall strong domestic economic data and upcoming supply at the refunding auctions was more than offset, especially at the front end, by a flight-to-safety bid on increasing and broadening worries about the Euroland fiscal situation, which directly boosted short Treasuries as money left troubled European government bond markets and also provided a good indirect lift from the weakness these concerns caused in risk markets. The situation in Greek markets at least showed some signs of stabilizing as the European Commission endorsed the country's plan to cut its budget deficit from 13% of GDP to 3% over the next few years, but worries increasingly have shifted to Portugal and Spain in recent days, and even Irish and Italian government bonds were starting to lag late in the week. And beneath the more systemic concerns about sovereign credit risk in Europe, the economic data have started to look increasingly soft, with a much weaker-than-expected industrial production report out of Germany Friday capping the past week's figures ahead of what could be disappointing Eurozone GDP results in the coming week. The apparent slowdown in European growth amid systemic concerns about European sovereign finances contrasted sharply with an increasingly positive economic outlook in Asia, leaving continued signs of reasonably solid US growth in the middle. Over the past week we boosted our GDP forecasts for Japan, China, India, Malaysia and Thailand, which together raised our 2010 GDP growth forecast for all of Asia to +7.4% from +6.6%. In the US the past week's solid economic news further confirmed the modestly more positive ongoing growth outlook but didn't cause any broad rethinking of our medium-term outlook for moderate, sustainable growth this year. Upside in the factory orders report offset weaker-than-expected construction spending numbers earlier in 4Q, and we see 4Q GDP growth being adjusted up to +5.8% from +5.7%. We continue to see 1Q tracking near +3%, a half point better than we were thinking a couple of weeks ago, but we still expect full-year 2010 growth to run near +3.25%. The early run of key January data was largely upbeat. Payrolls posted a surprising small decline, but other important details of the employment report were better than expected across the board, with a surge in the household measure of employment dropping the unemployment rate significantly, the average workweek expanding, aggregate hours showing good upside and aggregate earnings a big gain, and temp jobs within payrolls way up again. Earlier in the week, both ISM surveys showed upside, though surging factory sector activity continues to lead the recovery, as it has since the economy came out of recession in July. Early indications for January consumer spending were positive overall. Motor vehicle sales declined modestly entirely as a result of a large decline in Toyota's sales - and the problems at Toyota certainly could be a lingering issue for manufacturing output and auto sales - but chain store sales results were quite strong.
On the week, benchmark Treasury yields fell 1-13bp, led by the 5-year, while the long bond was little changed, resulting in 5s-30s jumping 12bp to just a few bp below the record high hit on December 10. 2s-30s steepened 7bp to within 5bp of the all-time hit on January 12. The 2-year yield fell 7bp to 0.75%, 3-year 13bp to 1.24%, 5-year 13bp to 2.22%, 7-year 10bp to 2.98%, 10-year 6bp to 3.55% and 30-year 1bp to 4.50%. Thursday was the last for now in a run of very heavy net paydowns of bills at the weekly auction settlement, which allowed the squeeze in the bill sector to ease a bit. This was the seventh straight weekly paydown of bills totaling US$127 billion, but we expect net bill issuance of US$50 billion over the next five weeks during peak tax refund season before heavy paydowns resume during heavy tax inflows in April. With the supply shortage temporarily easing, the 4-week's yield at least turned positive, rising 3bp to 0.02%, while the 3-month yield rose 1bp to 0.08%. There was a bit more upside early in the week, but flight-to-safety inflows largely reversed this. TIPS lagged badly, hurt by further weakness in commodity prices as the problems in Europe badly hurt the euro and sent the dollar much higher. TIPS were also unable to keep rising with nominals because of lack of interest from real rate-focused investors in buying at such rock-bottom current yields, with little apparent interest among real money investors in 10-year TIPS yields not far from all-time lows as they've approached 1.25%. On the week, the 5-year TIPS yield fell 7bp to 0.12%, 10-year rose 3bp to 1.31%, and 20-year rose 4bp to 1.96%. The flight-to-safety nature of much of the week's upside led to Treasuries outperforming swaps, mortgages and agencies except at the longer end, where Treasuries were softer. The benchmark 2-year swap spread rose 1.5bp to 30.25bp and 5-year 3.5bp to 34.5bp. Current coupon mortgage yields fell from about 4.35% to 4.30%. Mortgage yields have been in a narrow range of around 4.3-4.4% for the past month, which has kept average 30-year mortgage rates very close to an historically very low 5% for the past few weeks.
Risk markets seemed to be in a tailspin during the second half of the week after rallying Monday and Tuesday, but the S&P 500 managed a more than 2% rally in the last two hours of trading Friday to end the day slightly higher and the week only down 0.7%. Sector performance for the week ended up pretty narrowly mixed. Financials helped lead Friday's big turnaround but still did relatively poorly for the week with a nearly 2% drop, while basic materials, despite the weakness in commodity prices, and tech outperformed with small rallies. Credit came off the week's worst levels Friday afternoon but didn't see nearly as big a recovery at the very end of the week. Credit lagged stocks on the week, investment grade more so than high yield, after not seeing nearly as big a rebound at the end of the day Friday. In late trading Friday, the investment grade CDX index was 5bp wider on the week at 102bp, its worst close in over two months. The high yield index was only 5bp wider on the week through Thursday at 580bp and even after about a 0.75 point further loss Friday was only posting fairly small net losses for the week. The commercial mortgage CMBX market was mixed. The AAA gained 2% on the week to cut its year-to-date loss to only 1%, but junior AAA sank another 2% and A 1% to extend their losses for the year to 9% and 5%. The fiscal problems in Eurozone member countries is more like the fiscal problems in US states than a regular national issuer, since neither individual EMU members nor US states have much control over the monetary policy or exchange rate of the currency they are issuing debt in. This analogy certainly hasn't been lost on investors, who have continued to bid up municipal bond credit protection along with the sovereign CDS of strained European countries. In late trading Friday, the 5-year muni MCDX index was 6bp wider on the week at 178bp, a more than 40bp worsening so far this year and about a 90bp widening since the recent tights in October.
Non-farm payrolls fell 20,000 in January, hurt by weakness in construction (-75,000), finance (-16.000) and state and local government (-41,000) jobs. On the positive side, manufacturing (+11,000) rose for the first time in three years and temp employment (+52,000) posted another very big gain, a positive leading indicator for labor demand. Temp employment has now risen at a 50% annual rate over the past four months. Other underlying details were also quite positive. The unemployment rate fell three-tenths to 9.7% as the household measure of employment surged 784,000. It's increasingly looking like the cycle peak for the rate was reached at 10.1% in October, though rising consumer confidence could lead to a notable pick-up in labor force participation that would lead to renewed upside in coming months even if job growth remains solid. The average workweek rose a tenth to 33.9 hours, causing total hours worked to gain 0.2%. Manufacturing hours were particularly strong, and we now forecast a 1.1% surge in January industrial production as a result. Combined with a 0.2% increase in average hourly earnings, the upside in overall hours worked caused aggregate weekly payrolls, a measure of total wage income, to surge 0.5%, pointing to a robust gain in January personal income.
The rest of the initial run of January data was also positive. Both ISM surveys improved, though manufacturing continues to lead this recovery. The manufacturing ISM composite index rose 3.5 points in January to a very strong 58.5, a high since mid-2004. A surge in production (66.2 versus 59.7) was the biggest contributor. Orders (65.9 versus 64.8) saw a smaller gain this month but hit a similarly lofty level, and the employment index (53.3 versus 50.2) moved solidly into growth territory. Improving foreign demand and lean inventories continue to be big supports for the manufacturing sector recovery. The export orders index jumped 4 points to 58.5, near the top of the range seen over the past 20 years, while the customers' inventories index plunged to another record low of 32.0. Meanwhile, the composite non-manufacturing ISM index rose to 50.5 in January from 49.8 in December, a high since May 2008, though just barely in growth territory. The orders index (54.7 versus 52.0) hit its best level in over two years, while the business activity gauge (52.2 versus 53.2) declined but held above the 50-breakeven level. The employment gauge (44.2 versus 43.2) ticked up but was still at a weak level. Early indications for January consumer spending were positive overall, putting 1Q on pace for another modest rise in consumption. Motor vehicle sales fell somewhat, with declining sales at Toyota that weren't made up for by other companies explaining the drop. On the other hand, monthly chain store sales results overall were quite strong, with particularly good results from clothing and department stores that pointed to solid sequential gains in those components of the retail sales report. We see retail sales gaining 0.6% in January overall and 0.8% ex autos, which would leave 1Q consumption tracking near +2.5%.
That would account for a bit more than half of the 3.0% overall GDP growth we now forecast for 1Q, a half point better than we expected a couple of weeks ago. And this comes on top of the better-than-expected 4Q growth, which at this point appears likely to be marked up a bit further to +5.8% from +5.7%. Upside came from the factory orders report, which showed a much smaller decline in December factory inventories (-0.1%) than BEA assumed in preparing the advance estimate. The key point here looking forward, however, remains that inventories are still declining, just declining at a slower rate, and they are becoming increasingly lean relative to sales, with the I/S ratio in manufacturing falling to 1.29 in December from 1.32 in November, a low since August 2008 after a big correction from the recession peak of 1.47 hit in January 2009. Even with 4Q now likely to show a revised 3.7pp add from slower inventory liquidation, we expect a further add of a few tenths in 1Q (which would still leave the level of real inventories declining). This upside offset some softness in the December construction spending report that resulted from much worse-than-expected results for state and local government activity from October to December including revisions. Spending overall in December, however, held up better than expected, especially considering the unusually bad weather. Most notable in December was a very surprising small increase in private non-residential activity, which provided a much better starting point for 1Q business investment in structures after the record collapse seen in 2009. Structures investment only appears on track for a small further drop in 1Q. And the factory orders report continued to show big upside in orders and shipments for capital goods late last year, providing a very positive starting point for equipment investment to build on the 13% gain in 4Q. Overall business investment appears on track for a gain near +5% in 1Q after the 3% rise in 4Q. Before the durable goods report was released in late January, we were forecasting a small decline in 1Q investment, and this improved outlook for business spending accounts for most of our modestly more positive view for overall 1Q growth. While a 5.8% revised 4Q result and a 3.0% gain in 1Q would boost GDP growth for all of 2010 on an annual average a couple of tenths above our prior +3.1% estimate, we still see growth in the four quarters of 2010 averaging +3.2%, and we haven't made any fundamental changes to our outlook for a modest, sustainable rebound this year.
The domestic economic calendar in the coming week is light, especially early in the week, which will leave focus to a significant extent on developments in Europe. Domestically, the refunding auctions will be the main focus in the first part of the week, with a US$40 billion 3-year auction Tuesday, US$25 billion 10-year Wednesday and US$16 billion 30-year Thursday. Notable data releases due out include international trade and the Treasury budget Wednesday and retail sales Thursday:
* We look for the trade deficit to widen by a half billion dollars in December to US$37.0 billion, with exports and imports both rising 1.8%. Export upside should be led by capital goods, consistent with industry reports and factory shipment figures. On the import side, port data point to another big rise in non-energy goods imports from Asia, but this should be partially offset by lower oil imports, with Energy Department data pointing to a pullback in volumes and prices. Note that our forecast is somewhat more positive than the assumptions used by BEA in preparing the GDP report.
* We expect the January federal government budget deficit to narrow US$13 billion from a year ago to US$50 billion. However, all of the swing is attributable to payment shifts resulting from calendar effects. Adjusted for this factor, the deficit should be about US$37 billion larger than in January 2009. Receipts are expected to be about 10% below last January, although corporate taxes are holding up much better than payments from individuals at this point. We continue to see the budget deficit for FY 2010 running at US$1.325 trillion (or 9.1% of GDP).
* We forecast a 0.6% gain in overall retail sales in January and a 0.8% surge ex-autos. The chain store reports pointed to sharp sequential gains in both the general merchandise and apparel categories. So we look for a solid 0.7% rebound in the key retail control grouping following a disappointing performance in December. Also, gas stations are expected to show a price-related jump while the auto dealer category is likely to be little changed. At this point, we look for about a 2.5% rise in real consumer spending in 1Q - a bit better than the 2.0% gain seen in 4Q.
Recent inflation news has done little to ease concerns that Banco de Mexico is likely to embark on a tightening cycle starting around mid-year and lift interest rates by some 100bp by December. First, the finance ministry has reiterated its intention to progressively hike fuel prices, a process that began with two adjustments in December, which pushed regular gasoline quotes 1.0% higher. Second, headline inflation surprised on the upside in the first half of January and expectations for the full month are above 1.0%, the highest level since November 2008. And though the central bank kept its inflation forecast unchanged in the quarterly inflation report released at the end of January, it unveiled a higher growth outlook for the economy and reiterated the warnings that it will be of the "utmost importance" that medium and long-term expectations remain well anchored, as well as indicating that it was watching for potential second-round effects from the recent increase in taxes and fuel prices. Perhaps the only piece of dovish news of late has been the central bank's January survey, which showed a slight pullback in inflation expectations.
Contrary to the overwhelmingly majority of Mexico watchers who expect rate hikes starting mid-year, we reiterate our view that Banxico is likely to stay on hold during 2010. To be fair, recent news has challenged our call that Banxico is likely to accommodate the temporary inflationary shock this year without lifting the policy rate from the current level of 4.50% (see "Mexico: Hike Another Day", This Week in Latin America, December 8, 2009). But there are several reasons why, in our view, the central bank seems to be in no hurry to hike. First, Banco de Mexico has given itself plenty of room to maneuver with a cautious near-term forecast path. Second, the market seems to be ignoring the central bank's emphasis on medium- and long-term expectations, which have remained relatively stable. Indeed, the bank's medium- and long-term focus suggests, in our view, that the tax reform and the associated temporary price pressures represent a short-run cost that should translate into healthier public finances and thus reduce risks to the inflation outlook caused by potential fiscal woes down the road. And, last, rising 2010 GDP expectations mask what remains a two-tiered recovery: whereas activity in externally driven sectors like industry is rebounding briskly, domestic-focused areas of the economy remain sluggish, thus reducing the risk of demand-side pressures on inflation (see "Mexico: The Industrial Fiesta", This Week in Latin America, January 14, 2010).
Room to Maneuver
When the central bank first unveiled its assessment of the impact of the tax reform on December 2 and later reiterated it on January 27, it gave itself plenty of room to maneuver, in our view, by providing a relatively cautious set of estimates. Higher taxes and fuel quotes are projected to add 169bp to 2010 inflation, according the central bank. Adjustments to taxes represent 50bp or 30% of the total impact, with energy adding an extra 76bp or 44% of the total and public tariffs accounting for the rest. The forecast path, moreover, assumes a sharp spike in inflation in 1Q10 to as high as 4.75% on average from just 3.98% in 4Q; during 2H10, the authorities expect inflation to average as high as 5.25%. Importantly, the early-year increase in inflation is not just a consequence of a low comparison base. In Mexico, though annual inflation peaked in December 2008, the sharp sell-off in the peso and associated pass-through into prices of non-food merchandise kept annual inflation above the 6.0% threshold until May 2009; therefore, Mexico started to experience steady disinflation much later than in other Latin American countries like Brazil, Chile and Colombia where annual inflation peaked in October 2008 (see "Mexico: Reassessing the Balance of Risks", This Week in Latin America, April 20, 2009).
Indeed, despite the disappointingly high first-half January inflation print, market expectations remain comfortably within Banxico's forecast path for 2010. In fact, based on monthly figures from the most recent expectations survey, consensus inflation is running below the central bank's inflation forecast path for the second and third quarters of 2010. During the first and last quarters of the year, the consensus is right around the center point of the ranges of 4.25-4.75% and 4.75-5.25%, respectively. In turn, this means that even if coming inflation releases disappoint, Banco de Mexico may not find itself in the difficult position of having to revise its forecast path higher, with obvious consequences to its credibility and thus balance of risks.
But what about the fact that 2011 expectations remain well above target? First, we suspect that what matters most to the 2010 monetary policy outlook is that the recent swings in both 2010 and 2011 expectations are consistent with the central bank's view that hikes to taxes and fuels represent just a temporary shock. Since October - when participants likely began pricing in the impact of adjustments to administered prices and new taxes - expectations for end-2010 inflation rose by 39bp to 4.93% in January; by contrast, expectations for 2011 basely moved, rising just 5bp to 3.91%. Second, the absolute level of 2011 expectations, which remain well above the central target of 3% and the 2.75-3.25% 4Q11 forecast range, should be relevant in a larger debate about credibility and the importance of achieving the elusive 3% target in an efficient manner (see "Mexico: No Hike, No Clarity", This Week in Latin America, October 15, 2007). Without minimizing the significance of this debate, we suspect that it is not the key issue that will determine the timing of the eventual policy normalization.
In addition to watching carefully medium- and long-term expectations, Banxico has also indicated that it is monitoring potential second-round effects from the increase in taxes and fuel prices. One sign of potential contamination would be a meaningful increase in 2011 expectations, something that has not taken place. Another channel is via wage pressures as well as broad-based price increases beyond those directly affected by the changes in administered prices and taxes.
Wage pressures are likely to remain contained during 2010. Given the deep economic slump and related job losses - nearly 600,000 formal positions or over 4% of total formal jobs were lost in the year ending July 2009 - it is not surprising that average nominal wage hikes (+4.39%) lagged inflation (+5.30%) by a wide margin last year. And December's 5.2% increase in wages - the highest since August 2003 - seemed like a one-off rather than sign of things to come: only 1.4% of all 2009 wage negotiations took place in December and the upside surprise came from just one sector (metals and steel), where wages rose by 7.9%. Excluding this sector, wages rose just 4.1%, in line with last year's average.
Looking ahead, slack in labor markets is likely to cap wage pressures, in our view. Despite improving 2010 GDP expectations - which reached 3.3% in January, still below our 3.8% forecast - the recovery remains centered in externally driven sectors like manufacturing, while activity in domestic-focused areas of the economy has remained sluggish (see "Mexico: The Industrial Fiesta", This Week in Latin America, January 14, 2010). Indeed, reflecting the narrow nature of the recovery so far, consumer confidence has remained deeply depressed even as industrial sentiment has staged a V-shaped rebound. In our view, lack of strong signs from domestic-focused sectors so far should reduce the risk of demand-side pressures on inflation over the course of 2010; after all, manufacturing accounts for a quarter of total formal employment in Mexico. Importantly, surveys in the fast-recovering manufacturing sector do not point to mounting wage pressures: in 4Q09, only 3.2% of Banxico's industrial survey participants reported greater competition to hire production personnel, about one-sixth of the 18.1% that reported less competition. Indeed, when we net the results, the levels of labor market slack at the end of 2009 were not far from those seen during the 2001 recession.
Late 2009 inflation readings and the disappointing January first-half inflation readings did not point to generalized inflation pressures, in our view. For example, January's inflation surprise - up 0.75%M compared to consensus of 0.67%M - was caused mainly by a spike in volatile produce quotes (+3.1%) as well as tax and administered price pressures. Only six items - phone bills, beer, metro and bus fares, gasoline and LNG - contributed 0.25pp to the entire increase in first-half January inflation. Alternatively, diffusion measures do not indicate that tax changes are translating into broad-based price hikes. Paradoxically, the threshold for Banco de Mexico to increase interest rates due to evidence of generalized price pressures is quite high, in our view. Quantifying what ‘generalized' really means is somewhat tricky when tax hikes are coming in a context of upward adjustments to energy prices.
Short-Term Pain, Medium-Term Gain
An additional factor why we are not looking for rate hikes this year is the positive implication of the tax reform to the central bank's medium-term inflation balance of risks. Indeed, we suspect this is an important reason why the central bank has continued to emphasize, time and again, that it will be of the "utmost importance" that medium- and long-term expectations remain well anchored. The consensus, in our view, seems to be ignoring that the tax-related price pressures represent a necessary evil in the short term that, looking down the road, should translate into healthier public finances. A stronger fiscal house, in turn, means lower risks to the medium-term inflation outlook due to the reduced need for aggressive fuel price hikes or potential currency instability. Indeed, we don't think it was a coincidence that the central bank, in its most recent inflation report, explained at length its opinion that upward adjustments to fuel prices - which would be instrumental in closing the gap between domestic and international fuel quotes - were desirable from an efficiency standpoint.
To make up for revenue shortfalls, the finance ministry can resort to hikes to fuel prices (see "Mexico: Fueling Inflation", This Week in Latin America, August 17, 2009). In Mexico, the finance ministry has discretion over the pace and magnitude of gasoline, low-consumption electricity and diesel price adjustments, which remain an important source of revenues. For example, the fiscal authorities hiked fuel prices at an accelerated pace during 2H08, when soaring crude prices caused fuel subsidies to skyrocket to almost 2.0% of GDP annualized. Importantly, fuel price adjustments do not require congressional approval.
However painful in the near term, fuel price increases seem to be a prerequisite for an eventual liberalization. Controlled fuel prices represent an important automatic stabilizer to oil-related revenues: when crude prices decline sufficiently, taxes on domestic fuel prices offset some of the losses on crude exports, as was the case during early 2009, for example (see Mexico: Less Bang for the Oil Buck, June 9, 2008). The flipside, of course, is that when oil prices exceed budget assumptions by a sufficiently wide margin, subsidies on fuel prices eat up much of the benefit from higher crude prices. Narrowing the gap between domestic and international prices seems necessary before reforming the fuel pricing structure, which would probably require an additional fuel tax as well. If this were to happen, it would represent a major positive for the central bank's balance of risks as it would add some two-way movement to fuel prices - which currently only adjust upwards - and thus flexibility to the economy's pricing structure, in our view.
Bottom Line
Despite facing a severe tax and fuel-related inflationary shock, Banco de Mexico is likely to keep its policy stance unchanged during 2010. We are reiterating out out-of-consensus call that rates will stay at 4.50% this year despite recent disappointing inflation readings, rising growth expectations and warnings by the central bank about risks to the inflation outlook. Ample slack in the economy is likely to cap potential second-round effects on inflation from higher taxes and fuels; in addition, by focusing on medium- and long-term expectations and by providing a cautious inflation forecast path, the central bank seems to have maneuvering room to accommodate the temporary inflation shock without the need to tighten policy.
Introduction: Déjà Vu
There has been tremendous uncertainty about economic and policy outlook of late. In such times we tend to look to recent history for guidance. Is this going to be like 2003-04 where the authorities responded to an overheating economy with campaign-style macro-controls in April 2004 that lasted about six months and both the economy and stock market demonstrated remarkable resilience? Or is this going to be like 2006-07 where aggressive credit controls were imposed in October 2007 - especially vis-à-vis the property sector - lasting about nine months and contributed to - albeit not directly causing - a hard landing of the economy.
It May Be Like ‘2003-04' IF...
The situation in the run-up to tightening that began in April 2004 was quite different from the current one, making the tightening back then completely justified. The average YoY growth rates of key variables during the six months leading to the onset of tightening in April 2004 clearly pointed to an overheating economy: FAI 37%, Exports 37%, IP 18%, Loan 27%, and CPI 2.7%.
The aggressive tightening launched in April 2004 featured strict investment project approval, tight controls over bank lending and a moratorium on developing agricultural land for industrial/commercial use, as well as a RRR hike. There was only one interest rate hike six months after the tightening began, as the headline CPI inflation peaked and stared to moderate while PPI was about to peak.
Despite the aggressive tightening, the economy demonstrated remarkable resilience: while FAI growth decelerated sharply from the pre-tightening levels of 40-50%Y to about 20%Y in the months immediately after the launch of tightening before stabilizing around 25%Y thereafter. Meanwhile, IP growth only registered a modest slowdown, helped by extraordinarily strong export growth throughout the entire tightening cycle.
Obviously, the current cyclical conditions of the economy are far too weak to justify an aggressive tightening of the same magnitude that launched in April 2004. Moreover, it should be highlighted that the overheating in 2003-04 reflected remarkable strength in both domestic (i.e., FAI) and external (i.e., exports) demand.
The only explanation for the current round of tightening - although we prefer calling it ‘policy normalization' - with its beginning dated January 2010 appears to be early policy action to preempt an economic overheating like the one in 2003-04. Further policy action in this regard will likely be measured, hinging on the pace of improvement on the external demand front, in our view.
In this context, a repeat of 2003-04 is possible IF external demand were to turn out to be much stronger than expected (the ‘Summer: Overheating' scenario under our four-season framework materializing). This may therefore trigger aggressive policy tightening, in which case some components of the economy (e.g., FAI) may slow substantially in the short run, but the overall economy will likely be able to weather the policy shift reasonably well beyond the near term.
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