However, the current period of below-trend growth points to near-term upside risks to slack and thus downside risks to inflation. Those risks suggest a slower climb in inflation than we thought two months ago. Importantly, the rise we expect probably would not be enough to change the Fed's September assessment that "measures of underlying inflation are currently at levels somewhat below those ... consistent with ... price stability." Combined with an unemployment rate that remains unacceptably high, that means officials are falling short on both aspects of their dual mandate. Thus, it now seems likely that officials will act to boost growth and inflation with additional large-scale asset purchases.
Will the real core inflation measure please stand up? Measurement issues still cloud understanding of the current inflation rate and the downside risks associated with it. Core inflation has declined over the past year, measured by the core CPI, but inflation excluding food and energy has been stable reckoned by the Fed's preferred gauge, the PCEPI. Core CPI inflation has declined by 50bp to 0.9% over that period, but PCEPI core inflation stood unchanged at 1.4% between August 2009 and August 2010. Arithmetically, the deceleration in rents has accounted for all of the core CPI inflation decline to date. In the CPI, the gap between the published core rate and the core excluding shelter is 110bp, as rents account for fully 40% of the core CPI. By contrast, the same gap is only 40bp in the PCEPI, reflecting the fact that housing accounts for only 18% of that index. In the CPI, increases or stability in other factors such as transportation and medical care services have been an offset to declining rents.
Measurement aside, however, below-trend growth and more slack in the economy means that downside risks to inflation remain. Indeed, over the past year, other measures of inflation trends, like the Cleveland Fed's trimmed mean measure of CPI inflation, declined by 30bp to 0.9%. Yet in our view, those downside risks to inflation are smaller than many investors believe. Here's why.
Inflation analytics: Expectations and slack both matter. Inflation models include three key elements: a measure of inflation expectations, a gauge of slack in the economy, and factors that ‘pass through' to underlying inflation, like changes in energy or import prices. It appears that the slack-inflation relationship has loosened over the past several years, and that the pass-through has also diminished. The flattening of the so-called ‘Phillips curve' likely means that as slack increases, inflation may not fall as much today as it did in the past.
The Fed's role. A long period of effective monetary policy that promoted more stable inflation expectations is a key reason that the slack-inflation relationship may have shifted down, or altered its slope, so that empirical analysis must consider both possibilities. Either way, empirical studies show that inflation expectations will influence inflation, and in turn, that monetary policy anchors expectations. If there is uncertainty about monetary policy in either direction, it may add to uncertainty about inflation, including whether or not low inflation morphs into deflation. Arguably, the central bank's accountability to deliver on its goals is critical for its credibility and for the range of uncertainty around future price changes.
How much slack is there really? Our inability to measure economic slack and inflation expectations with any precision also adds to inflation uncertainty. Measures of slack, like the output gap, are unobserved, and the unemployment rate only measures slack in labor markets, not in product markets. Fed Vice-Chairman Kohn recalled a few years ago that "faulty estimates of potential output may have contributed to the monetary policy errors of the 1970s". That may be relevant today: Some fear that the financial crisis has depressed potential growth by as much as 1pp to 2%, heightening the upside risks to inflation. In our view, potential growth has declined, but only slightly, to about 2½%, with scant implications for inflation.
We think the Phillips curve has flattened. The upshot is that significant increases in economic slack - measured by the doubling of the unemployment rate or by the plunge in operating rates - over the past two years will depress, but are unlikely to crush, inflation. The good news is that the Fed's strenuous efforts to limit deflation risks have kept inflation expectations from falling.
Pushing inflation higher: Speed effects, global growth, the dollar and breakevens. Moreover, we believe that three factors are pushing inflation higher: Slack is narrowing, and inflation responds to changes in slack as well as to the level; strong global growth and a weakening dollar are starting to push up import quotes again; and inflation expectations are either stable or moving higher, suggesting little risk of substantial disinflation.
Speed effects. The idea that ‘speed effects' - or changes in slack - as well as the level affect inflation makes intuitive sense. The notion is that a trough in operating rates or a peak in the jobless rate will trigger a change in direction in businesses' and consumers' outlook for the factors that drive inflation. It may be reinforced by the fact that cyclically sensitive prices, like those for food and energy or other commodities, will rise in recovery. Consequently, such effects are strongest for wholesale or producer prices, but in turn, we believe that they matter for consumer prices as well. Today's below-trend growth backdrop is important: Slower growth and more slack mean that speed effects are fading. A return to above-trend growth next year is thus important to restart those inflation dynamics.
Those dynamics may be more sustainable in rental markets. Improving demand and limited supply have lifted occupancy rates by nearly 200bp in the past eight months. As a result, Axiometrics reports that effective rents are up by more than 4% in the year ended in August in 31 of the 81 markets they track. Those increases show up with a lag, so they will boost rents as measured in the CPI and PCEPI over the next several months.
Global factors. Equally important, however, several global factors seem likely to contribute to US inflation over the next few months. Among them: Strong global demand and limits on supply are boosting commodity and food quotes. Energy quotes have begun rising again, and our commodity team believes that the direction for those prices is higher. Measured in the CPI, meanwhile, US retail food prices have also accelerated - admittedly to a modest 1% rate over the past year. But the strength of global demand is pushing food prices higher. Finally, US import prices are beginning to turn up again. Consumer import prices ex autos rose 0.3% over the year ended in August. We believe that sellers typically pass some of these price hikes through to core prices with roughly a 2-4 month lag. A weaker dollar will reinforce the rise in import prices. These price hikes may also contribute to US inflation by reviving inflation expectations.
Breakevens. Encouragingly for the Fed, inflation expectations measured in the marketplace are rebounding. Measured by 5-year, 5-year inflation breakevens, inflation expectations have moved up by 30-50bp since Chairman Bernanke's speech at Jackson Hole, to 2.6% by the Fed's measure using a smoothed yield curve. And survey-based measures have been stable; in mid-September, median long-term inflation expectations in the University of Michigan canvass remained at 2.7%. While year-ahead inflation expectations declined to 2.2%, we believe that such expectations are strongly affected by fuel prices, which have drifted down recently. To be sure, such surveys are volatile and may be unreliable, as they are based on small samples, do not refer to any specific index, and encompass a wide dispersion of views across households. But directionally they are important to watch.
The Fed, the optimal inflation rate, and inflation expectations. The Fed can't levitate inflation higher. But officials can boost inflation by taking steps to support demand and lift inflation expectations. By specifying explicitly in the September FOMC statement that inflation is below the level the Fed associates with price stability, officials are clearly stating that the current level is suboptimal. That statement goes a long way toward fulfilling what we indicated the Fed needed to do following Chairman Bernanke's earlier speech at Jackson Hole: "...officials must decide whether they need to articulate more fully the model or framework for additional ease, including spelling out intermediate yardsticks for gauging success and more specific ultimate goals." With that framework spelled out - notwithstanding the forces described above that we expect will boost inflation - it now seems likely that the Fed will take additional steps to spur growth and inflation.
Treasuries rallied solidly again over the past week, extending the rally to 15-33bp over the past three weeks and leaving nominal yields in the short and intermediate parts of the curve and real yields at the longer end near record lows. Gains continue to be largely driven by expectations that the Fed will restart quantitative easing after the November 2-3 FOMC meeting, hopes for which were raised over the past week by speeches from a number of regional Fed presidents advocating a resumption of easing and a speech from Bank of England MPC member Posen arguing for resumed easing globally. Eight of the twelve regional Fed presidents spoke during the week, and comments on resuming QE were mixed, in line with a Monday article by the Wall Street Journal's Jon Hilsenrath reporting that the "Fed hasn't yet decided to step up its bond purchases, let alone agree on an approach." Still, sentiment certainly seems to be rapidly moving in favor of more easing. The two most dovish regional Fed presidents speaking the past week, New York's Dudley and Boston's Rosengren, are FOMC voters this year, as is St. Louis' Bullard, who has been advocating more QE for a while, and the Board of Governors added likely supporters of resumed easing with the confirmations of Yellen and Raskin. There is no real risk that Fed Chairman Bernanke would ever be outvoted, and whatever he decides is the best course in November will likely be approved with only the usual dissent from Kansas City Fed President Hoenig, but if he were to decide against resumed easing, it is starting to look as if it might be over the majority of FOMC sentiment. In any case, it seems that the bar for resumed easing is low, as perhaps it should be with inflation below target and the labor market far from full employment, even if, in our view, there isn't much reason to believe that resumed QE will have much impact on growth with rates already near record lows and most parts of the financial markets functioning normally. The Treasury market rally continued to reflect these doubts. TIPS' relative performance was mixed over the past week, with the longer end lagging, but the rally over the past few weeks as QE2 has been priced in has been entirely in real rates, indicating that ramped up Fed easing is expected to prevent renewed disinflation but won't help growth. If nothing else, though, the bar for Fed action is probably fairly low at this point as we look ahead to the data that will be released over the next month heading into the FOMC meeting and continue to suffer high uncertainty about the fiscal policy outlook after Congress adjourned until mid-November without addressing the expiring Bush tax cuts or making much progress on any other part of the budget for the new fiscal year that began Friday. The past week's economic news was mixed. The September ISM declined only modestly as expected to a still solid level, but the components were softer. Consumer confidence was weak in September, but auto sales rose to a two-year high aside from the peak of ‘cash for clunkers' in August 2009. This should help keep consumption on track for a third straight modest gain near +2% in 3Q after the personal income report showed steady +0.2% gains in real spending in August and July. The August construction spending report was sharply mixed but major weakness in private sector activity and strength in government were offsetting and didn't have a significant impact on our GDP forecast. We did make adjustments in our estimates for the pattern of real oil imports in the second half, however, that cut our 3Q net exports assumption by a point and raised our 4Q estimate by a point. This lowered our 3Q GDP estimate to +2.1% from +3.1% but with offsetting upside in 4Q.
For the week, benchmark Treasury yields fell 3-11bp, led by 5s and 7s after a run of strong 2-year, 5-year and 7-year auctions in the first part of the week. The old 2-year yield fell 3bp to 0.41%, 3-year 6bp to 0.62%, old 5-year 11bp to 1.25%, old 7-year 11bp to 1.88%, 10-year 9bp to 2.52%, and 30-year 7bp to 3.72%. The 3-year yield at week end was at another record low, while the 2-year, 5-year and (with a lot less history) 7-year yields hit record-low closes earlier in the week before giving up a bit of ground. While nominal yields at the longer end are still a ways from record lows (the low closing yield for the 10-year was 2.08% and 30-year 2.54% in December 2008), this is only because of market confidence that the Fed will be able to successfully resist deflation. It was the longer end of the TIPS market that saw new record-low yields the past week, as inflation expectations haven't moved much from pretty normal longer-term levels during the market rally of the past few weeks. In the latest week, the 5-year TIPS yield fell 13bp to -0.17%, 10-year 7bp to 0.71% after a record-low close Tuesday of 0.64%, and 30-year 2bp to 1.62%. With oil breaking out of its recent doldrums and front-month WTI surging 7% to a two-month high, approaching $82 a barrel, shorter-end TIPS outperformed over the past weeks while the longer end lagged the strong nominal gains. Over the past three weeks, however, all of the gains have been in real rates, with the 10-year nominal yield down 27bp, 10-year TIPS yield down 28bp, and the 10-year inflation breakeven up 1bp to 1.81%. During this period, the 5-year/5-year forward inflation breakeven has been steady near 2 1/4%, up 50bp from the August lows and very close to what actual CPI inflation was over the past five years. So while the extremely low level of long end real rates is not showing any optimism about the growth outlook, at least the Fed has had substantial success in stabilizing inflation expectations with the indication in the FOMC statement that renewed disinflation from current already too low levels would be resisted with renewed easing.
Elsewhere in rates markets, agencies put in a strong showing the past week, but mortgages and swaps lagged Treasuries. MBS spreads have risen to near their wides for the year in a run of underperformance over the past month as accelerating refinancing activity has raised supply fears and investors have remained nervous about the possibility of regulatory or legislative efforts to ease refinancings for higher rate mortgages. Still, the general level of rates has fallen so low recently that MBS yields have fallen back not too far from record lows, and lessened capacity constraints in the mortgage origination industry has allowed mortgage rates to track the recent rally more closely. Current coupon MBS yields fell about 10bp the past week from a bit above 3.4% to a bit above 3.3%. This follows a backup from all-time lows near 3.2% at the end of August to 3.55% in mid-September. Primary/secondary mortgage spreads had reached unusually wide levels at the lows in MBS yields and there was mostly just spread compression when yields rose, with average 30-year mortgage rates only rising 5bp to 4.37% from the record low of 4.32% hit at the end of August through mid-September. This week, average rates were back to the prior record low of 4.32%, and they will probably move to new lows in the coming week. Meanwhile, swap spreads have been moving steadily higher since mid-September as investors have increasingly priced in an expected richening of Treasuries if the Fed begins heavy purchases soon. The Wall Street Journal article Monday suggested that the Fed is leaning towards moving more towards the Bank of England's approach if QE is restarted, possibly announcing a targeted amount of buying to be done at each FOMC meeting until the next meeting and potentially adjusting amounts at each meeting. If the Fed were to start buying something on the order of $100 billion of Treasuries a month, this would absorb the entire current run rate of net Treasury issuance, with the F2010 budget deficit expected to narrow slightly to near $1.1-1.2 trillion. The potential richening in Treasuries versus other rates markets this could drive contributed to the benchmark 10-year swap spread rising another 3.25bp this week to 7.75bp, a two-month high.
Stocks had a very good September, but the end of the month and start to October the past week saw very little movement. The S&P 500 dipped 0.2% on the week, and the range of closes was a miniscule 0.6%, with a low of 1141.2 on Thursday and a barely higher high of 1147.7 on Tuesday. The break higher in oil prices helped energy stocks easily outperform the rest of the market with about a 3% rally on the week, while other major sectors showed small losses a bit worse than the overall 0.2% decline. Credit did significantly better, with the IG CDX index tightening 5bp on the week to 104bp, with about half the move coming Friday in a positive start to October after a 12bp tightening in September. Meanwhile, the commercial mortgage CMBX market had a good week to extend a strong run this year, with AAA index gaining 1.5% on the week for a 12% rally so far this year that has left it only 1.5% below the high hit shortly after the current series CMBX indices were launched in May 2008. The lower rated CMBX indices did better on the week and have a much bigger rally for the year - junior AAA was up 5% for the week and 22% YTD, AA 9% and 35%, and A 14% and 39% - but they have a lot further to go to get back near their spring 2008 series highs. This healing in the CMBS market is raising hopes that issuance could start to resume in a more meaningful way after the drought of the past couple years, with S&P predicting that CMBS issuance would rise to $6 billion in 4Q and $35 billion in 2011, which would be a big improvement from recent activity but only back to the levels of 1996 and 1997 and a small fraction of the peak near $225 billion in 2007.
The manufacturing ISM report was not as strong as we expected after the impressively strong results last month began a run of much improved data released through September. The composite index fell to 54.4 in September from 56.3 in August. While this remained a robust level consistent with good growth in the manufacturing sector, the composition of the overall index showed a more pronounced softening, with the orders (51.1 versus 53.1), production (56.5 versus 59.9), and employment (56.5 versus 60.4) indices falling significantly. This was partly offset by a surge in the inventories gauge (55.6 versus 51.4) to the highest level since 1984. On the positive side, growth was more broadly based, with 13 of 18 sectors reporting expansion in September, up from 11 in August and 10 in July.
A couple of releases for August bearing more directly on current quarter GDP growth didn't have any net impact on our underlying estimates. Personal consumption rose 0.4% in August, as expected, boosted by the 0.6% gain in underlying retail sales seen in the retail sales report and a decent rise in services outside of a pullback in spending on utilities after the unusually hot start to the summer. With the PCE price index up 0.2%, real spending gained 0.2% for a second month. Assuming another 0.2% rise in September, consumption for the quarter would be at +2.0% in 3Q after rising 2.2% in 2Q and 1.9% in 1Q. Real wage and salary income growth was a bit soft in August at +0.1%, in line with the sluggish employment report results last month. Over the past six months, however, this core earnings gauge has risen at a 2.7% annual rate, and we expect growth near 2.5% to continue through year-end, which would be sufficient to sustain this modest 2% consumption trend and a further gradual move higher in the savings rate. Although consumer confidence tanked in September, with the Conference Board's index plunging 5 points to a seven-month low on a much worse outlook for future growth and a further deterioration in views about the current job market, the first key data on September consumer spending was positive. Based on the automakers' reports, we estimate that motor vehicle sales rose to an 11.8 million unit annual rate in September from 11.4 in August, high since the peak of ‘cash for clunkers' in August 2009 and before that September 2008. Meanwhile, the August construction spending report saw sharply divergent but offsetting moves among the major categories that didn't impact our overall GDP forecast though it did impact the components. Weakness in homebuilding and business construction led us to cut our forecast for 3Q residential investment to -33% from -28% and for business investment in structures to -10% from -5%. A big gain in state and local government spending in August on top of sharp upward revisions to prior months, however, led us to boost our forecast for state and local government construction in 3Q to +11% from 0% and for overall state and local spending to +1% from -1%, offsetting the weak trajectory for residential and structures investment. While we didn't change our consumption forecast for 3Q and the upside in government construction and downside in the private sector were about offsetting, we changed our assumptions for oil imports to extend an unusual pattern in the GDP data in recent years of major strength in the middle two quarters of the year and big declines in the first and last quarters through this year. Previously, we had been looking for a significant correction in 3Q real oil imports after the 78% surge BEA reported, but now we're looking for another big gain in 3Q and then a sizable correction in 4Q, which would repeat a pattern that has developed over the prior few years as BEA's efforts to seasonally adjust the price gauge that the Census Department uses in reporting its version of real oil imports (which were actually down 12% in 2Q before BEA converted it into a 78% gain) seems to be adding to volatility rather than smoothing it out. This change in our assumptions doesn't impact our forecasts for the second half overall, but it lowers 2Q by a point and raises 4Q by a point. At this point, we are looking for a further slight drag from net exports in 3Q after the near record 3.5pp subtraction in 2Q and then a 2pp point add in 4Q. For 3Q, this was a point worse than our prior estimate for the net exports contribution, which lowered our GDP forecast a point to +2.1%.
Several more key early economic releases for September will be released this week after the ISM and motor vehicle sales reports, with focus on the employment report that has been pushed out until the second Friday this month because of the lateness of the September survey week and earliness of the first Friday in October. In addition, the nonmanufacturing ISM will be released Tuesday and monthly sales results from most major retailers on Thursday. Otherwise, the calendar is pretty quiet, with little in the way of Fed appearances after the busy past week and a break in supply until the 3-year, 10-year and 30-year auctions after the October 11 Columbus Day holiday, terms of which will be announced on Thursday. In addition to the employment report, nonmanufacturing ISM, and chain store sales results for September, the factory orders report for August will be released Monday:
* We forecast a 0.4% decline in August factory orders. A sharp drop in the volatile aircraft category, as previously reported in the durable goods report, points to some slippage in overall factory orders in August - even after accounting for some expected price-related upside in the nondurables sector. Also, we should see a small upward revision to factory orders for July. Finally, shipments are expected to show a modest dip (-0.6%) in August while inventories are likely to be up 0.4%.
* We look for a 15,000 decline in September nonfarm payrolls, with a pick-up in private sector job growth expected to be offset by another pullback in census employment and a sharp drop in the state and local government category. Specifically, our forecast breaks down as +110,000 private, -75,000 census, and -50,000 other government. Most of the expected drop in S&L government employment is concentrated in the education category. It appears that the recently enacted federal aid package helped to save a number of teaching positions at the local level, but press reports from around the country suggest that there were still a significant amount of cutbacks at the start of the school year. There are about 8 million teachers, administrators and support staff at the primary and secondary level and we are estimating about a 0.5% (or 40,000) decline in staffing for the current school year. For the household survey, we look for another uptick in the labor force participation rate to contribute to a slight rise in the unemployment rate to 9.7%. Finally, this report will include the government's preliminary assessment of the 2010 benchmark revision. We expect a small upward adjustment of about 100,000 (or +0.1%) this year. Over the past decade the range of annual revisions has been -0.6% to +0.7%.
The most pressing matter facing Brazil's next administration may turn out to be how to deal with a strengthening currency. While the presidential election is not over - Brazilians will go back to vote in a second round at the end of the month, the contrast with the election eight years ago when voters first elected Luiz Inacio Lula de Silva could hardly be greater. Then investors braced for capital controls designed to stem outflows; today, strong inflows in the run-up to Sunday's vote have triggered both verbal intervention - the finance minister last week declared that the country was facing an "international currency war" - as well as substantial US dollar purchases by the central bank. Eight years ago, concerns that a full-blown financial accident could unfold during the first months of the new administration's term prompted an important (and ultimately beneficial) rethinking of the policy mix. Today's strong inflows are unlikely to do the same; indeed, the risk of complacency appears to be higher today than ever.
Central Bank's Buying Spree
Faced with strong inflows, we expect the central bank to continue with its currency market intervention. During September, the central bank went on a buying spree, adding nearly $14 billion in reserves - more than one-third of the year-to-date purchases in only a month. Reserves at the end of September stood at $275.2 billion. To put that in perspective, Brazil's international reserves now cover more than four times the size of Brazil's public external debt and more than cover all public and private (excluding inter-company loans) external debt.
There is little reason to expect the central bank to stop dollar purchases. Indeed the finance ministry suggested in mid-September that it may join forces with the central bank by directing Brazil's new $10.5 billion sovereign fund (FSB) to purchase dollars as well. Unlike a traditional sovereign wealth fund which is often funded from budgetary surpluses, Brazil's FSB is funded by debt since the public sector is still running a sizeable overall budget deficit. That raises the unusual specter that Brazil could raise funding (and its gross debt position) to purchase even more dollars.
The challenge of course in buying up dollars - whether by the central bank accumulating reserves or from the sovereign fund - is the significant reverse carry from such operations. It is hard to find an economy where the cost associated with sterilized reserve accumulation is greater than in Brazil, given the wide spread between global interest rates (which reserves earn) and local interest rates (which the central bank must pay to sterilize the additional liquidity created by its interventions).
Recall that when the central bank buys US dollars, it must pay for the US dollar purchases with local currency. However, because the central bank does not want to leave excess local currency in the system (out of concerns over the inflationary impact), it ‘sterilizes' or soaks up the local currency by issuing bonds paying the hefty interest rates common in Brazil today. Unfortunately, with the overnight policy rate at 10.75% and with current US benchmark rates, Brazil's reserve position proves extremely costly. The reverse carry trade on Brazil's current reserve position of over $275.2 billion could cost as much as $25 billion on an annual basis. In contrast, the cost of Brazil's Bolsa Familia, the hugely popular conditional cash transfer program is expected to be under $8 billion this year.
A word of warning here: our simple calculation of the reverse carry costs likely exaggerates the true costs of Brazil's reserve position. If Brazil's reserves were significantly lower, Brazil might find its credit rating to be lower and the cost of financing higher. And Brazil's massive reserve position in 2008 most likely acted as powerful shock absorber and tempered the impact of the financial market turmoil on Brazil's economy. Still, the costs of reserve accumulation (and the prospects that the sovereign fund could also begin to buy up dollars) are hardly trivial.
New Taxes...
We also expect to see new taxes on inflows adopted in an attempt to limit pressure on the Brazilian real to appreciate. We would not be surprised to see a substantial increase in the tax on foreign currency transactions, the IOF, which currently stands at 2% - although changes seem unlikely ahead of the October 31 second round. The authorities have adjusted the IOF repeatedly since it was first introduced in March 2008. After introducing the IOF at 1.5%, it was suspended in October 2008 in the midst of global market turmoil. It was reintroduced last October at 2% and extended to include all foreign currency transactions including equity transactions. (A 1.5% tax on new ADR issuance was added in November to limit arbitrage between local shares and ADRs).
The authorities have suggested that any new increase in the IOF may apply to fixed income transactions as opposed to equity. After all, it might seem incongruent to announce a new tax on equity inflows just weeks after Brazil sponsored the globe's largest common stock offering, an offering designed to raise financing for Brazil's oil and gas infrastructure needs. In contrast, the authorities can argue that a tax directed at fixed income instruments would do little to impede long-term holders of Brazil bonds where the tax is diluted over years of holding the bonds. The greatest impact of the tax is on short-term holders: precisely the "hot money" that the authorities are seeking to avoid. There is also talk of other margin requirements that could be aimed at short US dollar positions in Brazil.
...Little Change
We do not expect, however, that the measures will have a significant impact on the direction of the Brazilian real. The authorities have already tried just about every variation being described today - as well as a few others, such as reverse currency swaps - and those moves have done little in the past eight years to change the direction of the currency. Neither the substantial build-up in international reserves - up more than five-fold under the current administration - nor a series of taxes and regulatory changes have altered the direction of the currency. At most, the measures - at a significant fiscal cost - may have tempered the pace of the real's gains. There is little reason to expect the measures to be more successful now than they have been during the past eight years. Indeed, in light of our US economics team's revised view that the Fed is now likely to engage in open-ended quantitative easing (QE2), we see risks that the inflows could pressure the real to an even stronger level than our current forecast of 1.65 real to the US in 2011. The latest survey of Brazilian economists has the real at 1.80 in 2011.
Real Hit to the Real Economy?
The challenge for Brazil is that the currency is likely to remain stronger than most Brazil forecasters anticipate. That, in turn, is likely to leave Brazil with an even larger current account imbalance than the -2.4% of GDP deficit we estimate for this year. After all, a strong real is likely to make imports more attractive, even as exports suffer. That may explain part of the dichotomy that we have begun to see in Brazil during this year when domestic demand has remained robust, but production has begun to show weakness. Real GDP on a monthly sequential basis has seen virtually no growth during the past four months: real GDP in July has barely risen from the (seasonally adjusted) level seen in April. And industrial production has faltered during the same period. August industrial production was virtually flat relative to July - it was down -0.1%. But more important than each monthly up and down turn is the trend: after rising steadily for nearly a year and a half, industrial production appears to have lost its way at mid-year.
We don't want to exaggerate the role that the strong real may have played in the recent faltering industrial output numbers. After all, this is not the first time that Brazil has seen dramatic currency strength. And part of the reason for the flood of imports in some sectors - such as steel - may have as much to do with weakened global demand as with the strength of the Brazilian currency (see recent comments by our Latam metals' analyst, Carlos de Alba, in Latin America Steel: Earnings Cuts Not Over Yet; Risks Still to the Downside, September 30, 2010). But it shouldn't come as a surprise that when import demand is growing at nearly twice the pace of exports, one finds an economy where demand indicators remain strong even as local production begins to slip.
Interestingly enough, Brazil's central bank appears to foresee a larger sustainable current account deficit. In its most recent quarterly inflation report, the central bank argues that neutral interest rate may have enjoyed a "significant reduction", thanks to the macro policies undertaken by the authorities - paying off the IMF debt in 2005, becoming a net public external creditor in 2007, obtaining investment grade in 2008. Those policies have helped reduce Brazil's default risk and have allowed Brazil to obtain more foreign inflows (external savings) and at a lower cost. Hence, with greater access to funding from abroad, an uptick in demand in Brazil can be met with investment (and imports) from abroad, rather than simply more inflation when demand outstrips domestic supply. If you accept the central bank's explanation for why the neutral interest rate has ‘significantly' fallen, it only follows that Brazil's sustainable current account imbalance may have also risen significantly. Of course, a stronger currency will likely erode manufacturing and leave Brazil even more vulnerable to global commodity swings and more dependent on external flows.
Bottom Line
Once the second round of the presidential race is decided at the end of the month, all eyes are likely to shift to who is to set fiscal and monetary policy for the next administration. But don't overlook how the administration deals with the nagging problem of an ever stronger currency. Unless the Fed makes a sharp reversal, we are likely to be in for an extended period of quantitative easing in the US and that is likely to keep pressure on Brazil's currency to strengthen further. Despite all the administrative measures and taxes imposed by the Brazilians during the past eight years, none was so draconian as to reverse the direction in Brazil's currency. We suspect that will be the case for the new administration as well: until the globe turns, Brazil is likely to battle a strengthening currency.
Looking back, the swing in sentiment towards CEEMEA in 2008 was astonishing. Up until around mid-2008, investors looked happy to continue to fund countries which were converging well above their speed limit, courtesy of abundant credit and generous interbank funding from Western European parents (for CEE). While many, including us, warned against the bubble-like characteristics of this surge in inflows and the wide current account gaps that were formed, hardly anyone expected the speed of the correction in external balances to be so brutal. With most CEEMEA economies now back on a path to growth (to varying degrees), we look here at where the crisis left external balances, which countries look more solid from a BoP standpoint, and what we think will happen to current account gaps in the years to come.
Where We've Come from, Where We're Headed to
We start our analysis by dividing the past two years into three periods: The pre-crisis peak in C/A deficits, the crisis trough and the current post-crisis status, which we compare against our forecasts. Since the countries we cover in the Middle East have huge current account surpluses, we excluded those from our analysis and concentrated on CEEMEA excluding GCC. Russia is the only oil-dominant country left in our analysis.
In the pre-crisis period, fast credit-fuelled growth of domestic consumption and imports, as well as sky-high oil prices, translated into current account deficits in most of the CEEMEA region, with CEE showing some extremes (Baltics, Romania), and Russia and Israel being the only exceptions to this rule. Back in the ‘days of exuberance', abundance of global liquidity created a false sense of optimism and trust in the sustainability of high growth and wide current account gaps, as well as the anticipation that structural changes and demographics in EM economies would eventually result in a move towards an improved domestic saving rate. Note that by 2008, CEE had accumulated a C/A deficit of 8% of GDP.
The global liquidity crisis and credit crunch that hit in late 2008 had an immediate impact on funding and current account positions. They shrank domestic demand and imports, leading to a sharp drop in the import bill, also aided by better terms of trade (lower oil prices). All countries in the region went through a massive adjustment in external balances, with notable declines in current account deficits in Romania, Hungary and Turkey, as one might have expected. Russia's surplus declined (on lower oil prices) while Israel's surplus rose further, by 3% of GDP. While ex-post this was an accident waiting to happen, the speed of the adjustment was so brutal that markets were taken by surprise.
The gradual recovery in growth, a moderate but permanent rise in commodity prices and improved credit conditions translated into some renewed widening in current account deficits, a process which in most of the region is still ongoing: Romania, Turkey and South Africa lead the current account deficit pack - although South Africa's current account deficit has declined somewhat recently. At the other extreme, Israel's surplus posted during the crisis should remain elevated in 2011, albeit at a lower level in comparison to 2010. In Russia, we see a lower current account surplus in 2011 on the back of a shrinking trade surplus coupled with a slight widening in the services deficit.
Quality versus Quantity
The current account is possibly the market's favourite vulnerability indicator, as it measures a country's overall funding needs. Indeed, the current account gap can also be expressed as the sum of public sector and private sector savings (i.e., the budget balance and household and corporate savings), so it is a broad measure of funding needs. That said, one clearly ought to look not just at the current account position, but also at the capital and financial accounts, i.e., the funding and its quality.
With such a diverse region, it is clearly problematic to produce a single summary statistic that captures both the current account position and the quality of its funding. A simple intuitive way of doing this is by computing the basic balance (BB), which we define here as the sum of the current account balance and net FDI inflows. A country with a current account deficit which is fully funded by FDI will have a BB equal to zero. The intuition behind this approach is that the higher the BB, the healthier the external accounts, as FDI is viewed as a steadier source of funding than, say, portfolio inflows.
Good FDI - Bad FDI?
There are of course clear limitations to this approach: not all FDI ought to be viewed as stable flows that augment productivity: for instance, speculative purchases of overpriced real estate by non-residents are still classified as FDI, whereas they represent ‘hot money' inflows to a greater extent than bond or equity purchases. Also, in Central Europe the EU flows recorded on the capital account represent more stable flows than FDI in most cases. But as a first approximation, and for consistency reasons, the BB as we define it is a good starting point to gauge fundamentals.
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