The ECB's wake-up call: Seasoned central bank observers certainly felt reminded of the Deutsche Bundesbank's appetite for springing surprises (usually hawkish ones) when ECB President Trichet presented the Council's assessment to the press last Thursday. The message was loud and clear: by dropping the description of policy being "appropriate" and by adopting "strong vigilance", the Council virtually pre-announced a rate hike in April or May at the latest.
Why such Bundesbank-like behaviour, which is very untypical for the ECB under the reign of President Trichet, who usually tries to gently steer market expectations? We think that the Council's genuine worries about rising headline inflation spilling over into inflation expectations and then core inflation and wages are only part of the story. In addition, the ECB probably wanted to send a wake-up call to undercapitalised governments and banks in the euro area. The ECB's credibility, especially in Germany, has been eroded by its ongoing purchases of government bonds and the continued extension of unlimited liquidity to addicted banks. The ECB's dilemma is that as long as governments don't come up with a grand fiscal solution and as long as banks don't have sufficient capital, the ECB will have to keep its unconventional measures in place. So, to reassert its eroding credibility, the ECB probably felt it needed to send a signal that it can still act, though only on interest rates. Our view continues to be that neither the EU Summit later this month nor the bank stress tests will be sufficient to solve the debt crisis, and the ECB's action suggests to us that it shares this concern.
Not just a one-off: Our European team now expects three 25bp rate hikes this year, taking the refi rate to 1.75% at year-end (see ECB Watch: Ready to Act, March 3, 2011). True, President Trichet said that a small hike soon should not be interpreted as the beginning of a series of hikes. However, he said the same when the ECB hiked rates in December 2005, a step that turned out to be exactly that - the first in a series. Note also that ECB Council member Axel Weber yesterday commented that he didn't want to alter market expectations of three rate hikes this year.
A risky endeavour: We see three implications from the ECB's tougher stance for Europe. First, this puts pressure on banks and peripheral governments as their funding costs go up. While the ECB continues to provide unlimited liquidity to banks and is still buying government bonds in ‘dysfunctional' markets, higher rates mean that the liquidity and new funding become more expensive. Together with a (likely) disappointing outcome of the late March EU Summit, this could lead to another intensification of the debt crisis over the coming months.
Second, a hawkish ECB could push the euro significantly higher. In fact, our FX strategists have revised their euro forecasts significantly higher across the board on the back of the ECB surprise (see FX Forecast Changes, March 6, 2011).
Third, higher funding costs for banks combined with a stronger euro increase the downside risks for the European economy, especially in the periphery.
Taking an A out of the AAA liquidity cycle? Moving onto the global ramifications, could a less expansionary ECB policy stance spell the end for the AAA liquidity cycle? Near-zero policy rates and quantitative easing in various forms have produced a sharp rise in global excess liquidity since early 2009, both in mature and in emerging economies. Excess liquidity thus was ample, abundant and augmenting, supporting asset markets and the real economy alike. More recently, growth in excess liquidity in the G3 has slowed, reflecting both a slowing in M1 growth (the numerator) and a pick-up in nominal GDP growth (the denominator). Clearly, rising short rates would tend to further dampen M1 growth in the euro area. At the same time, however, M1 growth in the US has re-accelerated, probably reflecting the very low level of interest rates and the impact of QE2, providing a counterweight to the slowdown in money growth in the euro area. In our view, the global liquidity cycle will only turn once the Fed embarks on a tightening campaign. However, the Fed has a very different approach to dealing with higher commodity prices and their impact on headline inflation to the ECB, which implies that US official rates will likely be left on hold well into next year.
Mars and Venus: The ECB's hawkish turn is yet another illustration of the transatlantic monetary policy divide. This divide is only partly due to different mandates: while the Fed has the dual mandate of promoting both low inflation and employment, the ECB's prime objective is price stability. The ECB and the Fed also differ in their emphasis on headline versus core inflation. While the ECB cares or worries more about headline inflation, which has been pushed higher by energy and food prices recently, the Fed is more focused on core inflation, which, while it appears to have bottomed, is still uncomfortably low. The difference in emphasis is not merely due to diverging philosophies; it also reflects diverging empirical regularities between the EU and the euro area. Put simply, in the US, core inflation typically leads or ‘dominates' headline inflation. By contrast, in the euro area, headline inflation typically leads or ‘dominates' core inflation. In other words, a shock to non-core prices such as energy or food in the euro area is more likely to feed into core inflation than in the US. Why? Labour and product markets in the euro area are still more regulated and less flexible than in the US and wages in some euro regions and sectors are still indexed to inflation, which leads to a propagation of non-core price shocks into core prices and wages. Thus, any given shock to non-core prices requires a bigger monetary response to prevent such propagation. In the US, meanwhile, the Fed can more easily adopt an attitude of ‘rational inaction' in response to the rise in commodity prices, as the pass-through to core prices is more limited.
Where does this leave the inflation merry-go-round? Essentially intact, we think, but probably with fewer members, as the ECB looks likely to get off. It remains intact because the merry-go-round consists of two basic players: the US Fed with its super-expansionary monetary policy, and EM economies, particularly China, importing this stance through US dollar quasi-pegs. Hence, we think the merry-go-round will remain in place until either the Fed removes a meaningful amount of monetary accommodation and/or EM economies allow meaningful appreciation of their currencies against their US dollar. That said, with the euro area likely coming off the merry-go-round, inflation will be less global. Where inflation prevails and where it does not will be an important driver of international relative prices - that is, exchange rates.
Bottom line: The likely ECB tightening this year does not fundamentally alter our view that global liquidity will remain ample, abundant and augmenting, and it is unlikely to materially dampen global inflation pressures. The key to both is the Fed's likely action or, more appropriately, inaction on interest rates for the remainder of this year, and many EM central banks' continued desire to cap currency appreciation vis-à-vis the US dollar. So, even though the Martians have landed in Europe, Venus continues to dominate globally.
Healthier-than-Expected Public Finances
We think that the fiscal deficit is now ‘mechanically' tracking around a £9 billion undershoot compared to the ‘official' OBR (Office of Budget Responsibility) forecast for 2010-11 (the fiscal year ending this month) of £148.5 billion.
Given the trajectory of the deficit, our forecast undershoot of only £6 billion for the fiscal year looks conservative. However, we assume that the scale of deficit improvement seen in January is not going to materialise again in February and March.
Treasury Very Unlikely to Spend All of Any ‘Windfall'
We see any significant increase in spending in this Budget as very unlikely for several reasons, including:
1) Possible downward GDP revisions: With GDP growth having contracted in 4Q, the Bank of England sounding ever closer to raising rates and oil prices rising, we assume that the real GDP growth forecasts for 2011 and 2012 may be revised down a touch, lowering future revenue projections. Hence, even if the OBR tells the Treasury that its projections are likely to show, say, an £8 billion better-than-expected deficit for this year, they are unlikely to show an £8 billion better deficit over the following four years (even before the Treasury has made any decision to spend more).
2) Uncertainty: The Treasury may also wish to take a cautious approach (i.e., not spend all of any ‘windfall'), given the amount of uncertainty around the fiscal projections. The OBR identifies potential output as a key source of uncertainty. From the Autumn Statement: "The biggest economic risk to the achievement of the mandate is the possibility that we may have significantly overestimated the level of economic potential, either now or in the future." The OBR estimates that the output gap would only need to be about 1.5% of GDP smaller than its central estimates to make it more likely than not that the mandate would be missed.
3) Narrative: Although this Budget will have a pro-growth narrative, we assume that the government will not want to risk additional spending being interpreted as backtracking at all on its broader fiscal plans or as acting imprudently. That should limit the proportion of any ‘windfall' being spent.
Our Tentative Central Case Budget Projections
We assume in our tentative central case Budget projections that, once you get towards the end of the projections, the OBR's projections look broadly similar to its last set of forecasts in November 2010. The impact of a better-than-expected starting point for the finances (i.e., a lower-than-expected deficit for 2010-11) is partly offset by a lower GDP assumption. The bulk of any additional spending we assume will be one-off rather than have recurring implications for the public finances.
We tentatively expect the forecasts for PSNB (ex-financial interventions) to show around £143 billion (9.6% of GDP) in 2010-11, £115 billion (7.4%) in 2011-12 and £34 billion (1.9%) in 2014-15. That would be around £6 billion lower than the OBR's current projections for the fiscal year just ending, £2 billion better the following year (assuming around £2-3 billion of additional spending) and around £1 billion better by 2014-15.
Potential Targets for Additional Spending
The government has made clear that this will be a pro-growth budget. Prime Minister Cameron at the Conservative Party Spring Conference used strong language on this: "the Budget...will tear down the barriers of enterprise and be the most pro-growth Budget this country has seen for a generation". It also looks likely that we will see some concession on the scheduled increase in fuel duty (in April) with, at a minimum, a delay until autumn (oil prices depending).
We continue to assume that most of these measures will have a relatively small direct spending implication and more expensive announcements will tend to have one-off financing implications. In further detail on the Budget from Chancellor Osborne in a recent speech: "It will look at planning delays, the new regulations, the bureaucracy and the costs that hold business back and stop jobs getting created." Several measures have been announced so far, including a £100 million investment in enterprise zones (specific local areas which will see tax breaks for example). The Department for Business Innovation and Skills (BIS) has launched a £50 million ‘Growth and Innovation' Fund, that could be used to help deliver training.
The Central Bank of Russia (CBR) faces a classic central banking dilemma between its domestic inflation objective and its exchange rate commitment. The inflation target, for headline inflation Dec 2010 to Dec 2011, was set by the president in his decree enacting the 2011 budget at 6.5%, which has generally been interpreted by the CBR leadership as 6-7% in their public statements.
Inflation set to rise above 10%. After two months of 2011, inflation YTD is running at 3.2%, and annual inflation at 9.5%. Typically in Russia, inflation rises in the first half of the year. Last year, however, inflation slowed from 8% in January to a low of 5.5% in July, due to the lagged effect of the monetary contraction in 2009 and the deflationary impact of the overhang of spare capacity after the crisis. As a result of this base effect, even if the pace of inflation moderates to amount to 6% in the first half of the year, as Prime Minister Putin predicted on March 4, headline annual inflation will rise to 10.5%.
High inflation in Russia is driving down living standards. The high inflation has not triggered an acceleration in wage increases across the board, reflecting slack in the labour market and fiscal constraint. As a result, real wage growth has declined to 0.6%Y in January as inflation rose, and real disposable incomes actually fell by an impressive 5.5%Y, reflecting the impact of the annual increases in the cost of utilities.
CBR and government response. Policy in Russia remains highly accommodative, with policy interest rates and key market rates in the 3-8% range, compared to CPI running at nearly 10% and PPI running at nearly 20%, which means that real interest rates are -2-7% and have declined by 4-5pp since inflation started to rise in summer 2010.
The CBR, concerned about weakness in the economy, has only cautiously tightened policy - a tick up in deposit rates in December, a rise in RRR in January, and a hike in policy rates and RRR in February. However, this has not yet been effective in raising the market rate, because they have been relatively small moves cumulatively, and they have been counteracted by the large supply of excess liquidity.
In addition to interest rates, there are a range of other policies and conditions which should bear down on inflation:
•· Fiscal tightening. The 2011 budget tightened policy by a significant 2% of GDP, led by a rise in excises and social contributions, with significant restraint on expenditure growth.
•· Domestic borrowing. The ambitious plan to raise RUB 1.3 trillion net of the RUB 1.8 trillion deficit on the domestic market would reduce ruble liquidity significantly, and it is currently on track.
•· Ruble appreciation. 2010 imports of US$248 billion were equivalent to 21% of total Russian consumption. The approximate 10% rise in the ruble against the basket since November would therefore translate into a 2% fall in prices, if importers pass on the reduced prices to consumers.
•· Market intervention. The government is pressuring companies - notably oil companies - not to raise prices. Grain exports are banned to July, and grain and sugar stocks have been sold on the domestic market in an effort to restrain prices.
We think these measures on their own will not deliver the inflation target. We expect the fiscal tightening to be undone by a supplementary budget mid-year to spend part of the additional oil revenue, in particular on raising pensions and budget wages. The absorptive impact of the domestic borrowing programme will be muted. In many Russian markets, a few players have significant market power, the result of a lack of competition due to high barriers to entry, and administrative pressure will only work in the short term to reduce price growth. Fundamentally, moreover, the ultimate fuel that drives inflation is growth in the money supply, and a successful policy must tackle this growth.
Inflation is a monetary phenomenon. Inflation in Russia shows a very strong relationship to growth in monetary aggregates with a relatively short 16-month lag. The money supply in Russia, both base and broad, has been growing rapidly, up 27%Y and 23%Y respectively in 2010, and with a bigger-than-normal increase in base money in January after a larger-than-usual December spending surge. The inflationary threat is well represented by the overhang of RUB 1.6 trillion (3.7% of GDP) in ruble liquidity held by commercial banks at the central bank (RUB 633 billion in deposits, RUB 995 billion in correspondent accounts).
In this situation, to reduce inflation and slow the growth of monetary aggregates, the CBR needs to tighten policy.
The CBR has no appetite for dollars. The CBR has given two reasons for delaying tightening policy in recent statements, despite inflation accelerating and spreading from food to core inflation. The first was the weak growth patch, which now seems of diminishing concern, given the increasingly strong results from industry (in January, steel output was up 16%, and in Jan-Feb rail shipments were up 8%, on an annual basis) and net exports. The second, offered in the CBR January statement, was the concern that capital inflows would be attracted by high rates. Our take is that the inflows would require an unpalatable choice - either adjust the exchange rate commitment and let the ruble appreciate, or intervene to buy dollars, which would in turn lead to an expansion in the ruble money supply and counteract the purpose of tightening policy in the first place.
The CBR decision on March 1 to widen the bands around the central rate after a comparatively mild net accumulation of reserves in February means, in our view, that the CBR puts tackling inflation ahead of its exchange rate commitment.
Oil drives the fiscal and external accounts. Oil and gas revenues in 2010 were 46% of total federal budget revenues, and on our estimates a US$1 increase in oil prices currently means RUB 70 billion increase in federal oil and gas revenues (0.16% of GDP). On the external account, the share of energy including oil, petroleum products and gas in total exports was 60% in 2010, and on our estimates a US$1 increase in oil prices adds a net US$1.8 billion to the current account (0.12% of GDP). We estimate the current account surplus at US$70 billion (4% of GDP) at US$96/bbl and US$88 billion (5.2% of GDP) at US$106/bbl this year. Due to instability in North Africa and concerns about supply disruptions, the Urals price surged from US$92/bbl at end-2010 to the current US$113/bbl, driving a 5.3% YTD nominal and 8% YTD real appreciation of the ruble versus EUR/USD basket.
We expect a second ‘tighten-and-widen' package in the next few weeks. We assume that the North African premium stays in the oil price and it remains at its current US$110-115/bbl level for the next couple of months. At this oil price, the strong current account surplus will feed continued pressure for appreciation. Since Russia also needs to tighten policy to put it back on track to hit its inflation target, and reducing inflation has become politically important in the election year, we expect a second ‘tighten-and-widen' package in the next few weeks.
We expect the ruble to climb to 32.5 by the end of 2Q and stay at that level till end-2011, which would mean 1.5% further real appreciation. Assuming that the CBR acts in line with previous behaviour and its statements, we see the CBR widening the intervention bands around the central rate by a further ruble to a six-ruble-wide band against the basket at 31.95-37.95, in effect permitting further appreciation. We expect the ruble to then rapidly climb to the edge of the band of heavy intervention, up to 32.5 by the end of 2Q. Further on, we expect the ruble to stay at that level until end-2011, which would mean 1.5% further real appreciation. Incorporating the recent EUR/USD forecast changes from our global FX team (see G10: FX Forecast Changes, Gabriel de Kock, March 6, 2011), our end-2011 USD/RUB forecast now stands at 27.1.
In tightening, we see a minimum package of a 25bp hike in deposit rates - "the key rate in a situation of excess liquidity" - and RRR in March, if the inflation outturn is reasonable and, if inflation rises, a more aggressive package of a 25bp hike in all policy rates, and a 50bp hike in deposit rates plus a rise in RRR.
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