Resilience in the face of external shocks: We think the global economy is relatively resilient and thus able to absorb the Japan disaster and elevated oil prices for two reasons. First, initial cyclical conditions are favourable: household balance sheets in the former credit bubble economies have improved since the crisis, providing more of a (savings) cushion to dampen the impact of higher energy prices on consumer spending. Also, corporate profit margins are wide following years of relentless cost-cutting, implying that the companies' shock-absorption capacity has risen. Second, the very expansionary global monetary and fiscal policy stance provides ongoing support for the economic expansion. Thus, any shocks hitting the global economy at this early-cycle stage are likely to cause less harm than the same shocks would in a late-cycle expansion where personal savings rates and profit margins are lower and policy already restrictive.
Reacceleration in 2H11: We see growth in the G10 economies rebounding in the second half of this year from a weaker first half, led by the US and Japan. In the US, we ascribe much of the weaker-than-expected first quarter growth to weather distortions. Near-term supply disruptions related to the Japan tragedy may delay some of the forthcoming rebound, but we look for a snapback in GDP growth to about a 4.5% pace in 2H11. In Japan, our team is looking for the recession to give way to a V-shaped recovery starting during the second half of this year thanks to economic stimulus and supply chain normalisation. Europe, by contrast, looks set to defy the reacceleration trend as growth should moderate throughout the year in response to a stronger euro and ECB rate hikes, and our euro area team has made a substantial downward revision to the 2012 outlook. Outside the G10, Chinese growth should pick up steam again in the second half as we expect policy to turn supportive around mid-year.
Rebalancing on track: Rebalancing has long been a cornerstone of our constructive global outlook, and we expect it to remain on track. Our forecasts show current account surplus countries such as China and Germany continuing to transition towards stronger domestic consumption, and deficit countries such as the US and the UK strengthening their export base and manufacturing sectors through higher capex. This bodes well for a more balanced global economy, which should make the expansion more sustainable.
Higher global inflation: While our view on global growth hasn't changed much, our inflation forecast has been revised higher for 2011-12, reflecting higher oil price assumptions (our base case uses the current oil futures curve, for other scenarios see below). We now see global inflation averaging almost 4% this year and 3.4% next year, up from 1.9% in 2009 and 3.3% in 2010. A local peak for inflation still looks likely around mid-2011, reflecting a less expansionary policy stance in EM and ebbing base effects from energy prices. However, we continue to believe that the risks to our team's baseline inflation forecasts are skewed on the upside, especially if our technical assumption of flat to slightly down energy prices based on the futures curve turn out to be too low.
Exiting super-expansionary monetary policies: A key focus for markets over the rest of this year is likely to be timing, pace and modalities of the exit from super-expansionary monetary policies in the US and Europe. The ECB looks set to execute its virtually pre-announced first rate hike this Thursday, and our euro team looks for a total of four quarter-point increases in the refi rate to 2% by this time next year. We expect the Bank of England, torn between sluggish growth and rampant inflation, to wait until August before implementing the first hike. But as ever, the Fed's moves will be most important for markets: we look for QE2 to end in June, followed by a gradual tweaking of the FOMC language during 2H in response to reaccelerating growth, gradually higher core inflation and an improving labour market, paving the way for a first rate increase in 1Q12. Japan will remain an exception as the Bank of Japan will likely keep rates unchanged and expand its quantitative easing measures in order to help facilitate and finance economic reconstruction.
TOAST and BOAST: Two scenarios illustrating the risk/ reward: The uncertainties around the MENA situation and oil markets as well as the implications of the Japan disaster on global supply chains remain high. Therefore, we have run two specific scenarios for oil prices and global trade to illustrate the risk/reward around our baseline economic forecasts.
• TOAST: Our adverse scenario for the global economy assumes that the (Brent) oil price surges to US$140 in the near term and then stays there throughout 2011 and 2012. We also assume that global trade growth falls 5% short of the baseline in both years. TOAST stands for Tough Oil And Soggy Trade. The result, on our estimates, would be a serious bout of stagflation. Global GDP growth would fall about one percentage point below our baseline forecast in both 2011-12 (3.2% and 3.6%, respectively), and inflation would turn out to be about one percentage point higher (4.8% and 4.5%, respectively). Trade- and oil-dependent AXJ countries and Europe would be hit disproportionally hard.
• BOAST: Our favourable scenario assumes that the (Brent) oil price eases to US$90 in the near term and stays there, and global trade growth is 5% above baseline in 2011-2012. BOAST stands for Benign Oil And Surging Trade. The result would be global GDP growth at 4.8% this year (0.6pp above baseline) and a hefty 5.4% (0.8pp above baseline) in 2012, with China and India displaying double-digit growth rates. Global inflation would drop by only 0.5pp below baseline as lower energy prices would be partially offset by higher core inflation due to dwindling slack in the economy.
Asymmetric impact...It is worth noting that, according to our team's estimates, the two symmetric shocks we assume (+/- US$25 on the oil price and +/- 5% on global trade growth) would have an asymmetric impact on growth and inflation: from current levels, higher oil and lower trade would do more harm than lower oil and higher trade of the same magnitude would do good. The reason for this could be that consumers and companies may not expect oil prices to remain at their current elevated levels, but assume that this is just a temporary spike. So, if oil eases back to US$90, the positive impact on growth and inflation may be limited. Conversely, a surge to US$140, which would disappoint built-in expectations for mean-reversion, could trigger a significantly stronger response in demand and inflation.
...and asymmetric policy responses: Another interesting asymmetry would be the likely policy responses by the Fed and the ECB in the TOAST and BOAST scenarios. Our US team thinks that in the stagflationary TOAST scenario the Fed would hike rates by less in 2012 (to 1%) than in its main scenario (which has the fed funds rate going to 2.5% by end-2012). By contrast, our European team thinks the ECB would raise rates by more in the stagflationary TOAST scenario (to 2.5%) than in its main case (2%). Consequently, the hit to growth in the euro area in the TOAST scenario would be larger than in the US. Conversely, in the bullish BOAST scenario of lower oil and inflation and higher trade and growth, the Fed would raise rates by more than in our base scenario, while the ECB would hike rates by less.
We are cutting our GDP estimates for 2012 by half a point, at the same time we are raising 2011 a bit. On the back of earlier-than-expected ECB rate increases and a higher-than-expected exchange rate, we are cutting our 2012 GDP forecast from 1.7% to 1.2%. At the same time, the stronger-than-expected momentum in the first few months of this year causes us to raise our 2011 estimate from 1.5% to 1.7%. Contrary to our previous forecasts and the current consensus estimates, we are now looking for a deceleration in the growth momentum, not a small acceleration. The forecast change puts us meaningfully below the consensus for next year, which still sits at 1.7%, and makes us the most bearish house on the Street.
More than the absolute numbers we are forecasting, we would stress the change in direction for growth. In our view, we could be close to a turning point in the forecasting cycle. We would expect more forecasters to start to bring down their 2012 numbers in the coming months. Such a turnaround in the forecasting cycle, where until now forecast revisions were only on the upside, likely matters more to investors than the point estimates. More forecasters bringing down their estimates will likely trigger a debate on the sustainability of the euro area recovery, thus creating fresh headwinds for risk assets in 2H. This would reinforce the view of our equity strategy team that European equity markets will likely experience a more difficult second half this year (see European Strategy: Three Risks in the Next Stage of the Cycle, February 14, 2011). Similarly, our credit strategy team would dial down the exposure to high yield credit in the face of ECB rate hikes and instead stay close to selective investment grade names (see European Credit Strategy: Taking a Hike, March 11, 2011).
The main reason for us lowering our 2012 forecasts is the combination of early ECB rate hikes and a stronger appreciation in the euro this year. We had changed our view on the ECB and the euro in early March on the back of the surprisingly hawkish ECB press conference in which ECB President Trichet strongly hinted at the Governing Council being willing to pull the trigger at the April meeting (see ECB Watch: Ready to Act, March 3, 2011). At the time, we changed our ECB call from no rate hike this year to 75bp before year-end. This unprecedented step in which the ECB, for the first time ever, will hike interest rates before the Federal Reserve (something that even the Bundesbank never dared) caused our FX team to nudge its euro forecasts up markedly (see G10: FX Forecast Changes, March 6, 2011, and FX Pulse: Hiking Season, March 17, 2011). Neither of these two changes was yet incorporated in our baseline forecasts. In addition, we had to incorporate the latest upward move in the price of oil. Modeling the impact of these changes in the assumptions underlying our forecasts, we estimate the impact to be felt most strongly in late 2011 and early 2012. In addition, the global economics team was re-running their forecasts to incorporate the latest policy actions, commodity price movements and the recent events in Japan (see Global Forecast Snapshots: Global Resilience, April 6, 2011).
Both domestic demand and export dynamics hit. The downward revision in our headline GDP forecast in 2012 largely stems from the expected deceleration in the dynamics in late 2011 and early 2012. The delayed impact is due to the time lags with which changes in interest rates and the currency typically affect economic activity. While the euro obviously is primarily working through the growth contribution of net exports, the higher interest rates are primarily affecting domestic demand (notably investment spending). To a lesser degree, we expect negative repercussions for consumer spending growth. But clearly consumer spending growth is already being hit by fiscal austerity and higher commodity prices (including oil prices).
Thus far, the impact of the events in Japan on Europe has been relatively muted in terms of direct economic linkages. It is important to bear in mind that Japan only takes 2.2% of the euro area exports and the euro area only buys 3.3% of its imports in Japan. If anything, the incoming activity data that we keep feeding into our GDP indicators are still pointing to small upside risks to our 1Q GDP estimate, even after we raise our estimate from 0.4%Q to 0.6%Q (or from 1.6% to 2.3% in annualised terms). Even the potential supply chain disruptions seem to be smaller than initially feared. Hence, the main impact of the events in Japan on Europe might eventually be that several governments are rethinking their energy policy, something that could potentially exacerbate the impact of the current commodity price shock - e.g., in Germany where the government has imposed a moratorium on its nuclear power stations.
In our view, the inflation outlook in the euro area remains a relatively benign one over the medium term. On our forecasts, headline inflation will likely average 2.3% this year but then ease back to 1.8% next year. Core inflation pressures are likely to remain subdued, given the muted increase in unit labour costs we are forecasting. In our view, companies still have very limited pricing power and trade unions in the euro area still have limited bargaining power. True, there are some exceptions, notably in Germany, but these exceptions tend to be for sectors with considerable international exposure and strong productivity gains rather than domestic service-oriented sectors. With monthly headline inflation numbers likely to ease back to low readings such as 1.5% in the middle of next year, on our forecasts, we believe that the ECB is likely to decide to put its tightening campaign on hold for a while at that time.
ECB likely to pause its tightening cycle in 2012. Against the backdrop of a renewed deceleration in growth and an inflation rate that is back below the price stability ceiling, we expect the ECB to pause its tightening campaign in the spring of 2012. Until then, however, we expect the ECB to raise the refi rate by a total of 100bp, starting with a first move at the April Governing Council meeting. Initially, we believe the main motivation for the ECB's desire to tighten monetary policy is to remove the emergency element from the extremely low level of its official policy rate at present. Our 2011 forecast is very close to what the money markets are pricing in for the ECB policy action. Only once the refi rate is back at around 2% is the ECB is likely to become more data-dependent again. At this stage, we expect the bank to acknowledge the dip in growth and hit the pause button. With the ECB in tightening mode for the next 12 months, we also see government bond yields moving higher and expect 10-year Bund yields to rise towards 3.75% by next spring. This compares to a current yield for 10-year Bunds of 3.4%. Like our interest rate strategy team, we think that two-year yields have further to rise, causing the 2-10s curve to flatten but still stay steeper than it has done historically in a tightening cycle (see European Interest Rate Strategist: Separation Principle in Practice, March 4, 2011).
Peripheral pain likely to rise further once growth loses momentum. A renewed deceleration in growth across the euro area will likely cause additional pressure in the periphery, we think. Slower growth will make it even harder for Finance Ministers to achieve their ambitious budget targets, be it within strict IMF/EU adjustment programmes (Greece, Ireland) or under the Stability and Growth Pact commitments. Further, fiscal stabilisers are unlikely to be allowed to adjust fully to cushion against the impact of slower growth, given that public finances are already under severe pressure. Finally, higher interest rates and bond yields in the core could also contribute to funding pressures in the periphery.
To get an idea of the country impact of the combination of early ECB rate hikes and a stronger euro, we looked at the macroeconometric models developed by the central banks that - together with the ECB - form the Eurosystem and hence are estimated in a consistent, like-for-like fashion. We feed these models with two different shocks: an ECB rate increase by 100bp and an appreciation of the euro by 10% in trade-weighted terms. Note that these estimates are only providing some broad-brush guidance. As such, the models are only one factor that we take into consideration when running our forecasts for the individual euro area countries.
The countries that are further to the left and further to the bottom in Exhibit 5 in the full report will be hit harder by higher ECB rates and a stronger euro. Note that the shocks are estimated separately so, to get the impact of a combined shock, we need to add up the values depicted in the chart; e.g., for the euro area the total impact would be -0.9% (of which 0.22% is the impact of the higher rates and 0.7% is the impact of the stronger euro). This provides only a very crude approximation though, given that these developments are usually not additive.
We find that France, Belgium and, surprisingly, Portugal, have historically been more resilient than the euro area average to these two shocks. The closer a country is positioned to the upper right hand corner, the more ‘bullet-proof' it is against these shocks. In Portugal, however, this largely seems to be a timing issue for after two years, Portugal feels the impact of an ECB rate hike much more than the euro area average. This is what one would expect, given the elevated level of leverage in the private sector in Portugal and the widespread use of variable rate mortgages.
Vice versa, Germany, Greece and Finland have been more sensitive than the euro area average to changes in interest rates and exchange rates. For Germany and Finland, this will likely be a reflection of their large industrial sector and specialisations in cyclical sectors. At the current juncture, both countries should benefit from their underlying strength and the improvements in cost-competitiveness over the last few years. Germany is one of the countries for which we forecast a rather steep deceleration in growth, from 2.6% to 1.6% over 2011/12.
Finally, several countries - including Spain and Italy - are very close to the euro area in terms of their sensitivity to these two shocks. For Italy, this is largely a timing issue as Italy will start to feel the impact of higher interest rates much more after two years. Spain, however, at least historically also after year two is still close to the average impact on the euro area. These estimates for Spain are encouraging and would seem to support our view that Spain is different to other peripheral countries (see Spain Economics: On the Mend, March 7, 2011). We would caution though that the Spanish economy today is much more leveraged than it was during the time period in which these models have been estimated, and variable-rate mortgages now account for 90% of mortgages.
Last but not least, we would highlight that Ireland is less sensitive to euro gyrations than the euro area as a whole. While it is not much more sensitive to interest rate changes in the first year, it also feels more of a pinch in year two. In addition, the same caveats for Spain also apply to Ireland. One difference though is that variable-rate mortgages only account for 67% of the housing debt and Irish banks already started to raise mortgage interest rates a year ago despite the policy rate still being unchanged at 1%.
For full details, see European Economics: Clouds Gathering Over Growth Outlook, April 7, 2011.
The ‘output gap' measures spare capacity: The output gap measures the amount of spare capacity in the economy. It is the difference between the actual level of output (GDP) and the ‘potential' level of output. ‘Potential' is the (unobserved) maximum level of output that could be produced without putting so much pressure on resources that it bids up the prices of those resources and creates inflation.
The gap is highly uncertain: Estimating the current output gap is no easy task. There is no official estimate of the output gap (unlike GDP) and there is no single accepted method of measuring the gap. A variety of approaches exist and all suffer different drawbacks. The three most common methods are: i) to assume that potential output is a smoother version of actual output (GDP); ii) to estimate potential output by measuring the amount of resources available (e.g., machinery, labour, etc.); and iii) to estimate the gap using measures of spare capacity from business surveys.
As a result, estimates of the output gap are prone to revision: The best estimate of the gap, for a given quarter, may change over time. That's because over time we learn more about that quarter, actual GDP will be revised, and this information can be used to improve the estimate of the gap. Additionally, information about previous and subsequent quarters will put that period into better perspective.
The ‘real-time' uncertainty shows the OECD's estimate of the UK's output gap (the percentage difference between actual output and potential output) in December 2008, then again in December 2009 and lastly in December 2010. Each December, the OECD has re-estimated the output gap. Over just a three-year period, it has made quite large changes to its best estimate of the gap. The revisions are particularly large at the end of the sample, where the OECD is forecasting the output gap and information about these periods is very limited.
Where's the gap now? Current estimates of the output gap vary widely. In the government's recent Budget, the OBR predicted an output gap of -3.9% in 2011 (i.e., actual output will be 3.9% below potential output, suggesting a substantial amount of spare capacity). Predictions from city and non-city forecasters (collected by the Treasury in March) ranged from -0.4% (suggesting almost no spare capacity) to -5.9% (indicating a lot of spare capacity). The median was -2.8%. Our own preliminary work points to a relatively smaller amount of spare capacity than predicted by the OBR, but our estimates vary substantially depending on the technique used.
The financial crisis has likely lowered potential output, but the extent of damage is still unclear - this adds to the ‘normal' level of uncertainty around the output gap: The financial crisis had a profound impact on actual output (GDP). In our view, it has also likely damaged the potential level of output (and the rate at which it is likely to grow). Broadly, potential output can be thought of as being the product of three inputs: 1) the amount of capital (e.g., machinery); 2) the amount of labour; and 3) the productivity with which capital and labour can be combined. Below, we briefly list how the financial crisis may have affected each input:
1. Capital: Growth in the capital stock (e.g., machinery) was dampened by the large fall in investment (in part due to impaired credit availability) and increased rates of capital scrapping (as a result of companies going out of business).
2. Labour: Unemployment has risen, which can lead to skill deterioration (particularly among the long-term unemployed) and may increase the number who become discouraged and drop out of the labour force.
3. Productivity: The crisis has triggered a shift in the source of the UK's growth, away from construction and the financial sector towards manufacturing. Reallocating resources towards these new, faster-growing sectors takes time and may, in the interim, lower productivity.
The greater the damage to potential from the crisis, the smaller the amount of spare capacity (all else unchanged).
The gap has become critically important to the government's fiscal mandate: Given the difficulty in ‘gauging the gap', it is tempting to ignore it altogether. However, the output gap plays a key role in judging the success of fiscal policy. That's because the government's fiscal mandate (adopted last year) depends upon the output gap. Its mandate is to achieve a cyclically adjusted current balance by the end of the rolling, five-year forecast period (2015-16). The cyclically adjusted current balance is the structural balance (or structural deficit) - it's that part of the balance (deficit) that cannot be attributed to the relative strength or weakness of the economy. It is estimated by adjusting the balance by the output gap.
The government looks ‘on track' to meet its mandate: In the latest Budget, the OBR judged that the government has a greater than 50% probability of eliminating the structural deficit by 2015-16.
But a small revision to the current output gap could throw the government ‘off track': In the latest Budget, the OBR estimated that the output gap was around -3% in 3Q10. It conducted a sensitivity analysis and found that this starting point for the output gap would only need to be approximately -1.5% for it to be more likely than not that the mandate would be missed. In our view, this is not a particularly large revision compared to the OECD estimates, and when compared to the large range of estimates among consensus.
We lean towards there being slightly less spare capacity than the OBR predicts. If the output gap was subsequently revised to -1.5% (or higher), then it would imply that further fiscal consolidation should have been undertaken (assuming no change in the deficit itself).
The OBR has acknowledged the large uncertainty around its predictions of the output gap. In November, it noted that "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". A lower level of potential would mean less spare capacity and a larger structural deficit (assuming the deficit itself stayed unchanged).
Uncertainty around the output gap may reduce the effectiveness of the mandate: Uncertainty around the output gap may impair assessments of how the government has performed relative to its mandate. A recent paper, which compared estimates of the structural balance at different points in time for OECD countries, found that the balances are subject to large revisions over time and that an important cause was revisions to the output gap. The authors conclude that the current estimates of the structural balances have low power at predicting fiscal slippages. This means that in years to come, when the current output gap is hopefully a little less uncertain, we may find that the government was substantially more or less likely to hit its mandate than current forecasts suggest.
Mis-measuring the output gap can also lead to mistakes in monetary policy: The output gap provides a gauge of inflationary pressure and so is an important input to monetary policy. The greater the amount of spare capacity (i.e., the more negative the output gap), the more downward pressure on inflation. Research by staff at the Bank of England found that, at times, the output gap has been subject to "substantial measurement error". The authors estimate that in the 1970s and 1980s UK policy-makers at the time thought that the level of output was respectively 7 and 5 percentage points further below potential than now appears to be the case. Their simulations suggest that, as a result of these output gap measurement errors, average UK inflation was 2-7pp higher in the 1970s, and 1-5.5pp higher in the 1980s.
Large degree of uncertainty on the MPC over the size of the output gap and its impact on inflation: Uncertainty over the size of the output gap and its impact on inflation are two reasons, in our opinion, for the unprecedented range of views among the current Monetary Policy Committee (MPC). At present, the nine-member committee favour, among them, four different policy settings.
At one end, Andrew Sentance favours a 50bp increase in the Bank Rate and no extension to the Quantitative Easing programme. In a recent speech entitled Ten Reasons to Tighten, Sentance gave "spare capacity and the labour market" as reason six. He points to survey measures which suggest relatively little spare capacity and the relatively low level of unemployment (compared to previous recessions). Accordingly, he is "not expecting to see much dampening impact of inflation from capacity pressures looking ahead".
At the other end is Adam Posen, who favours no increase in the Bank Rate and a £50 billion extension to the QE programme. He estimates that the output gap is "at least 3% of GDP, and probably above 4%". He considers that there has been only "minimal diminishment" in potential trend growth and that the "UK economy could grow faster for longer without generating inflation from overheating". He has quipped that workforces of the advanced economies did not wake up one morning and find that their left arms had disappeared.
Our own view on capacity aligns more closely to Sentance's. Even though the financial crisis did not ‘lop off any left arms', it still may have substantially lowered the level and growth rate of potential output (which, all else unchanged, would imply less spare capacity). Partly because of this, we remain concerned about upside risks to inflation over the medium term, and in contrast to the BoE, we do not see CPI inflation falling below the 2% target in 2012.
2003: The more (less) transparent, the less (more) predictable: In 2003, (our now chief economist) Joachim Fels looked at the relative predictability of the interest rate actions of the BoE, ECB and the Fed (see A Tale of Three Central Banks, July 21, 2003). His observations included that, although the BoE was the "Rolls Royce of central banks in terms of transparency", it was also the least predictable of the three central banks. Between January 1999 and July 2003, in Reuters interest rate polls, participants only predicted 10 out of the 17 interest rate changes - 59%. That contrasts with a near-perfect record for the Fed, while ECB watchers had got 67% of the moves right and, further, the ECB was becoming increasingly predictable.
We look at how this story has changed since 2003, focusing on the comparison between the ECB and the BoE and again relying on Reuters polling data. For the purposes of this exercise, we do not analyse predictions of QE and other ‘unconventional measures'.
2003 to present: BoE predictability improves, but still lags the ECB: BoE predictability has improved sharply since the 1999-2003 period, measured in terms of the number of times Reuters poll participants have correctly predicted interest rate moves (counting a prediction as correct if the direction has been correctly predicted rather than necessarily the size of the move). Consensus was right 85% of the time compared to 59% in the earlier time period. However, that still lags the record of ECB watchers at 94% for the more recent period.
Reasons why BoE predictability might have improved: We see several possible explanations:
1. Reflection of the economic backdrop and greater ‘agreement': Some of the improvement in predictability may of course be a bit ‘spurious', helped by the fact that for the Bank of England, six out of the 20 rate changes seen between August 2003 and March 2011 were seen between October 2008 and March 2009 when the case for cutting rates was probably stronger than at any point since 1999 (when our analysis starts). It is certainly the case that there seems to have been a greater degree of agreement on the MPC over the later period, with the vote split on fewer occasions since 2003.
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