We don't share these doubts: Our big-picture view on growth remains unchanged from last month (see Global Forecast Snapshots: Global Resilience, April 6, 2011). We are constructive on economic growth; we think the global economy is quite resilient to the shocks we've seen; and we think that this recovery will be quite sustainable because of global rebalancing. Being constructive on growth does not mean we are blindly bullish. We don't believe that global GDP will continue to grow at the 5% snapback pace we saw in 2010. Rather, we expect GDP to moderate to a little over 4% this year (4.2% to be precise) and we look for 4.6% next year. The important point is that we look for global growth to be above its long-term trend rate, which is 3.6% for the last 40 years.
Too young to die: Keep in mind that this global recovery is only two years old - it only started in the middle of 2009. On average, recoveries in the global economy have lasted a little more than six years. The shortest one over the past 40 years took place in the second half of the 1970s and lasted only four years. The longest one was in the 1980s and ended after eight years. Recoveries typically end when major imbalances in an economy have developed and become unsustainable - such as overinvestment in the late 1990s or overconsumption in the late 2000s - and when monetary policy becomes very tight. Neither is true now.
The global economy is relatively resilient: Despite the oil price shock, initial conditions are favourable because household and corporate balance sheets have improved since the financial crisis. Balance sheet clean-up and repair in the private sector has partly come at the expense of the public sector balance sheet, but that's another story. Personal savings rates have increased in former bubble economies like the US and the UK, and corporate profit margins have widened to record highs. This implies that the capacity of both households and companies to absorb shocks from higher oil and commodity prices has increased.
Global monetary and fiscal conditions are still very expansionary: Most governments are shying away from tightening fiscal policy despite large deficits. The global real short-term interest rate is still negative and way below the growth rate of the economy, indicating very easy monetary policies. Long-term interest rates are also very low and have eased further recently. As for the monetary policy tightening in China and other EM countries, we think that much of this is not genuine tightening. For example, the many increases in banks' required reserves imposed by the People's Bank of China are largely aimed at neutralising the hot money inflows that pump up domestic liquidity. This is not a genuine tightening, but rather an attempt to make sure that liquidity doesn't get even more abundant.
Moreover, while many central banks have been raising nominal interest rates, in most cases the increases in policy rates have lagged behind the increase in inflation. So, real rates have eased further in many cases. In short, monetary and fiscal conditions are still very easy around the world and should make the recovery quite resilient for now.
Global rebalancing is a powerful underlying trend: Global rebalancing means that the big consumers in the world economy are becoming savers, the big importers are becoming exporters, the big exporters are becoming importers and the big savers are becoming consumers. Global rebalancing requires new capital spending: the US export sector doesn't have enough capacity and needs to expand - one reason why we have been seeing strong spending on equipment in the US. Conversely, China needs to direct more resources into the domestic economy. So, global capex is likely to be supported over the next several years, and companies have enough cash on their balance sheet to finance this spending. With the global imbalances that built up in the credit-fuelled boom of the 2000s diminishing and global capex being supported, this recovery look set to be more sustainable over time.
Global inflation is our bigger worry: While we are less worried about the growth outlook than most, we continue to worry more than the markets about further upside to inflation as what we've called the global ‘inflation merry-go-round' keeps spinning (see The Global Monetary Analyst: The Inflation Merry-Go-Round, January 26, 2011). Core developed economies and emerging economies' central banks are the drivers behind this merry-go-round. Super-expansionary monetary policy in the mature economies is imported by emerging economies through their US dollar soft or hard pegs. This has been pumping up EM growth and commodity prices and is fuelling EM wage and consumer price inflation. Having gained a toe-hold in EM, inflation is then exported into mature economies through more expensive goods exports. ‘Rationally inactive' central banks in the mature economies accommodate this imported inflation, ultimately risking a domestic inflation take-off.
Financial repression at work: Normally, one would expect an ongoing, sustainable recovery and higher inflation to push bond yields significantly above their current low levels. Paradoxically, however, we think that bond yields will remain relatively low (though not as low as they presently are) despite resilient growth and upside inflation surprises. One reason is that the major central banks' responses to higher inflation will be relatively muted, in our view, given concerns about high unemployment (as in the US) and peripheral sovereign and banking problems (as in the euro area). Thus, real short-term interest rates are likely to remain unusually low for quite some time. Another factor that is likely to put a lid on bond yields is financial repression (see Sovereign Subjects: Ask Not Whether Governments Will Default, but How, August 25, 2010). Economic history is replete with examples of how governments, though taxation and various forms of regulation, have strongly encouraged or forced private and institutional investors to keep buying government bonds at uneconomic prices at times of elevated inflation rates. In these episodes, low or even negative real interest rates helped governments to cope with high public debt levels. This time will be no different, in our view. Regulators are already (for the sake of financial stability) forcing banks, insurance companies and pension funds to increase their holdings of safe government bonds, thus creating a captive investor group. This, together with low short-term interest rates and higher inflation, is likely to promote a prolonged period of very low or even negative real interest rates that should help to make the high and rising public debt bearable for governments.
Risk of fewer hikes than we expect... In our view, the MPC's inflation forecasts look consistent with at least one rate rise this year, compared to our own forecast for two rate rises (August and November). The content and tone of the Inflation Report and press conference continue to suggest that the MPC is (collectively at least) in no hurry to raise rates and Governor King stressed that the big picture had not changed much.
...but more hikes than the market expected: Yesterday, the market appeared to be priced for a bit less than one rise by year-end and rates at around 1.45% by end-2012 (our forecast: 2%). The swathes chart suggests to us that the BoE's median inflation forecast is slightly above 2% after incorporating a ‘market rate' profile. This crudely suggests that the market, if anything, doesn't have quite enough priced in (assuming that the BoE broadly has it about right on GDP and inflation). Further, the ‘market rate' profile incorporated in its inflation forecast has more rate hikes than markets had priced in prior to today's Report (0.8% by end-2011 and 1.7% by end-2012).
Not fully supportive of our rate view, but... The swathes chart looks consistent with at least one, rather than at least two, rate rises this year. However, it is difficult to tell how much higher the bank's inflation forecasts are until the numerical projections are published next week. Further, if wage growth/wage settlements pick up as we expect over the next three months, we still expect the MPC to raise rates in August.
Key trigger for an August rise remains higher wage growth: In our view, the BoE sounded slightly less concerned about persistently high inflation becoming entrenched in wage growth. Hence, we think that a sharp rise would likely prompt particular worry among the MPC.
Our three key takeaways are:
1. The BoE's forecasts show slightly higher inflation pressures over the medium term compared to February, though the message from Governor King was that the big picture hadn't changed much;
2. Assuming the BoE ‘has it about right' on the economy, its inflation forecasts look consistent with expecting at least one rate rise this year from the MPC (and 100bp of rate rises in 2012);
3. There is still a good chance that the first rate rise from the MPC comes in August (our central case).
The numbers below correspond to the charts in Exhibit 3 in the full report.
Chart 1: Inflation fan chart using constant interest rates
Q: How have the BoE's inflation forecasts changed?
A: The MPC's near-term inflation forecasts have been revised up (as well flagged by the MPC). Its medium-term forecasts are also higher. The single most likely outcome for inflation at the two-year horizon (based on unchanged policy) now looks clearly above the 2% target. This suggests to us (all else equal) that we should expect rates to rise this year.
Chart 2: Market interest rates table
Q: How much tightening has the BoE assumed in the other key charts we focus on?
A: The ‘market' interest rate expectations (which underlie the swathes chart and main inflation fan chart) show a 0.7% policy rate in 3Q and 0.8% in 4Q. By the end of 2012, the profile shows the policy rate at 1.7%. This looks lower than our own central forecast (a first 25bp rate rise in August, 1.0% rates by end-2011 and 2.0% by end-2012).
Chart 3: Swathes chart (incorporating ‘market' interest rate expectations)
Q: Is the ‘market interest rate' profile consistent with hitting the inflation target (part 1)?
A: The swathes chart, in our view, now indicates that the MPC thinks the probability of inflation being above target two to three years ahead is slightly above 50%. Hence, this suggests that the MPC's median inflation forecast is slightly above the BoE's 2% target at that horizon, once a ‘market' profile for interest rate rises is incorporated. This suggests that a rate profile with a little more than 0.8% by end-2010 and 1.7% by end-2012 looks reasonable (if you think the MPC has ‘got it broadly right' on the economy).
Chart 4: Inflation fan chart using ‘market' interest rate expectations
Q: Is the ‘market interest rate' profile consistent with hitting the inflation target (part 2)?
A: If the MPC is broadly right on the economy, at face value this chart suggests that the market has a little too much priced in for rate rises. Two to three years ahead, the chart appears to show that the single most likely outcome for inflation (the mode - which lies within the darkest band of the fan chart) is a little below the 2% target.
Chart 5: Snapshot inflation distribution chart
Q: How do we make sense of the apparent difference in message between the two charts mentioned above?
A: Although the single most likely outcome for inflation is just below 2% on the BoE's inflation outlook, it sees the risks as skewed to the upside. This implies that the median forecast (partly deducible from the swathes chart) will be higher than the mode (which lies within the darkest band on the fan chart). The former effectively incorporates an element of risk-adjustment.
We think that the ‘swathes' chart is more important than the fan charts for forecasting monetary policy changes. We think that this view is borne out by past Inflation Reports: If the emphasis had merely been on the darkest band (mode) of the fan chart, the MPC should have been doing more QE. That is because in the fan chart which assumes unchanged monetary policy, this darkest bit of the fan chart was below 2% two years ahead in every Inflation Report between QE ending in February 2010 until the February 2011 report.
Why Do We Expect a First Rate Rise in August?
Our expectation for an August rate rise is driven by three factors. First, we expect to see further signs that inflation is becoming entrenched in expectations. Specifically, we anticipate a significant rise in wage growth/wage settlements and a further uptick in inflation expectations over the coming months. Second, although we anticipate weak GDP growth, we anticipate positive GDP growth in 2Q, released just ahead of the August rate meeting (0.3%Q). A contraction would, in our view, make an August rate rise very unlikely, in our view, almost no matter what had happened to wages and inflation expectations. Third, this Inflation Report makes a 4Q rate rise look more likely than a 3Q rate rise, but still leaves August a significant probability, in our view. For more detail on our rate outlook, see "Why We Still Expect the MPC to Raise Rates in August", The Gilt Edge, May 4, 2011.
What Would Trigger a Later Rise?
The risks to our call for a first rate rise in August are skewed towards a later move. First, the recovery in wage growth may be more gradual. A key indicator for assessing the severity of this risk will be wage settlement data. However, in its March release, the Incomes Data Services, for example, noted that an early look at April suggested that wage growth may be picking up, with most of the deals recorded so far at 3% or higher. Second, the bumpy nature of the recovery may make the MPC hesitant about raising rates in August: we only expect 0.3%Q GDP growth in 2Q. Growth may be dampened further by the late timing of Easter and the additional Royal Wedding bank holiday, if this has led people to take more annual leave during this period than normal. Third, assuming that there are no major surprises for the MPC on growth or inflation over the next three months, its forecasts look consistent with a first rate rise either in 3Q or 4Q.
Our Forecasts versus the BoE's
The BoE's central forecast for GDP growth (the mode) continues to look optimistic compared to our own. Its central forecast for inflation appears similar to our own until late 2012. At that point, our central forecast for inflation looks a little higher. It continues to appear that the MPC places greater weight on spare capacity as a significant drag on inflation over the medium term. The numbers underlying the BoE's forecasts will be published next week alongside the Minutes.
For the accompanying charts, please see the full report.
The headline deficit exceeded forecasts significantly, but there is a reason behind this: Turkey's current account deficit is high and it has been widening decisively over the past year. A deficit of approximately 7.5% of GDP this year is very likely, and we believe that it is fully priced in. With the recent rise in commodity prices, Turkey's C/A came under the spotlight and all numbers are being heavily scrutinised, given the unorthodox monetary policy approach by the CBT. There is nothing new here. However, when the March headline current account deficit came out at a record US$9.8 billion against the expected US$8.2 billion, there was a significant negative reaction in the market and the currency weakened some 1%.
Likely to be a one-off issue: Looking at the details of the balance of payments data, we noticed two issues that made the weak headline number look somewhat less worrisome. First, the income account posted a sharp outflow of US$1.9 billion in March that was highly unusual, reflecting the repatriation of profits (such as dividends) on foreign investors' investments in Turkey. We do not know details of any specific transactions. However, we know that under normal circumstances the monthly reading of this account should have been around US$0.5 billion. Hence, the US$1.4 billion deviation here resulted in the main surprise about the headline. We think that this will be a one-off issue and will not be repeated any time in the near future. Second, foreign direct investment (FDI) posted the highest monthly inflow of the past three years at US$2.6 billion in March, more than offsetting the adverse impact of the outflow posted in the income account. Since there were some banking sector-related transactions in March, we associate this FDI inflow with that. Indeed, there is a possibility that the high FDI inflow and the surprise outflow in the income account might have been related. At any rate, the high FDI inflow is also likely to be a one-off matter, as we do not expect any sizeable FDI transactions to materialise soon.
Looking at the details of the balance of payments, we see the following points to be noteworthy to mention:
1) The headline deficit: At US$9.8 billion, the deficit was a record high, but as we mentioned earlier this is likely to be a one-off matter and will correct starting with April data. That said, even the consensus expectation of US$8.2 billion would be considered a very high monthly print, and it seems clear to us that Turkey's current account deficit is too high. The 12-month rolling current account deficit reached a massive US$60.6 billion (around 7.5% of GDP) and is unlikely to decline any time in the next six months, in our view.
2) The non-energy component of the deficit is reaching worrisome levels and should be addressed more forcefully: It is a fact that Turkey's widening current account deficit had been on the back of rising energy prices. However, with March data at hand, we see the non-energy component also hitting a record-high number (even if the one-off factors are corrected for).
3) FDI inflows reached a 40-month high: At US$2.6 billion, FDI inflows helped financing to a significant extent and was a partial relief to the pain associated with the headline print. However, this is likely to be a one-off jump in the near term and not the beginning of a trend, we think.
4) Portfolio inflows also posted an all-time high: At US$5.2 billion, there was a massive inflow of capital that funded the current account deficit to a significant extent. At first sight, the number might look worrisome and suggest that the deficit was being financed by ‘hot money'. This is not the case, in our view. Out of the US$5.2 billion figure, US$2.2 billion was associated with the recent 10-year Samurai bond issue by the Republic of the Turkey. We would not consider this financing as short term or hot. Hence, this was also a one-off jump, in our view.
5) Net errors went through some revision: The unaccounted flows in the first two months of the year stood at a significant US$5.5 billion. With the March data release these were revised down to US$3.4 billion and spread around certain capital account items. The March net error term was also positive but slightly lower at US$950 million, which brought the 1Q11 cumulative number to US$4.3 billion.
6) Reserve accumulation at record high as well: Overall, despite the record-high current account deficit, the inflows from FDI, portfolio flows and other financing (corporate and banking sector borrowing) were very strong and resulted in a monthly rise of US$3.1 billion in reserves. The 12-month rolling cumulative reserve rise amounted to US$15.8 billion.
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